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The Dangers Of Over-Diversifying Your Portfolio
Weve all heard the financial experts expound on the benefits of diversification, and its not just talk; a personal stock portfolio must be diversified to some degree. After all, none of us wishes to put all our eggs in one basket and expose ourselves to the inherent risk of holding only one stock. But can you go too far in spreading your bet? Indeed you can. Here well show you how investors tend to become overdiversified and how you can maintain an appropriate balance.
What Is Diversification?
When we talk about diversification in a stock portfolio , were referring to the attempt by the investor to reduce exposure to risk by investing in various companies across different sectors, industries or even countries. Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works, but to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility. This is because different industries and sectors dont move up and down at the same time or at the same rate - if you mix things up in your portfolio, youre less likely to experience major drops, because when some sectors experience tough times, others may be thriving. This provides for a more consistent overall portfolio performance. (For background reading, see The Importance of Diversification.)
That said, its important to remember that no matter how diversified your portfolio is, your risk can never be eliminated. You can reduce risk associated with individual stocks (what academics call unsystematic risk), but there are inherent market risks (systematic risk) that affect nearly every stock. No amount of diversification can prevent that.
Can We Diversify Away Unsystematic Risk?
The generally accepted way to measure risk is by looking at volatility levels. That is, the more sharply a stock or portfolio moves within a period of time, the riskier that asset is. A statistical concept called standard deviation is used to measure volatility. So, for the sake of this article you can think of standard deviation as meaning risk.
According to the modern portfolio theory, youd come very close to achieving optimal diversity after adding about the 20th stock to your portfolio. In Edwin J. Elton and Martin J. Grubers book Modern Portfolio Theory and Investment Analysis, they conclude that the average standard deviation (risk) of a portfolio of one stock was 49.2%, while increasing the number of stocks in the average well-balanced portfolio could reduce the portfolios standard deviation to a maximum of 19.2% (this number represents market risk). However, they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolios risk by about 0.8%, while the first 20 stocks reduced the portfolios risk by 29.2% (49.2%-20%).
Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldnt be farther from the truth. There is strong evidence that you can only reduce your risk to a certain point at which there is no further benefit from diversification.
True Diversification
The study mentioned above isnt suggesting that buying any 20 stocks equates with optimum diversification. Note from our original explanation of diversification that you need to buy stocks that are different from each other whether by company size, industry, sector, country, etc. Put in financial parlance, this means you are buying stocks that are uncorrelated – stocks that move in different directions during different times.
As well, note that this article is only talking about diversification within your stock portfolio. A persons overall portfolio should also diversify among different asset classes, meaning allocating a certain percentage to bonds, commodities, real estate, alternative assets and so on.
Mutual Funds
Owning a mutual fund that invests in 100 companies doesnt necessarily mean that you are at optimum diversification either. Many mutual funds are sector specific, so owning a telecom or healthcare mutual fund means you are diversified within that industry, but because of the high correlation between movements in stocks prices within an industry, you are not diversified to the extent you could be by investing across various industries and sectors. Balanced funds offer better risk protection than a sector-specific mutual fund because they own 100 or more stocks across the entire market.
Many mutual fund holders also suffer from being over-diversified. Some funds, especially the larger ones, have so many assets (i.e. cash to invest) that they have to hold literally hundreds of stocks and consequently, so are you. In some cases this makes it nearly impossible for the fund to outperform indexes - the whole reason you invested in the fund and are paying the fund manager a management fee.
Conclusion
Diversification is like ice cream: its good, but only in reasonable quantities.
The common consensus is that a well-balanced portfolio with approximately 20 stocks diversifies away the maximum amount of market risk. Owning additional stocks takes away the potential of big gainers significantly impacting your bottom line, as is the case with large mutual funds investing in hundreds of stocks. According to Warren Buffett: wide diversification is only required when investors do not understand what they are doing. In other words, if you diversify too much, you might not lose much, but you wont gain much either.
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States have their own requirements for finding and claiming unclaimed property. If you believe you have unclaimed property, the state will require you to send them information about yourself to verify your ownership of the unclaimed property. After verifying your ownership, the state will either mail you a claim form or permit you to fill out the form online and print it for submission to the state.
Only new information will affect the price. Judging from the reaction of many stocks to news events, there seems to be evidence to support this case.
Information Overload: How It Hurts Investors
Our information-based society is often plagued with excess. There are many areas of everyday life in which information overload prevails, but the investment sector may well be where the consequences are the most serious. And the less financial knowledge and understanding people have, the worse they cope.
Information Overload Leads to Bad Decisions and Passivity
An important investigation on this very issue by Julie Agnew and Lisa Szykman (both professors at the Mason School of Business, Williamsburg, VA), published in the Journal of Behavioral Finance (2004), reveals that people with a low level of financial knowledge suffer particularly from overload, which leads them to take the path of least resistance, the default option in defined contribution retirement plans. Many are simply overwhelmed and cannot cope at all. (For a related reading, see Taking A Chance On Behavioral Finance.)
TUTORIAL: Behavioral Finance Use Investment Information Effectively
For a lot of people, financial security and peace of mind depend on making the right financial decisions now and in the future. Yet, there is growing evidence that far too many individuals make very poor decisions, and many cannot be described as making decisions at all.
While some investors inevitably have too little information, others have too much, which leads to panic and either bad decisions or trusting the wrong people. When people are exposed to too much information, they tend to withdraw from the decision-making process and reduce their efforts. (A lack of information, which one could call underload can have the same result, by the way, and is certainly just as dangerous).
In other words, simply providing people with information about investment options, may not be enough to produce rational and sound decisions. Investment information needs not only to be sufficient without being overwhelming, it also needs to be easy to use, and actually be used. This is a very real problem with potentially dreadful consequences. (To learn more, see Financial Media 4-1-1 For Investors.)
The Specific Causes of Overload
Agnew and Szykman tell us that there are three main causes of information overload. One is pure quantity. The second is having too many options (although too few is also bad), and the third factor is option similarity. If everything seems the same, differentiating one alternative from another is confusing and difficult. Well use their findings to extend to general investors rather than simply DC plan contributors.
Also important in the use of information is the investors level of financial knowledge. That is, knowledge which is directly relevant to the investment process. Theoretical economic or general business knowledge may be no help at all, being too removed from the nuts and bolts of money management. We are talking here about an awareness of how investment should be done in practice, what works and what does not.
The research indicates that many investors dont even have a basic understanding of financial concepts. This applies more to those who earn less. Not surprisingly, people who have never had much money, have had little practice in investing it. For this reason, someone who suddenly wins the lottery or inherits is often at a loss, initially metaphorically and then, not uncommonly, literally. (For a related reading, see Do Financial Decisions Get Better With Age?)
Consequences of Overload: Asset Misallocation
Floundering in a maze of information opens people up to misselling. Namely, getting really lousy, unsuitable investments foisted on them. These may be too risky, too conservative or insufficiently undiversified, to name just three of the classic horrors. In short, investors land up with investments that are lucrative only for the seller, or which are simply easy to sell and no trouble to manage.
In their experiment, Agnew and Szykman found that people who were not coping with the investment information just went for the default option, which was easiest to do. They did not bother to find out what is really best for them. In the real world of investment, this is truly dangerous. An investment that is totally devoid of risk, just cash, for instance, really does not pay off in the long run. This option may lead to an inadequate retirement fund, and almost everyone should have some equities.
By contrast, having too many stocks or weird, exotic funds, assets and certificates, is extremely volatile and can win or lose you a fortune. Most investors do not want such risks, and are often unaware that they are taking them – until disaster strikes. This kind of portfolio can lead to wealth, if you are lucky, and poverty if you are not. For most people, it is not worth the gamble, neither psychologically nor financially. (To learn more, see Achieving Optimal Asset Allocation.)
Coping with Information Overload
This can be done from both sides of the market. Brokers, banks and so on, need to ensure that they only provide investors with what they really need to know, and it must be simple to understand. The point is that the average investor needs to be informed sufficiently (but no more) on what will help them make the right decisions. There is a clear optimum, beyond which dysfunctional overload occurs, and of course, too little is just as bad. It is also absolutely essential for the sell side to ensure that the information is understood and converted into the appropriate investment decisions.
If investors themselves find they are being swamped with information, and truly do not have the skills or time to figure it out and use it, they need to go back to the seller and ask for concise information that they can use. If this fails to be provided, it is probably best to take ones money and business elsewhere.
Investors themselves do need to make an effort to find out what is appropriate for them. As indicated above, this can be daunting, but for this reason, sellers and regulators need to get the message across that the more they learn and the more they know, the safer the investment process.
There are inevitably some people who just cannot or will not understand the information and use it. This may be due to a lack of education or a phobia about money, and some people are just not prepared to bother with their money. Such individuals do then need some sort of independent advisor whom they can trust. (For more, see Advice For Finding The Best Advisor.)
Conclusion
An important research project from the Mason School of Business in Virginia informs us of the very serious problem of information overload (or the converse of underload) in the financial services industry. Ensuring that investors have an optimal amount of information that they can (and do) understand, and really use as a basis for decision making, is easier said than done. But it must be done; both the industry and investors themselves need to be proactive in solving the problem. The variety of potential investments, and the evolving nature of the relevant markets means that an ongoing, reciprocal and productive process of information provision and utilization is absolutely fundamental to peoples financial future and peace of mind.
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Signals that are available on candlestick charts may not appear on bar charts.
OTC Markets Group Inc. (“OTC Markets”) identifies securities with a Caveat Emptor symbol to inform investors that, in OTC Markets’ opinion, there is reason to exercise additional care and perform thorough due diligence in making investment decisions for a particular security.
Finding The Right Trading Coach
If you have ever thought about getting a trading coach or trading program, or bought a book about trading, this topic may have crossed your mind. If the coach knows so much about trading, why is he or she teaching others? This is an interesting question and relates to the old adage: Those that cant ... teach. Meaning those who were unsuccessful at an endeavor move to the teaching realm to coach others. Many people dont like the idea that a trader who cant make big money should be teaching others. But does your coachs personal success really matter? In other words, is a full-time trader in a better position to help you than someone who no longer trades or has never traded? When we break down the pros and cons you may realize you werent giving some people the credibility they deserve, and were possibly giving too much credit to others. (For general investment information refer to Top 10 Commandments Of Investing.) Arguments for Both Sides
A coach who is a trader will claim to have definite advantage over someone who doesnt trade. This may be true if the coach has the track record to back this claim up, but just because a person is successful at trading does not mean he or she can effectively relay that skill to someone else.
On the other hand, a coach who no longer trades can still provide great benefit if he or she is an effective teacher . A non-trader coach may have been successful as a trader in the past, but has chosen to give up trading. The reasons for this are numerous: some traders prefer coaching to trading, have found trading too stressful, want to help others or have already succeeded and want a new challenge, to list but a few potential reasons. However, it may also be that the trader has failed miserably. At first it may seem that this person would not be a good coach, but this is not necessarily true; we can learn a lot from other peoples failures. In addition, even though someone was unable not implement a certain system themselves due to lack of discipline, psychological or physiological reasons, this does not mean that a different person cant be successful using the same method.
Both sides can likely agree on the fact that in order to coach someone else, a teacher needs to have experience in what students will go through. Essentially, coaches must have market experience in some form or another. The coach needs to know what hurdles students will have to go over, and be able to help them navigate through those obstacles. This does not mean they need to have traded personally, but they will at least have to have been in an environment where they witnessed others trading. Observation can be a great teacher that can lead to the teaching of others.
A Deeper Look
On both sides of the argument there are examples of traders being great and horrible coaches, as well as coaches who no longer trade (or never did) that are fantastic. Think for a moment about a sport. The athletes who play professional sports are the best athletes in the world, and yet they are often coached by someone who has inferior skill. This is OK, because the coach is there to help hone another persons skills. Just because coaches dont have the qualities of a peak performance athlete does not mean they cant pick out and elevate those qualities in others. On the flip side, we have had some amazing talents who could not and cannot effectively pass on whatever it was that made them great athletes.
When we look at trading, or investing , much worth is placed in those who dont actually trade the markets professionally. Market analysts gauge the market using varying tools and methods and relay that information to others. While many analysts may not be traders, some are often very accurate in their market analysis. Having a birds eye view of the unfolding situation allows them to make predictions without an investment in the outcome. These insights are helpful to many traders, even though the information comes from someone who may have never placed a trade.
Never having placed a trade does pose a problem for the trader. The market is constantly moving, and while an analyst may be able to anticipate the direction and magnitude of a move, the gyrations along the way can have the power to wipe a trader out if he or she executes a move at the wrong time. In this case, a student trader would benefit from having the information constructed into something tradeable by a trading coach.
How to Find a Good Coach
With arguments on both sides, there is no hard-and-fast rule when it comes to which is better. The bottom line is whether someone gets you the knowledge and skills that you want. If the coach is teaching you in a way you understand and you feel you are getting your moneys worth, that is what counts.
Trading and coaching is a business. Coaches need to recruit students - this is how they make money . Therefore, sales pitches abound across media sources. When seeking to improve your trading, this can be overwhelming. That said, you can often narrow your search down quite quickly by following a few simple guidelines.
1. Dont Focus on a Coachs Personal Results
Dont worry about whether a potential coach was a trader, is a trader or what his or her personal track record is. Personal trading results dont matter; what matters is how a given coachs students are doing. Look for reviews by students about a coach or training program , and if possible contact a few students directly to ask them about their experience.
2. Avoid Getting Emotional
Sales pages are meant for the hard sell. Therefore, sift through sales pages with an analytical mind, not an emotional one. Is there any substantiation to an advertisers claims? People who know the markets know that no one is right all the time, so skip past coaches and programs that promise outlandish results.
3. Consider Your Personality and Style
If you have some experience already, look for someone who meshes with your personality and style. Do you understand the language the coach uses? Does his or her method seem simple and easy to understand? Complex methods can be hard to implement and may not be easily passed from one person to another. Also, if you cant understand what someone else is saying when you are first introduced to their work, it is likely only going to get harder to understand down the road.
Conclusion
Good information, coaching and training programs can be found, but in order to hit on the best possible program, traders need to do some research. This includes finding reviews of any product or service being considered, and touching base with those companies or individuals to see what they have to offer. We can also discard any offers that promise outlandish results or are hard to understand. Trading can be difficult, but learning about it should be much easier - especially if you take the time to seek out the best possible sources.
Many companies in the lower market tiers of the OTC categorization system do not meet the U.S. listing requirements for trading on a stock exchange such as the New York Stock Exchange or NASDAQ. Many of these issuers do not file periodic reports or make available audited financial statements, making it very difficult for investors to find reliable, unbiased information about those companies. For these reasons the SEC views many of the lower tier companies traded on OTC Markets as "among the most risky investments.
Candlestick Chart
Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years.
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Variety A Bitter Spice For Investors
Customer confusion is a phenomenon that has emerged relatively recently and is normally considered in terms of conventional marketing. For instance, if you go into a big box store, you will be confronted with dozens of models of various products, which, to the average person, may look pretty much the same. This can be confusing and problematic for both customers and firms.
The same thing often occurs in the investment market, but the effects are even more substantial and the consequences for consumers may be far more serious than for other goods and services. If youve ever felt overwhelmed by the array of financial products in the market, read on for some tips on how to simplify your portfolio.
Customer Confusion
A number of studies reveal that while customers may initially be attracted to a wide choice of products, many eventually give up in despair or make the wrong decisions. For instance, Frank Pillar and his colleagues investigated the consequences of mass confusion and the burden of choice in the online world (Journal of Computer-Mediated Communication, 2005). I also looked at the confusion phenomenon from a broader marketing perspective in Choice That Sends Out Wrong Buying Signals (Daily Telegraph, 2005).
What these studies suggest is that being spoiled for choice has serious implications, not just for the successful marketing of investment products , but on the gains or losses for investors. In the investment sector, the main victims are those that are financially inexperienced and rely on brokers and advisors to recommend products.
Too Many Choices
For instance, investment magazines and the financial sections of many newspapers display a remarkable array of products, categories, sub-categories and statistics. This often confuses consumers.
Take theThe Wall Street Journal Europe, which has a section on international investment funds. In August 2007, the total fund listing for Alliance Bernstein, which is just one organization, contained more than 60 funds: five conservative funds, seven balanced and various permutations of growth funds, value funds and so on. For less experienced investors in particular, choosing which fund or combination of funds will work best for them can be very difficult.
Too Much Complexity
Some products such as (certain types of) certificates, options and derivatives are notoriously complex and each constitutes its own esoteric world. An article from the highly-regarded Swiss Neue Zuercher Zeitung entitled Confusion Over Complex Financial Products (July 2007), makes this exact point. Referring to the collateralized debt obligation (CDO) market, the article points out that because of the high level of complexity, these products are difficult to evaluate and rate.
Furthermore, the markets for all investments are in constant flux. This means that even if you have clarity at one point in time, confusion can arise later as a result of ongoing developments relating to interest rates, market sentiment, economic data and many other factors.
The Dangers of Confusion
With the truly overwhelming selection of assets in the financial markets, many investors find it nearly impossible to make efficient and effective purchasing decisions based on the right criteria. In fact, they are often totally unable to figure out what they really need or even understand what they are being offered. When investing becomes a stressful ordeal, customers minds tend to shut down in protest. Their wallets either go back into their pockets or their money ends up in the wrong place.
In addition, inexperienced investors are particularly vulnerable to misselling. As a result, cases abound in which people put large sums of money into the hands of a broker, having no idea how their money will be handled. In a worst-case scenario, the money is plugged into products that are totally unsuited to the unwitting investor.
The growing number of choices in the market can mean that even experienced brokers may not be able to cope with the changing array of funds in the market and, as a result, may limit themselves to a very narrow range. In other words, brokers may sell specific products either because they are genuinely good, or simply because they are familiar. The latter reduces confusion - even for brokers - but can be financially dangerous for their clients. Unscrupulous brokers may also stick to the products that bring in the highest commission. This truly unethical behavior is also facilitated by consumer confusion.
Coping with Confusion
There is a right and a wrong way to cope with confusion about which products belong in your portfolio. The wrong way is to cop out and put everything in cash or in one product or asset class. This leads to a poorly constructed and inadequately diversified portfolio. Conversely, some investors have a hodgepodge of all kinds of assets that do not fit together at all. This is also poor asset allocation and it too can prevent an investor from realizing appropriate returns.
Find A Trustworthy Advisor
Learning enough to make good investments or finding people you can rely on and trust are good ways of working through the customer confusion problem. Some effort is essential in order to avoid falling into the classic investment traps. That is, you need to make sure you either knowhow to invest well, or you need to know that you are relying on people who merit your trust.
However, given the extraordinary complexity of the investment world, it is necessary to accept some limitations to the above. In this business, even an expert does not know everything. For example, a bond specialist may not be the best person to turn to for guidance on equity investments or foreign products. In order to get the best financial advice , you need to consider where peoples expertise lies and where it ends.
Keep It Simple
Even if you have good advisors, dont let your portfolio get too busy. Limit your portfolio to a variety of asset classes and items that both you and your broker understand. For example, the conventional wisdom is that if you have a portfolio of individual stocks, 10-15 stocks is about all that you can cope with without becoming overwhelmed. It simply is not possible to keep tabs too many bits and pieces in a portfolio.
For this reason, despite what they often promise, funds with 40 or more holdings tend to track the market as a whole. That is, individuals or fund managers with overloaded and excessively complex portfolios tend not to manage them actively and effectively. As a result, a market indexfund that is designed to move with the market may be more effective - not to mention much less confusing.
In the same vein, if you have 30 different funds, it is likely to be very difficult to manage, monitor and control them all effectively. For some investors, a mixed fund that does all this for you might be the best way to avoid confusion. Such funds contain a combination of asset classes such as stocks, bonds and alternative assets and they do all the monitoring and rebalancing. If they do it well, it is probably the simplest and least confusing way to invest for those with limited time or little inclination to manage their own money.
The Bottom Line
If confusion is to be avoided, you need to keep your portfolio simple and sensible, but at the same time, sufficiently diversified. Take the time to find this balance, and avoid becoming overwhelmed by new products. Investing neednt be complicated, and if you avoid confusion, your portfolio will reward you for it.
Spreads are often the result of the amount of information available on a security. This information may come in the form of past trading data, news or company financials. If very little information is available on a security, spreads may be very large because the market maker does not want to be caught off guard by a better-informed investor.
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Even though deviations will occur and there will be periods when securities are overvalued or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them.
10 Tips For Choosing An Online Broker
One of the most important investment decisions youll make has nothing to do with stocks, bonds or mutual funds. This crucial decision is picking a broker. There are dozens of companies offering brokerage services on the internet , and many of them are just as good or better than traditional, brick-and-mortar businesses, but how to decide which one is best for you?
Here are 10 critical factors youll want to consider:
1. Discount is not always a good deal. Consider starting out with a full-service broker. They are often best for novice investors who may still need to build confidence and knowledge of the markets. As you become a more sophisticated investor, you can graduate into investing more of your money yourself.
2. Availability is key. Try hitting the companys website at different times throughout the day, especially during peak trading hours. Watch how fast their site loads and check some of the links to ensure there are no technical difficulties.
3. Alternative trading provides flexibility. Although we all love the net, we cant always be at our computers. Check to see what other options the firm offers for placing trades. Other alternatives may include touch-tone telephone trades, fax ordering, or doing it the low-tech way - talking to a broker over the phone. Word to the wise: make sure you take note of the prices for these alternatives; they will often differ from an online trade .
4. The brokers background matters. What are others saying about the brokerage? Just as you should do your research before buying a stock, you should find out as much as possible about your broker . (To learn more, check out Picking Your First Broker.)
5. Price isnt everything. Remember the saying you get what you pay for? As with anything you buy, the price may be indicative of the quality. Dont open an account with a broker simply because it offers the lowest commission cost. Advertised rates for companies vary between zero and $40 per trade, with the average around $20. There may be fine print in the ad specifying which services the advertised rate will actually entitle you to. In most cases, there will be higher fees for limit orders, options and those trades over the phone with your broker. You might find that the advertised commission rate may not apply to the type of trade you want to execute.
6. Minimum deposits may not be minimal. See how much of an initial deposit the firm requires for opening an account. Beware of high minimum balances: some companies require as much as $10,000 to start. This might be fine for some investors, but not others.
7. Product selection is important. When choosing a brokerage, most people are probably thinking primarily about buying stocks . Remember there are also many investment alternatives that arent necessarily offered by every company. This includes CDs, municipal bonds, futures,options and even gold/silver certificates. Many brokerages also offer other financial services , such as checking accounts and credit cards.
8. Customer service counts. There is nothing more exasperating than sitting on hold for 20 minutes waiting to get help. Before you open an account, call the companys help desk with a fake question to test how long it takes to get a response.
9. Return on cash is money in the bank. You are likely to always have some cash in your brokerage account. Some brokerages will offer 3-5% interest on this money, while others wont offer you a dime. Phone or email the brokerage to find out what it offers. In fact, this is a good question to ask while youre testing its customer service!
10. Extras can make a difference. Be on the lookout for extra goodies offered by brokerages to people thinking of opening an account. Dont base your decision entirely on the $100 in free trades, but do keep this in mind.
The Bottom Line
With a click of the mouse, from just about anywhere in the world, you can buy and sell stocks using an online broker. The right tools for the trade are key to every successful venture; finding success in the market begins with choosing the right broker.
Affinity fraud refers to investment scams that prey upon members of identifiable groups, such as religious or ethnic communities, the elderly, or professional groups. The fraudsters who promote affinity scams frequently are - or pretend to be - members of the group.
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Strengths of Technical Analysis
Focus on Price
If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments.
Portfolio Management Tips For Young Investors
Too many young people rarely, or never, invest for their retirement years. Some distant date, 40 or so years in the future, is hard to imagine. However, without investments to supplement retirement income, if any, retirees will have a difficult time paying for lifes necessities. TUTORIAL:Stocks Basics
Smart, disciplined, regular investment in a portfolio of diverse holdings, can yield good long-term returns for retirement and provide additional income throughout an investors working life.
An often stated reason for not investing is a lack of knowledge and understanding of the stock market. This objection can be overcome through self-education and step-by-step through the years, as an investor learns by investing. Classes in investing are also offered by a variety of sources, including city and state colleges, civic and not-for-profit organizations, and there are numerous books targeted to the beginning investor.
However, youve got to start investing now; the earlier you begin, the more time your investments will have to grow in value. Heres a good way to start building a portfolio, and how to manage it for the best results. (For related reading, see Top 5 Books For Young Investors.)
Start Early
Start saving as soon as you go to work by participating in a 401(k) retirement plan, if its offered by your employer. If a 401(k) plan is not available, establish an Individual Retirement Account (IRA) and earmark a percentage of your compensation for a monthly contribution to the account. An easy, convenient way to save in an IRA or 401(k) is to create an automatic monthly cash contribution. Keep in mind, the savings accumulate and the interest compounds without taxes, as long as the money is not withdrawn, so its wise to establish one of these retirement investment vehicles early in your working life.
Another reason to start saving early is that usually the younger you are, the less likely you are to have burdensome financial obligations: a spouse, children and mortgage, for example. That means you can allocate a small portion of your investment portfolio to higher risk investments, which may return higher yields.
When you start investing while young, before your financial commitments start piling up, youll probably also have more cash available for investing and a longer time horizon before retirement. With more money to invest for many years to come, youll have a bigger retirement nest egg.
To illustrate the advantage of value investing as soon as possible, assume you invest $200 every month starting at age 25. If you earn a 7% annual return on that money, when youre 65 your retirement nest egg will be approximately $525,000. However, if you start saving that $200 monthly at age 35 and get the same 7% return, youll only have about $244,000 at age 65. (For additional reading, see Accelerating Returns With Continuous Compounding.)
Diversify
Select stocks across a broad spectrum of market categories. This is best achieved in an index fund. Invest in conservative stocks with regular dividends, stocks with long-term growth potential, and a small percentage of stocks with better returns, along with higher risk potential. If youre investing in individual stocks, dont put more than 4% of your total portfolio into one stock. That way, if a stock or two suffers a downturn, your portfolio wont be too adversely effected. Certain AAA rated bonds are also good investments for the long term, either corporate or government. Long-term U.S. Treasury bonds, for example, are safe and pay a higher rate of return than short- and mid-term bonds. (To learn more on investing in bonds, read Bond Basics: Different Types Of Bonds.)
Keep Costs to a Minimum
Invest with a discount brokerage firm. Another reason to consider index funds when beginning to invest is that they have low fees. Because youll be investing for the long-term, dont buy and sell regularly in response to market ups and downs. This saves you commission expenses and management fees, and may prevent cash losses when the price of your stock declines.
Discipline and Regular Investing
Make sure that you put money into your investments on a regular, disciplined basis. This may not be possible if you lose your job, but once you find new employment, continue to put money into your portfolio.
Asset Allocation and Re-Balance
Assign a certain percentage of your portfolio to growth stocks, dividend paying stocks, index funds and stocks with a higher risk, but better returns.
When your asset allocation changes (i.e., market fluctuations change the percentage of your portfolio allocated to each category), re-balance your portfolio by adjusting your monetary stake in each category to reflect your original percentage. (For more information, read Five Things To Know About Asset Allocation.),
Tax Considerations
A portfolio of holdings in a tax-deferred account, a 401(k), for example, builds wealth faster than a portfolio with tax liability. You pay taxes on the amount of money withdrawn from a tax deferred retirement account. A Roth IRA also accumulates tax free savings, but the account owner doesnt have to pay taxes on the amount withdrawn. To qualify for a Roth IRA, your modified adjusted gross income must meet IRS limits and other regulations. Earnings are federally tax free if youve owned your Roth IRA for at least five years and youre older than 59.5, or if youre younger than 59.5, have owned your Roth IRA for at least five years and the withdrawal is due to your death or disability, or for a first time home purchase.
The Bottom Line
Disciplined, regular, diversified investment in a tax deferred 401(k), IRA or a potentially tax-free Roth IRA, and smart portfolio management can build a significant nest egg for retirement. A portfolio with tax liability, dividends and the sale of profitable stock can provide cash to supplement employment or business income. Managing your assets by re-allocation and keeping costs, such as commissions and management fees, low, can produce maximum returns. If you start investing as early as possible, your stocks will have more time to build value. Finally, keep learning about investments throughout your life, both before and after retirement. The more you know, the more your potential portfolio return, with proper management, of course.
Be certain that you fully understand the distinctions among these terms, and be certain that the risk level you choose accurately reflects your investment goals. Be sure that the investment products recommended to you reflect the category of risk you have selected.
The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar.
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The Multiple Lives Of A Stock Trader
Whether they are working full- or part-time, traders are likely to experience multiple swings in their careers. Just like the markets they trade , they too will experience uptrends and downtrends in personal profits, and even the odd crash or windfall. But, over the long run, it is the trader who stays vigilant - who knows when to trade actively and when to sit on his hands - who stays in the game over the long run.
The phases a trader cycles through have different characteristics. By understanding the qualities of the market, the systems you are trading and how these might affect your personal profits, you can better adjust and hopefully minimize the effect of declining profits or losses. Psychologically, it can also help to know that almost all traders go through similar experiences, both good and bad. (If volatility and emotion are removed, passive, long-term investing comes out on top. Read Buy-And-Hold Investing Vs. Market Timing.)
The Trader Downtrend
This is very likely where most traders begin their careers. They have capital, they usually have some sort of game plan and they begin trading with full expectations of becoming wealthy from the financial markets. But alas, even though there may be a few early wins, capital often starts to deteriorate. The capital may even completely evaporate. Hopefully, many lessons are learned during this time and it can be viewed as a paid education. A trader can pay the market to learn - unfortunately, many fail to realize what the market is showing them. Instead, they get angry that the market is not going where they think it should go, or they berate themselves so much that they become crippled in making proper market analysis. (Trends are what allow traders and investors to capture profits. Find out whats behind them. Read 4 Factors That Shape Market Trends.)
Experienced traders likely went through this early education as well. Even as experienced traders, they will face times where losses seem to mount or profits are extremely hard to come by. During these times, it is the experienced traders, well, experience, that allows him or her to stay alive in the financial markets. Some do fall, however, and their former profits are distributed back to the markets. Understanding why this phenomenon occurs can help new and experienced traders avoid being wiped out, or as in the case of many, being wiped out again.
When profits are dwindling or losses are mounting, here are a few questions to ask:
• Is my trading plan complete? Does it account for all types of markets (uptrend, downtrend and flat)?
o A plan should account for all types of markets, even if that means the plan states not trading during certain times or conditions.
• Is my trading plan feasible based on current market conditions?
o Certain strategies will not work in certain market conditions. It is important to realize this and minimize trading until conditions become more favorable. A strategy that uses volatility will likely do poorly in dull markets and a breakout strategywill see more false signals in longer term, ranging markets.
• Are my position sizes exposing my capital to undue risk ?
o While risk tolerance varies, the higher the risk per trade, the less likely a trader is to last. Risking no more than 1-2% of capital on a given trade is a good rule of thumb.
• Have I been averaging down?
o There is no reason to add to a losing position. Risk is likely increasing when we average down, and it is increasing on a position that has not shown us what we expected.
• Have I been following my trading plan?
o Everything mentioned above should already be covered in the trading plan. If it is, then all you need to do is follow your plan. Remember why the rules were chosen in the first place, renew your commitment to them and take some time to re-analyze your plan and implement it.
The Trader Uptrend
Hopefully, most trader will get to experience an uptrend in their trading lives; it is the part where profits materialize and increase. In really good times, winning trades seem to come no matter what and the trader feels invincible. These are great times and should be enjoyed while they last. However, while it is easy to get caught up in the emotion of a winning streak, the trader must realize it will end. To maintain your edge, there are a few things to keep in mind and question while this good streak is going.
Why is my plan working so well right now? Can I adapt it to work better in other market conditions?
o It is possible the strategies employed meld well with the current financial climate, but is it possible these strategies could be adapted to other market environments to improve performance during those times as well?
• While good times should be taken advantage of, would an adverse market move wipe out a disproportionate amount of profits?
o During good times it is easy to take on more risk than is necessary. The feeling of invincibility can become a detriment if, when the streak finally ends, it wipes away all or a large portion of former profits. Keep risk in check, even in the good times.
• Are stops and trailing stop orders being used?
o Just because many trades have worked out recently does not mean you should abandon using stops. Always make sure risk is defined before each trade. Trailing stop orders will be beneficial to you if you have large, unrealized profits. By using a trailing stop, you will be able to realize at least some of the unrealized profits should the market turn.
Trade Actively or Sit on Your Hands
Many great traders have said that knowing when not to trade is what separates the winning traders from the losers. During a bull market, anyone can buy stocks and win, but it is the pro who knows when to back off and avoid losing those profits. This takes experience and, as we have learned, even the experienced traders get caught up, make mistakes and go through phases where they experience diminished profits or rising losses.
Thus, as outlined in the questions above, it is important to build a trading plan and trading psychology that uses the good times while not exposing oneself to financial detriment if the market turns, and also only trading when it is prudent to do so. Figuring this out can often be a simple and logical process. As an example, if the market is in an extremely tight range, even a day trader may not enter the market because the profits are too small relative to fees and risk. Therefore, at times it is better to sit on the sidelines and wait for opportunities to arise which allow traders a better chance to make significant profits.
Conclusion
It often appears that traders have many lives; some wipe out multiple accounts before finally getting it, while others experience large swings, never quite reaching the profits they want. Still others lose everything. No matter the case, trading is never a perfectly smooth vocation. By asking yourself pertinent questions and adhering to a well-prepared trading plan, many of the bumps can be avoided. For traders going through tough times, if a solid plan is implemented there is sunshine after the storm.
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Broker-dealers often receive buy and sell orders that ‘match’ – meaning, someone is willing to sell a security for the same price someone else is willing to buy the same security. In this situation, broker-dealers will execute the trade “internally”.
The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell.
3 Ways To Increase Your Investment Performance
November 10 2011| Filed Under » Investing Basics, Investment, Stocks
Although buy low and sell high is a strategy that has resulted in big accumulations of wealth, this isnt how the professionals find their success. Instead, a savvy investor strategically deploys their money, in order to allow it to work in more than one way; they multitask their money.
The retail investor who is accustomed to working with stocks can simultaneously put their money to work in three ways:
• Price Action - The stock will hopefully rise in value
• Dividend - The fee a company pays you in exchange for using your money.
• Call Revenue - The money an investor pays you when you sell a covered call against your stock.
Price Action
If investing were a game, the way youd win would be to buy a stock at a low price and sell it at a higher price, on a later date. If you own a home, you understand this concept in a very practical way.
In order to make a profit on your investment, its often best to use one of two strategies to do that. The first is called value investing. Stocks, just like the products you purchase every day, go on sale from time to time and value investors wait for that sale price. This makes it even easier to make a profit, because stocks that are undervalued (on sale) have more room to grow. (Learn how to value invest, read 5 Must-Have Metrics For Value Investors. and The Value Investors Handbook.)
The second way is momentum trading. Some investors believe that the best time to buy a stock is when it continues to go higher, because just as we learned in grade school, an object in motion tends to stay in motion. The problem with momentum trading is that it tends to work better for shorter-term investors. For our strategy, we want to think long term. The more years you hold the stock, the better your potential returns could be.
How to Pick Your Stock
Your favorite stock may not work for this strategy, because it must pay a dividend, it must have a price that is cheap enough that you can purchase 100 shares, and it must trade a lot of shares each day; at least 1 million shares of daily volume is best. Remember that a companys value is not based on its price. There are a lot of high quality stocks that are under $30 per share and there are a lot of low quality stocks that trade above $100. I have found that stocks between $15 and $30, with at least a 2% dividend yield, are ideal. Finally, you dont want a highly volatile stock. If it has wild price swings, that will be much tougher to manage.
This is where you put your stock research and evaluation skills to work. Once you find your stock, assuming that you want to value invest, look for this name to be in the middle, or towards the bottom, of the trading range for the past 52 weeks. If it isnt there now, either wait for it to give you a price that you want, or find another company. There are plenty of worthy candidates for this strategy. (Learn more in Enter Profitable Territory With Average True Range.)
Dividend
In a high-tech stock trading world, investing for a dividend might be considered boring, but dividends can be a big income source for the long-term investor. Between 1929 and 1990, 40% of all stock market gains were a result of that boring, quiet dividend, according to the research report High Yield, Low Payout by Credit Suisse.
The dividend gives us two advantages that help our money work for us in more than one way. Firstly, it gives us a stable income. Sure, a company can choose to pay or not pay a dividend, as they would like, but for a high quality company, with a low payout ratio, there is a lower chance of the dividend on a quarterly payment getting cut. Secondly, it lowers your cost basis for the stock you purchased.
Lets assume that you did your research and decided on stock XYZ. You bought 100 shares for $30 per share, which at the time had a 3% dividend yield.
$3,000 x 3% = $90 each year. Not only are you making $90 each year, but since a dividend is paid to you in cash into your account (most of the time), each year that you own your 100 shares, you can apply that dividend payment to what you paid for the stock and, in this case, subtract 90 cents per share. After just five years, your stock that cost you $30 per share, goes down to $25.50 per share. Many long-term investors reduce the price they paid for a stock to $0, just from the dividend. (Learn more about this in How do I figure out my cost basis on a stock investment?)
Covered Call
Covered calls are a little more complicated. If you dont feel confident with this leg of the strategy, buying a stock and collecting the dividend as it goes higher will still be an impressive gain. (If you dont know how a covered call works, read about them here: The Basics of Covered Call.)
Before we sell the covered call we have to make two important decisions:
• What is the strike price?
• How many months into the future do we want our contract to expire?
Strike Price
A covered call is an options contract strategy that gives the holder of the contract the right to purchase your 100 shares, if it is at or above the strike price. Presumably, you dont want your shares taken from you, although you may change your mind in later years, so your strike price needs to be high enough that the stock doesnt rise above the strike price, but low enough that you can still collect a healthy premium for the risk youre taking.
This decision is tough. If your stock is in a downtrend, you can probably sell an option with a strike that isnt much higher than the stocks current price. If the stock is in an uptrend, for the sake of safety, consider waiting to sell the call, until you believe the move up has run its course, and the stock will soon go the other way. Remember, when the stock rises in value, the value of your option falls. This also adds the benefit of the covered call acting as a hedge. (For more advanced reading on these types of strategies, check out An Alternative Covered Call Options Trading Strategy.)
Expiration Date
The further into the future you take your option, the more of a premium you will be paid upfront, to sell the call, but thats also more time that your stock has to stay below the strike price, to avoid having it called away from you. For your first contract, consider going three months into the future.
The covered call will make money for you as soon as you sell it, because the premium that the buyer paid is deposited directly in to your account. It will continue to make money for you if the price of your stock falls. As the price falls, so does the premium. You can purchase the contract back from the buyer at any time, so if the premium falls, you can purchase it for less than you sold it. That equals profit. On the other hand, if the stock rises above the strike price, you can purchase the contract for more than you sold it and incur a loss, but it saves you from having to give up your 100 shares.
One of the best ways to use the covered call is for the collection of the premium at the beginning, and although you can buy the option back if it goes up or down, save this for severe circumstances. Also remember that the money you collect by selling your covered call can also be subtracted from the price you paid for the stock (For more, check out Cut Down Option Risk With Covered Calls.)
Go Virtual
The best way to learn a complicated investing strategy, like the covered call, is by using a virtual platform where you dont have to worry about losing real money. You can still purchase the stock and collect the dividend, but wait to sell the covered call until youre comfortable with how it works.
The Bottom Line
For most investors, putting money in high quality stocks for long periods of time, while harnessing dividend income, is the best way to make money in the market. Later, once you understand how to use the covered call, you can significantly increase your yield. Although the fixed income side of investing isnt as thrilling to watch, it is the most appropriate for retail investors and as we can see, the numbers can add up fast.
Trader's Remorse
Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match.
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Firms may also negotiate trades over the phone. While the same process and rules apply, the speed with which trades are executed is inherently slower than OTC Link.
Financial Advice With Zero Return
Many people rely on financial advisors, either independent ones or those employed at banks. The good ones will at least ensure that you have a sensibly diversified portfolio and that it stays that way. However, a recent study indicates that many advisors do not increase the actual investment returns on an ongoing basis.
What Advisors Do and Dont
An investigation conducted at the University of Frankfurt in Germany reveals that neither portfolios advised by banks nor independent advisors, do any better than those for which no advice was given. Finance professor Andreas Hackethal explains that the main problem is the failure of advisors to correct systematic investment errors sufficiently, while at the same time, they generate additional costs. (For related reading, see Diversifying Your Portfolio.)
Furthermore, this work almost certainly applies to the United States. According to Hackethal, an investigation by Bergstresser et. al in the U.S., demonstrated that mutual funds sold through U.S. broker channels underperform other mutual funds. They take this as indirect evidence that brokers or advisors do not add value for clients.
The Frankfurt-based study used client data from a large German bank and from an online broker that specializes in providing independent advice. The survey sample that was given advice, performed no better than the execution-only group.
The researchers also confirm that banks (and certain other advisors) have the wrong incentive structures, so that the advisory process all too often helps only the seller and not the investor. (To learn more, read Paying Your Investment Advisor - Fees Or Commissions?)
Investor Reluctance to Obtain and Follow Good Advice
Good advisors are clearly hard to find, but they are indeed out there. However, Hackethal found a widespread client reluctance to use good, skilled advice, preferring to rely on their own generally mediocre investment skills. A staggering 95% of those questioned were not even interested in free independent advice from an advisor with no incentive, at all, to recommend specific products.
Equally amazing is the fact that of the remaining 5%, only half actually followed the advice that they were given. Of this tiny group, half again followed the advice only half-heartedly, even though the recommendations would have led to substantially better returns.
It seems to be mainly wealthy, experienced investors who really appreciate the value of good advice from the right people. Yet, almost anyone would benefit from a second, objective opinion on what to do with their hard-earned savings.
The Solutions
The Frankfurt researchers do not believe that more governmental regulation is the answer either. In particular, given the above consumer attitudes to advice, purely seller-side regulation seems doomed to fail. For instance, Hackethal doubts that simply providing more information in the form of brochures, for example, will help much. It will take a lot more to achieve the necessary transparency and learning effects … with respect to investment risks and opportunities.
Clearly, somehow, investor attitudes towards advice need to change and the incentive structures in the industry as well. In addition, investment selling processes at banks may need to be overhauled in a more general sense. There is a compelling need to establish just why, in so many instances, the advisory process fails to work for the investor.
There are undoubtedly independent and bank advisors who can and will help people get more bang (and bank) for their buck. What is lacking is an understanding of the difference between good, mediocre and really bad advice. Above all, far greater market transparency is essential, so that people are able to draw the appropriate distinctions between a fine investment, a rip-off and the various shades of gray between the two extremes. At present, too many investors just do not know who they are dealing with. As Hackethal puts it the person sitting opposite them could be excellent or an outright crook. The clients just dont know. (Learn more on how to Find The Right Financial Advisor.)
An Important Benefit Remains - with Genuinely Independent Advisors
Independent financial advice can, however, at least prevent excessively risky, undiversified portfolios. That is, even if an advisor does not lead to better returns, if they can prevent you from having a high risk portfolio that rockets in a boom and plummets in a bear market, that can be worth a lot. This is a separate issue and needs to be kept in mind. The above research dealt with better investment performance, not with avoiding disastrous losses in a crash.
The Bottom Line
Financial advice can be pretty ineffectual for two main reasons. Firstly, when the incentive structures are wrong, the advice benefits mainly or only the bank or broker. Secondly, investors are remarkably reluctant either to seek out or follow objective advice from a third party. Overcoming this highly unsatisfactory situation entails a combination of changed structures and attitudes on both the buyer and seller sides of the market. This is not easy to achieve, and regulation alone will certainly not do it. The industry needs to take a long, hard look at what it is doing, both wrong and right.
A downtrend begins when the stock breaks below the low of the previous trading range.
The OTC market is not suitable for unsophisticated or novice investors. You should gain a thorough understanding of your rights as an investor and investigate the background of the issuing company, individual broker, and brokerage firm before you invest.
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An Introduction To Stock Market Indexes
June 04 2011| Filed Under » Index Fund, Investing Basics, Stocks
Its not unusual for people to talk about the market as if there were a common meaning for the word. But in reality, the many indexes of the differing segments of the market dont always move in tandem. If they did, there would be no reason to have multiple indexes. By gaining a clear understanding of how indexes are created and how they differ, you will be on your way to making sense of the daily movements in the marketplace. Here well compare and contrast the main market indexes so that the next time you hear someone refer to the market, youll have a better idea of just what they mean.
Tutorial: Stock Basics
The Dow
If you ask an investor how the market is doing, you might get an answer that is based on the Dow. The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known and most frequently used indexes in the world. It includes the stocks of 30 of the worlds largest and most influential companies. The DJIA is whats known as a price weighted index. It was originally computed by adding up the per-share price of the stocks of each company in the index and dividing this sum by the number of companies - thats why its called an average. Unfortunately, it is no longer this simple to calculate. Over the years, stock splits, spin-offs and other events have resulted in changes in the divisor, making it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dows price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have the same effect on the DJIA as a $1 change in the price of a $20 stock, even though one stock may have changed by 0.8% and the other by 5%.
A change in the Dow represents changes in investors expectations of the earnings and risks of the large companies included in the average. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. On the other hand, because the Dow is made up of some of the most well-known companies in the U.S., large swings in this index generally correspond to the movement of the entire market, although not necessarily on the same scale. (For more information on this index, see Calculating The Dow Jones Industrial Average.)
The S
Furthermore, the future price cannot be determined using past or current prices (sorry technical analysts).
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Although exchange-listed stocks can be traded OTC on the third market, it is rarely the case. Usually OTC stocks are not listed nor traded on exchanges, and vice versa. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks have alternative disclosure guidelines (for example, OTCQX stocks through OTC Market Group Inc), and others have no reporting requirements, for example Pink Sheets securities.
These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis.
Companies that follow the International Reporting Standard or the Alternative Reporting Standard by making filings publicly available through the OTC Disclosure
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This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value.
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This is only 1 point higher and a trader would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline, and it is something to consider when drawing support lines.
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