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A Beginners Guide To Managing Your Money
Online brokers and easy access to financial data make investing your money as easy as starting a savings account, but in a world where the Internet has made do-it-yourselfers out of many, is investing a do-it-yourself activity and if it is, why not just fire your financial advisor or pay less fees to your mutual funds and set up a portfolio of your own? See: Risk and Diversification
The Internet has changed the way we live our lives. Not long ago purchasing stock was not as easy as it is now. The order went through a complex network of brokers and specialists before the execution was completed. In 1983, that all changed with a dentist in Michigan who made the first online stock transaction using a system developed by what is now E*TRADE Financial. (For related reading, see Brokers and Online Trading.)
The Effect
That one trade changed how investment products are transacted, researched and discussed. Computerized trading has resulted in highly liquid markets making it easy to buy and sell most securities quickly. The do-it-yourselfer now has access to the same free financial data that the professionals use, and websites like Stocktwits set up entire communities of investors and traders who exchange information in real time.
But just because its possible, does that mean that managing your own money is a good idea? Professional investors have a saying, The stock market is an expensive place to learn how to invest . They understand that its easier to lose money than it is to make money, and because of that, some argue that the wealth of information available to people with little financial background may offer a false sense of security.
Tools are only as good as the knowledge and experience of the person using them. Does a high priced software package used by the worlds best composers result in beautiful music? Does the newest innovation in surgical technology make a person with no prior training in medicine a top performing surgeon?
Theres no doubt that the Internet has given the retail investor the tools that they need to effectively manage their own money, but what about the knowledge and experience to use the tools effectively? For an investor who wants to manage their own money, what types of fundamental knowledge should they have before firing their financial adviser? (To learn more, read 4 Steps To Building A Profitable Portfolio.)
Modern Portfolio Theory
First, understand modern portfolio theory (MPT) and gain an understanding of how asset allocation is determined for an individual based on their individual factors. In order to gain a true understanding of these principals, youll have to dig deeper than the top level Internet blog articles that tell you that MPT is simply understanding allocation. MPT is not just about the allocation but also its efficiency. The best money managers understand how to position your money for maximum return with the least amount of risk. They also understand that efficiency is highly dynamic as the person ages and their financial picture changes.
Along with efficiency comes the dynamic nature of risk tolerance. At certain points in our lives, our risk tolerance may change. Along with retirement, we might have intermediate financial goals like saving for college or starting a new business, the portfolio has to be adjusted to meet those goals. Financial advisors often use proprietary software that produces detailed reports not available to the retail investor. (Read how to determine What Is Your Risk Tolerance?)
Academic Understanding of Risk
In the plethora of free resources, risk is treated too benignly. The term risk tolerance has been so overused that retail investors may believe that they understand risk if they understand that investing may involve losing money from time to time. Its much more than that.
Risk is a behavior that is hard to understand rationally because investors often act opposite of their best interests. A study conducted by Dalbar, Inc. showed that inexperienced investors tend to buy high and sell low, which often leads to losses in short-term trades.
Since risk is a behavior, its extremely difficult for an individual to have an accurate, unbiased picture of their true attitude towards risk. Day traders, often seen as having a high risk tolerance, may actually have an extremely low tolerance because theyre unwilling to hold an investment for longer periods. Great investors understand that success comes with fending off emotion and making decisions based on facts. Thats hard to do when youre working with your own money.
Efficient Market Hypothesis
Do you know how likely you are to out invest the overall market? What is the likelihood of any one football player being better than most of the other NFL players, and if they are better for a season what is the likelihood that they will be the best of the best for decades?
Efficient Market Hypothesis (EMH) might contain the answer. EMH states that everything known about an investment product is immediately factored into the price. If Intel releases information that sales will be light this quarter, the market will instantly react and adjust the value of the stock. According to EMH, there is no way to beat the market for sustained periods because all prices reflect true or fair value.
For the retail investor trying to pick individual stock names hoping to achieve gains that are larger than the market as a whole, this may work in the short term, just as gambling can sometimes produce short-term profits, but over a sustained period of decades, this strategy breaks down, say the proponents of EMH.
Even the brightest investment minds employing teams of researchers all over the world havent been able to beat the market over a sustained period. According to famed investor Charles Ellis in his book, Winning The Losers Game: Timeless Strategies For Successful Investing.
Opponents of this theory cite investors like Warren Buffett who have beat the market for most of his life, but what does EMH mean for the individual investor? Before deciding on your investing strategy , you need the knowledge and statistics to back it up.
If youre going to pick individual stocks in the hopes that theyll appreciate in value faster than the overall market, what evidence leads you to the idea that this strategy will work? If youre planning to invest in stocks for dividends, is there evidence that proves that an income strategy works? Would investing in an index fund be the best way? Where can you find the data needed to make these decisions? (For additional reading, see 7 Controversial Investing Theories.)
Experience
What do you do for a living? If you have a college degree, you might be one of the people who say that you didnt become highly skilled as a result of your degree but instead, because of the experience you amassed. When you first started your job were you highly effective from the very beginning?
Before managing your own money, you need experience. Gaining experience for investors often means losing money, and losing money in your retirement savings isnt an option.
Experience comes from watching the market and learning first-hand how it reacts to daily events. Professional investors know that the market has a personality that is constantly changing. Sometimes its hypersensitive to news events and other times it brushes them off. Some stocks are highly volatile while others have muted reactions.
The best way for the retail investor to gain experience is by setting up a virtual or paper trading account. These accounts are perfect for learning to invest while also gaining experience before committing real money to the markets. (Learn to trade with the Investopedia Stock Simulator, risk free!)
The Bottom Line
Many people have found success in managing their own money, but before putting your money at risk, become a student in the art of investing. If somebody wanted to do your job based on what they read on the Internet, would you advise it? If you were looking for a financial advisor, would you hire yourself based on your current level of knowledge? Your answer might be yes, but until you have the knowledge and experience as a money manager, managing a brokerage account with money that you could stand to lose might be OK, but leave your retirement money to the professionals.
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Are You A Disciplined Investor?
In the late 1990s, many investors enjoyed the fruits of positive double-digit returns with their equity investments. Then, during the period of January 1, 2000, through December 31, 2002, the S
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12 Things You Need To Know About Financial Statements
Knowing how to work with the numbers in a companys financial statements is an essential skill for stock investors. The meaningful interpretation and analysis of balance sheets, income statements and cash flow statements to discern a companys investment qualities is the basis for smart investment choices. However, the diversity of financial reporting requires that we first become familiar with certain general financial statement characteristics before focusing on individual corporate financials. In this article, well show you what the financial statements have to offer and how to use them to your advantage.
1. Financial Statements Are Scorecards
There are millions of individual investors worldwide, and while a large percentage of these investors have chosen mutual funds as the vehicle of choice for their investing activities, a very large percentage of individual investors are also investing directly in stocks. Prudent investing practices dictate that we seek out quality companies with strong balance sheets, solid earnings and positive cash flows.
Whether youre a do-it-yourself or rely on guidance from an investment professional, learning certain fundamental financial statement analysis skills can be very useful - its certainly not just for the experts. Over 30 years ago, businessman Robert Follet wrote a book entitled How To Keep Score In Business (1987). His principal point was that in business you keep score with dollars, and the scorecard is a financial statement. He recognized that a lot of people dont understand keeping score in business. They get mixed up about profits, assets, cash flow and return on investment.
The same thing could be said today about a large portion of the investing public, especially when it comes to identifying investment values in financial statements. But dont let this intimidate you; it can be done. As Michael C. Thomsett says in Mastering Fundamental Analysis (1998):
That there is no secret is the biggest secret of Wall Street - and of any specialized industry. Very little in the financial world is so complex that you cannot grasp it. The fundamentals - as their name implies - are basic and relatively uncomplicated. The only factor complicating financial information is jargon, overly complex statistical analysis and complex formulas that dont convey information any better than straight talk.
What follows is a brief discussion of 12 common financial statement characteristics to keep in mind before you start your analytical journey.
2. What Financial Statements to Use
For investment analysis purposes, the financial statements that are used are the balance sheet, the income statement and the cash flow statement. The statements of shareholders equity and retained earnings, which are seldom presented, contain nice-to-know, but not critical, information, and are not used by financial analysts. A word of caution: there are those in the general investing public who tend to focus on just the income statement and the balance sheet, thereby relegating cash flow considerations to somewhat of a secondary status. Thats a mistake; for now, simply make a permanent mental note that the cash flow statement contains critically important analytical data.
3. Knowing Whats Behind the Numbers
The numbers in a companys financials reflect real world events. These numbers and the financial ratios/indicators that are derived from them for investment analysis are easier to understand if you can visualize the underlying realities of this essentially quantitative information. For example, before you start crunching numbers, have an understanding of what the company does, its products and/or services, and the industry in which it operates.
4. The Diversity of Financial Reporting
Dont expect financial statements to fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. The less-experienced investor is going to get lost when he or she encounters a presentation of accounts that falls outside the mainstream or so-called typical company. Simply remember that the diverse nature of business activities results in a diversity of financial statement presentations. This is particularly true of the balance sheet; the income and cash flow statements are less susceptible to this phenomenon.
5. The Challenge of Understanding Financial Jargon
The lack of any appreciable standardization of financial reporting terminology complicates the understanding of many financial statement account entries. This circumstance can be confusing for the beginning investor. Theres little hope that things will change on this issue in the foreseeable future, but a good financial dictionary can help considerably.
6. Accounting Is an Art, Not a Science
The presentation of a companys financial position, as portrayed in its financial statements, is influenced by management estimates and judgments. In the best of circumstances, management is scrupulously honest and candid, while the outside auditors are demanding, strict and uncompromising. Whatever the case, the imprecision that can be inherently found in the accounting process means that the prudent investor should take an inquiring and skeptical approach toward financial statement analysis.
7. Two Key Accounting Conventions
Generally accepted accounting principles (GAAP) are used to prepare financial statements. The sum total of these accounting concepts and assumptions is huge. For investors, a basic understanding of at least two of these conventions - historical cost and accrual accounting - is particularly important. According to GAAP, assets are valued at their purchase price (historical cost), which may be significantly different than their current market value. Revenues are recorded when goods or services are delivered and expenses recorded when incurred. Generally, this flow does not coincide with the actual receipt and disbursement of cash, which is why the cash flow becomes so important.
8. Non-Financial Statement Information
Information on the state of the economy, industry and competitive considerations, market forces, technological change, and the quality of management and the workforce are not directly reflected in a companys financial statements. Investors need to recognize that financial statement insights are but one piece, albeit an important one, of the larger investment information puzzle.
9. Financial Ratios and Indicators
The absolute numbers in financial statements are of little value for investment analysis, which must transform these numbers into meaningful relationships to judge a companys financial performance and condition. The resulting ratios and indicators must be viewed over extended periods to reflect trends. Here again, beware of the one-size-fits-all syndrome. Evaluative financial metrics can differ significantly by industry, company size and stage of development.
10. Notes to the Financial Statements
It is difficult for financial statement numbers to provide the disclosure required by regulatory authorities. Professional analysts universally agree that a thorough understanding of the notes to financial statements is essential in order to properly evaluate a companys financial condition and performance. As noted by auditors on financial statements the accompanying notes are an integral part of these financial statements. Take these noted comments seriously. (For more insight, see Footnotes: Start Reading The Fine Print.)
11. The Auditors Report
Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly traded companies. Before digging into a companys financials, the first thing to do is read the auditors report. A clean opinion provides you with a green light to proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not want to proceed.
12. Consolidated Financial Statements
Generally, the word consolidated appears in the title of a financial statement, as in a consolidated balance sheet. Consolidation of a parent company and its majority-owned (more that 50% ownership or effective control) subsidiaries means that the combined activities of separate legal entities are expressed as one economic unit. The presumption is that a consolidation as one entity is more meaningful than separate statements for different entities.
Conclusion
The financial statement perspectives provided in this overview are meant to give readers the big picture. With these considerations in mind, beginning investors should be better prepared to cope with learning the analytical details of discerning the investment qualities reflected in a companys financials.
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What Is An ETF?: An Infographic
Sometimes reading up on everything that the market has to offer isnt the best way to learn. Its understandable, and perfectly OK, if as a beginner investor, a lot of the unfamiliar words and concepts go straight over your head. The fact is, some people are visual learners, and they do better with pictures than words.
So lets take a look at ETFs. Chances are that if youre new to investing youve heard all about ETFs and that theyre a great investment for people who want to get into the market. However, did you really understand the explanations of why? Heres an easy way to break it down, provided by Mint.com.
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Does It Still Pay To Invest In Gold?
From gold exchange-traded funds (ETFs ) to gold stocks to buying physical gold, investors now have several different options when it comes to investing in the royal metal. But what exactly is the purpose of gold? And why should investors even bother investing in the gold market? Indeed, these two questions have divided gold investors for the last several decades. One school of thought argues that gold is simply a barbaric relic that no longer holds the monitory qualities of the past. In a modern economic environment, where paper currency is the money of choice, golds only benefit is the fact that it is a material that is used in jewelry.
On the other end of the spectrum is a school of thought that asserts gold is an asset with various intrinsic qualities that make it unique and necessary for investors to hold in their portfolios . In this article, we will focus on the purpose of gold in the modern era, why it still belongs in investors portfolios and the different ways that a person can invest in the gold market.
A Brief History on Gold
In order to fully understand the purpose of gold, one must look back at the start of the gold market. While golds history began in 3000 B.C, when the ancient Egyptians started forming jewelry, it wasnt until 560 B.C. that gold started to act as a currency. At that time, merchants wanted to create a standardized and easily transferable form of money that would simplify trade. Because gold jewelry was already widely accepted and recognized throughout various corners of the earth, the creation of a gold coin stamped with a seal seemed to be the answer.
Following the advent of gold as money, golds importance continued to grow. History has examples of golds influence in various empires, like the Greek and Roman empires. Great Britain developed its own metals based currency in 1066. The British pound (symbolizing a pound of sterling silver), shillings and pence were all based on the amount of gold (or silver) that it represented. Eventually, gold symbolized wealth throughout Europe, Asia, Africa and the Americas.
The United States government continued on with this gold tradition by establishing a bimetallic standard in 1792. The bimetallic standard simply stated that every monetary unit in the United States had to be backed by either gold or silver. For example, one U.S. dollar was the equivalent of 24.75 grains of gold. In other words, the coins that were used as money simply represented the gold (or silver) that was presently deposited at the bank.
But this gold standard did not last forever. During the 1900s, there were several key events that eventually led to the transition of gold out of the monetary system. In 1913, the Federal Reserve was created and started issuing promissory notes (the present day version of our paper money) that guaranteed the notes could be redeemed in gold on demand. The Gold Reserve Act of 1934 gave the U.S. government title to all the gold coins in circulation and put an end to the minting of any new gold coins. In short, this act began establishing the idea that gold or gold coins were no longer necessary in serving as money. The United States abandoned the gold standard in 1971 when the U.S. currency ceased to be backed by gold.
The Importance of Gold In the Modern Economy
Given the fact that gold no longer backs the U.S. dollar (or other worldwide currencies for that matter) why is it still important today? The simple answer is that while gold is no longer in the forefront of everyday transactions, it is still important in the global economy. To validate this point, one need only to look as far as the reserve balance sheets of central banks and other financial organizations, such as the International Monetary Fund. Presently, these organizations are responsible for holding approximately one-fifth of the worlds supply of above-ground gold. In addition, several central banks have focused their efforts on adding to their present gold reserves.
Gold Preserves Wealth
The reasons for golds importance in the modern economy centers on the fact that it has successfully preserved wealth throughout thousands of generations. The same, however, cannot be said about paper-denominated currencies. To put things into perspective, consider the following example.
Example - Gold, Cash and Inflation
In the early 1970s, one ounce of gold equaled $35. Lets say that at that time, you had a choice of either holding an ounce of gold or simply keeping the $35. Both would buy you the same things at that, like a brand new business suit, for example. If you had an ounce of gold today and converted it for todays prices, it would still be enough to buy a brand new suit. The same, however, could not be said for the $35. In short, you would have lost a substantial amount of your wealth if you decided to hold the $35 and you would have preserved it if you decided to hold on to the one ounce of gold because the value of gold has increased, while the value of a dollar has been eroded by inflation. (For more insight, read All About Inflation.)
Gold as a Hedge Against a Declining U.S. Dollar and Rising Inflation
The idea that gold preserves wealth is even more important in an economic environment where investors are faced with a declining U.S. dollar and rising inflation (due to rising commodity prices). Historically, gold has served as a hedge against both of these scenarios. With rising inflation, gold typically appreciates. When investors realize that their money is losing value, they will start positioning their investments in a hard asset that has traditionally maintained its value. The 1970s present a prime example of rising gold prices in the midst of rising inflation. (For related reading, see What Is Wrong With Gold?)
The reason gold benefits from a declining U.S. dollar is because gold is priced in U.S. dollars globally. There are two reasons for this relationship. First, investors who are looking at buying gold (like central banks) must sell their U.S. dollars to make this transaction. This ultimately drives the U.S. dollar lower as global investors seek to diversify out of the dollar. The second reason has to do with the fact that a weakening dollar makes gold cheaper for investors who hold other currencies. This results in greater demand from investors who hold currencies that have appreciated relative to the U.S. dollar.
Gold as a Safe Haven
Whether it is the tensions in the Middle East, Africa or elsewhere, it is becoming increasingly obvious that political and economic uncertainty is another reality of our modern economic environment. For this reason, investors typically look at gold as a safe haven during times of political and economic uncertainty. Why is this? Well, history is full of collapsing empires, political coups, and the collapse of currencies. During such times, investors who held onto gold were able to successfully protect their wealth and, in some cases, even use gold to escape from all of the turmoil. Consequently, whenever there are news events that hint at some type of uncertainty, investors will often buy gold as a safe haven.
Gold as a Diversifying Investment
The sum of all the above reasons to own gold is that gold is a diversifying investment. Regardless of whether you are worried about inflation, a declining U.S. dollar, or even protecting your wealth, it is clear that gold has historically served as an investment that can add a diversifying component to your portfolio. At the end of the day, if your focus is simply diversification, gold is not correlated to stocks, bonds and real estate. (For more insight, read The Importance Of Diversification.)
Different Ways of Owning Gold
One of the main differences between investing in gold several hundred years ago and investing in gold today is that there are many more options to participating in the intrinsic qualities that gold offers. Today, investors can invest in gold by buying:
• Gold Futures (For more on this investment type, see Trading Gold And Silver Futures Contracts.)
• Gold Coins
• Gold Companies
• Gold ETFs
• Gold Mutual Funds
• Gold Bullion
• Gold jewelry
Conclusion
There are advantages to every investment. If you are more concerned with holding the physical gold, buying shares in a gold mining company might not be the answer. Instead, you might want to consider investing in gold coins, gold bullion, or jewelry. If your primary interest is in using leverage to profit from rising gold prices, the futures market might be your answer.
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5 Reasons To Avoid Index Funds
Modern portfolio theory suggests that markets are efficient , and that a securitys price includes all available information. The suggestion is that active management of a portfolio is useless, and investors would be better off buying an index and letting it ride. However, stock prices do not always seem rational, and there is also ample evidence going against efficient markets. So, although many people say that index investing is the way to go, well look at some reasons why it isnt always the best choice. (For background reading, see our Index Investing Tutorial and Modern Portfolio Theory: An Overview.)
1. Lack of Downside Protection
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund , such as one that tracks the S
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How To Outperform The Market
All investors must reevaluate and refine their investing styles and strategies from time to time. As we gain investing experience and knowledge, our view of the market is likely to change and most likely broaden how we envision the extent of our investing capacity. Those who want to try to outperform the market - that is, realize returns greater than the market average - might consider an active trading strategy, even if only for a portion of their portfolio. Here we explain what active trading is, how active traders view the market, their tools and investment vehicles and finally, the risks associated with their style.
What Is Active Trading?
The best way to understand active trading is to differentiate it from buy-and-hold investing, which is based on the belief that a good investment will be profitable in the long term. This means ignoring day-to-day market fluctuations. Using a buy and hold strategy, this kind of investor is indifferent to the short-term for two reasons: first, because he or she believes any momentary effects of short-term movements really are minor compared to the long-term average, and second, because short-term movements are nearly impossible to exactly predict.
An active trader, on the other hand, isnt keen on exposing his or her investments to the effect of short-term losses or missing the opportunity of short-term gains. Its not surprising then, that active traders see an average long-term return not as an insurmountable standard but as a run-of-the-mill expectation. To exceed the standard, or outperform the market, the trader realizes that he or she must look for the profit potential in the markets temporary trends, which means trying to perceive a trend as it begins and predict where it will go in the near future.
Below is a chart that demonstrates the difference between the long and short-term movements of the market. Note that even though the security moves upward over time, it experiences many smaller trends in both directions along the way.
Performance and the Short Term
Traders are active because for them the importance of the markets short-term activity is magnified - these market movements offer opportunity for accelerated capital gains. A traders style determines the time frame within which he or she looks for trends. Some look for trends within a span of a few months, some within a few weeks, and some within a few hours. Because a shorter period will see more definitive market movements, a trader analyzing a shorter time frame will be more active, executing more trades.
A greater number of trades doesnt necessarily equal greater profits. Outperforming the market doesnt mean maximizing your activity, but maximizing your opportunities with a strategy. An active trader will strive to buy and sell (or vice versa in the case of shorting) at the two extremes of a trend within a given time frame. When buying a stock, a trader may try to buy it at the lowest point possible (or an upwards turning point, otherwise known as a bottom) and then sell it when there are signs that it has hit a high point. These signs are generally discerned by means of technical analysis tools, which we discuss below. The more the trader strives to buy and sell at the extremes, the more aggressive - and risky - is his or her strategy.
Maximizing returns or outperforming the market isnt just about reaping profits, its also about avoiding losses. In other words, the trader will keep an eye out for any signs that the security is about to take a surprising turn in an undesirable direction. When these signs occur, the trader knows that it is time to exit the investment and seek profits elsewhere. A long-term trader, on the other hand, stays invested in the security if he or she has confidence in its value, even though it may be experiencing a downward shift - the buy and hold investor must tolerate some losses that the trader believes are possible to avoid.
Technical Analysis
You need particular analytical techniques and tools to discern when a trend starts and when it will come to an end. Technical analysis specializes in interpreting price trends, identifying the best time to buy and sell a security with the use of charts. Unlike fundamental analysis, technical analysis sees price as an all-important factor that tells the direction a security will take in the short term. Here are three principles of technical analysis:
• For the most part, the current price of a stock already reflects the forces influencing it - such as political, economic and social changes - as well as peoples perception of these events.
• Prices tend to move in trends.
• History repeats itself.
From these three principles emerges a complicated discipline that designs special indicators to help the trader determine what will happen in the future. Indicators are ways in which price data is processed (usually by means of a calculation) in order to clarify price patterns, which become apparent when the results of the indicators calculation are plotted on a chart. Displayed together with plotted historical prices, these indicators can help the trader discern trend lines and analyze them, reading signals emitted by the indicator in order to choose entry into or exit from the trade. Some examples of the many different types of indicators are moving averages, relative strength and oscillators.
Fundamental analysis can be used to trade, but most traders are well trained and experienced in the techniques of charting and technical analysis. It is a blend of science and art that requires patience and dedication. Because timing is of the utmost importance in active trading, efficiency in technical analysis is a great determiner of success.
Leverage
The short term approach of investing offers opportunities to realize capital gains not only by means of trend analysis, but also through short-term investing devices that amplify potential gains given the amount invested. One of these techniques is leveraging, which is often implemented by something called margin.
Margin is simply the use of borrowed money to make a trade. Say you had $5,000 to invest: you could, instead of simply investing this amount, open a margin account and receive an additional, say, $5,000 to invest. This would give you a total of $10,000 with which to make a trade. So, if you invested in a stock that returned 25%, your $10,000 investment turns into $12,500. Now, when you pay back the original $5,000, youd be left with $7,500 (well assume interest charges are zero), giving you a $2,500 profit or a return of 50%. Had you invested only $5,000, your profit wouldve been only $1,250. In other words, margin doubled your return.
However, as the upside potential is exacerbated, so is the downside risk. If the above investment instead experienced a 25% decline, you would have suffered a loss of 50%, and if the investment experienced a 50% decline, you wouldve lost 100%. You may have already guessed that, with leverage, a trader can lose more than his or her initial investment! As such it is a trading tool that should be used only by experienced traders who are skilled at the art of timing entry into and exit from investments. Also, since margin is borrowed money, the less time you take to pay it back, the less interest you pay on it. If you take a long time to try to reap profits from a trade, the cost of margin can eat into your overall return.
The Risks
Active trading offers the enticing potential of above-average returns, but like almost anything else thats enticing, it cannot be achieved successfully without costs and risks.
The shorter time frame to which traders devote themselves offers a vast potential but, because the market can move fast, the trader must know how to read it and then react. Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses - especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time consuming and expensive. Any person thinking of becoming an active trader should take this into account.
Also the higher frequency of transactions of active trading doesnt come for free: brokerage commissions are placed on every trade and, since these commissions are an expense, they eat into the traders return. Because every trade costs money, a trader must be confident in his or her decision: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what he or she is doing and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.
Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year. This could differ from a more passive investor who holds investments for numerous years and does not pay capital gains tax on a yearly basis. Capital gains tax expense must also be factored in when an active trader is calculating overall return.
Conclusion
As you gain more education and experience as an investor, you may become curious about the different ways to reach returns. It is important to be willing to learn about different strategies and approaches, but it is equally important to know what suits your personality, skills and risk tolerance. You may have guessed that active trading is best suited to those who are committed to taking control over their portfolio and pursuing their goals quickly and aggressively. All of this requires a willingness to not only take risks, but also keep up skills and efficiency. If this sounds like you, it may be time to start learning more!
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3 Psychological Quirks That Affect Your Trading
The most troublesome problems we face as traders are the ones that we dont even know exist. Certain human tendencies affect our trading, yet we are often completely unaware they are affecting us and our bottom line. While there are many human tendencies, we will look at three that, if not managed, can block the road toward achieving our financial goals.
The Enemy We Dont Know
When dealing with trading in a technical way, we can see where we erred and attempt to fix it for next time. If we exit a trade too early in a move, we can adjust our exit criteria by looking at a longer time frame or by using a different indicator. However, when we have a solid trading plan and are still losing money, we need to look at ourselves and our own psychology for a solution. (Test your investment strategy before entering the market, but first read Stimulate Your Skills With Simulated Trading.)
When we deal with our own minds, often our objectivity is skewed and, thus, cannot properly fix the problem; the true problem is clouded by biases and superficial trivialities. An example of this is the trader who does not stick to a trading plan, but fails to realize that not sticking to it is the problem, so he continually adjusts strategies, believing that is where the fault rests.
Awareness is Power
While there is no magic bullet for overcoming all of our problems or trading struggles, becoming aware of some possible base issues allows us to begin to monitor our thoughts and actions, so that over time we can change our habits. Awareness of potential psychological pitfalls can allow us to change our habits, hopefully creating more profits, lets look at three common psychological quirks that can often cause such problems.
Sensory Derived Bias
We pull information from around us to form an opinion or bias and this allows us to function and learn, in many cases. However, we must realize that, while we may believe we are forming an opinion based on factual evidence, often we are not. If a trader watches the business news each day and forms an opinion that the market is going higher, based on all the available information, he may feel he came to this conclusion by stripping away the media personnels opinions and only listening to the facts. However, this trader still may face a problem: When the source of our information is biased, our own bias will be affected by that.
Even facts can be presented to give credence to the bias or opinion, but we must remember there is always another side to the story. Furthermore, constant exposure to a single opinion or viewpoint will lead individuals to believe that that is the only practical stance on the subject. Since they are deprived of counter evidence, their opinion will be biased by the available information.
Avoiding the Vague
Also known as fear of the unknown, avoiding what may occur, or what is not totally clear to us, prevents us from doing many things and can keep us locked in an unprofitable state. While it may sound ridiculous to some, traders may actually fear making money. They may not be aware of it consciously, but traders often worry about expanding their comfort zone, or simply fear that their profits will be taken away through taxes. Inevitably, this may lead to self sabotage. Another source of bias may come from trading only in the industry with which one is most familiar, even if that industry has been, and is predicted to continue, declining. The trader is avoiding an outcome because of the uncertainty associated with the investment. (To learn about the home bias, check out Is Biased Investing Holding You Back?)
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Another common tendency relates to holding onto the losers too long, while selling the winners too quickly. When prices fluctuate we must factor in the magnitude of the movement, to determine if the change is due to noise or is the result of a fundamental effect. Pulling out of trades too quickly often results from ignoring the trend of the security, as investors adopt a risk-averse mentality. On the other hand, when investors experience a loss, they often become risk seekers, resulting in an over-held losing position. These deviations from rational behavior lead to irrational actions, causing investors to miss out on potential gains, due to psychological biases. (For insight into investors attitudes, refer to Understanding Investor Behavior.)
Tangibility of Anticipation
Anticipation is a powerful feeling. Anticipation is often associated with an I want or I need type of mentality. What we anticipate coming is some time in the future, but the feeling of anticipation is here now and it can be an enjoyable emotion. It can be so enjoyable, in fact, that we make feeling anticipation our focus, instead of achieving what it is we are anticipating in the first place. Knowing that a million dollars is going to show up on your doorstep tomorrow would create a fantastic feeling of excitement and anticipation. It is possible to become addicted to this feeling and thus put off taking payment.
While easy money delivered to the door is more than likely to be grabbed by the eager homeowner, when things are not quite as easy to come by, we can fall into using the feeling of anticipation as a consolation prize. Watching billions of dollars change hands each day, but not having the confidence to follow a plan and take a chunk of the money, can mean we subconsciously decided that dreaming about the profits is good enough. We want to be profitable, but wanting has become our goal, not profitability.
What to Do About It
Once we are aware that we may be affected by our own psychology, we realize it may affect our trading on a subconscious level. Awareness is often enough to inspire change, if we do in fact work to improve our trading.
There are several things we can do to overcome our psychological roadblocks, beginning with removing inputs that are obviously biased. Charts dont lie, but our perceptions of them may. We stand the best chance of success if we remain objective and focus on simple strategies that extract profits from price movements. Many great traders avoid the opinions of others, when it comes to the markets, and realize when an opinion may be affecting their trading.
Knowing how the markets operate and move will help us overcome our fear, or greed, while in trades. When we feel we have entered unknown territory where we dont know the outcome, we make mistakes. However, if we have a firm understanding, at least probabilistically, of how the markets move, we can base our actions on objective decision making.
Finally, we need to lay out what we really want, why we want it and how we are going to get there. Listen in on the thoughts that run through your head right when you make a mistake, and think about the belief behind it; then work to change that belief in your everyday life.
The Bottom Line
Our biases can affect our trading, even when we dont think we are trading on biased information. Also, when an outcome appears vague, we err in our judgment, even though we have a conception of how the market is supposed to move. Our anticipations can also be deterrents from achieving what it is we think we want. To aid us in these potential problems, we can remove biased inputs, gain more understanding of market probabilities and define what it is we really want from our trading.
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Ostrich Approach To Investing A Bird-Brained Idea
Of the different investment strategies and behaviors that an investor or fund manager can adopt, some notable ones include active investing , passive investing and the ostrich effect.
• Active investing involves the constant buying and selling of securities in order to profit from short-term changes in the stock market. This strategy is often very beneficial when the market is doing particularly well.
• Passive investing is just the opposite of active investing: it employs a buy-and-hold strategy to profit from long-term trends in the stock market and is used by investors who want to avoid risks.
• Both active and passive investors may exhibit the ostrich effect, or a tendency to ignore bad news in the market.
While there are similarities between passive investing and the ostrich effect, such as the risk-averse nature of the investors who practice them, there are also major differences. These differences, and the dangers of ignoring market news, will be explored here.
What Is Passive Investing?
Passive investing is a long-term strategy that involves restricted buying and selling of securities. A passive investor buys securities in order to hold them for a long period of time, because he or she believes that stocks will go up in the long run.
An investor who invests passively does not seek to beat the market; he or she just wants to match the markets returns. In order to accomplish this, passive investors often invest in index funds and exchange-traded funds (ETF) that mirror market indexes. This is why passive investing is sometimes referred to as index investing. (Get to know the most important market indexes and the pros and cons of investing in them in Index Investing.)
Advantages of Passive Investing
Some advantages of passive investing include the following:
• Lower costs and higher profits: Investing in index funds usually incurs lower management fees, because a passively traded portfolio requires fewer resources and less time to manage than an actively traded portfolio. If an actively traded portfolio yields the same returns as a passively traded portfolio, the passive investor is going to receive a higher return, because when investors sell a security, the amount of profit they receive is equal to the sell price less the buy price, minus management fees and trading commissions. (Learn how you can save on fees and commissions in Settling Wrap Fees.)
• Automatic gains from market upswings: Since passive portfolios are constructed to closely follow the performance of market benchmarks like the S
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How To Pick A Good Mutual Fund
Are you thinking about investing in a mutual fund, but arent sure how to go about it or which one is the most appropriate based on your needs? Youre not alone. However, what you may not know is that the selection process is much easier than you think.
Identifying Goals and Risk Tolerance
Before acquiring shares in any fund, an investor must first identify his or her goals and desires for the money being invested. Are long-term capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses, or to supplement a retirement that is decades away? Identifying a goal is important because it will enable you to dramatically whittle down the list of the more than 8,000 mutual funds in the public domain .
In addition, investors must also consider the issue of risk tolerance. Is the investor able to afford and mentally accept dramatic swings in portfolio value? Or, is a more conservative investment warranted? Identifying risk tolerance is as important as identifying a goal. After all, what good is an investment if the investor has trouble sleeping at night?
Finally, the issue of time horizon must be addressed. Investors must think about how long they can afford to tie up their money, or if they anticipate any liquidity concerns in the near future. This is because mutual funds have sales charges and that can take a big bite out of an investors return over short periods of time. Ideally, mutual fund holders should have an investment horizon with at least five years or more.
Style and Fund Type
If the investor intends to use the money in the fund for a longer-term need and is willing to assume a fair amount of risk and volatility, then the style or objective he or she may be suited for is a long-term capital appreciation fund. These types of funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be volatile in nature. They also carry the potential for a large reward over time.
Conversely, if the investor is in need of current income, he or she should acquire shares in an income fund. Government and corporate debt are the two of the more common holdings in an income fund.
Of course, there are times when an investor has a longer-term need, but is unwilling or unable to assume substantial risk. In this case, a balanced fund, which invests in both stocks and bonds, may be the best alternative.
Charges and Fees
Mutual funds make their money by charging fees to the investor. It is important to gain an understanding of the different types of fees that you may face when purchasing an investment.
Some funds charge a sales fee known as a load fee, which will either be charged upon the initial investment or upon the sale of the investment. A front-end load fee is paid out of the initial investment made by the investor, while a back-end load fee is charged when an investor sells his or her investment, usually prior to a set time period, such as seven years from purchase.
Both front- and back-end loaded funds typically charge 3 to 6% of the total amount invested or distributed, but this number can be as much as 8.5% by law. Its purpose is to discourage turnover and to cover any administrative charges associated with the investment. Depending on the mutual fund , the fees may go to a broker for selling the mutual fund or to the fund itself, which may result in lower administration fees later on.
To avoid these sales fees, look for no-load funds, which dont charge a front- or back-end load fee. However, be aware of the other fees in a no-load fund, such as the management expense ratio and other administration fees, as they may be very high.
Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come right off of the reported share price at a predetermined point in time. As a result, investors may not be aware of the fee at all. The 12b-1 fees can, by law, be as much as 0.75% of a funds average assets per year.
One final tip when perusing mutual fund sales literature: The investor should look for the management expense ratio. In fact, that one number can help clear up any and all confusion as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investors return will be at the end of the year.
Evaluating Managers and Past Results
As with all investments, investors should research a funds past results. To that end, the following is a list of questions that perspective investors should ask themselves when reviewing the historical record:
• Did the fund manager deliver results that were consistent with general market returns?
• Was the fund more volatile than the big indexes (meaning did its returns vary dramatically throughout the year)?
• Was there an unusually high turnover (which can result in larger tax liabilities for the investor)?
This information is important because it will give the investor insight into how the portfolio manager performs under certain conditions, as well as what historically has been the trend in terms of turnover and return.
With that in mind, past performance is no guarantee of future results. For this reason, prior to buying into a fund, it makes sense to review the investment companys literature to look for information about anticipated trends in the market in the years ahead. In most cases, a candid fund manager will give the investor some sense of the prospects for the fund and/or its holdings in the year(s) ahead as well as discuss general industry trends that may be helpful.
Size of the Fund
Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelitys Magellan Fund. Back in 1999 the fund topped $100 billion in assets and it was forced to change its investment process to accommodate the large daily (money) inflows. Instead of being nimble and buying small- and mid-cap stocks, it shifted its focus primarily towards larger capitalization growth stocks. As a result, its performance suffered.
So how big is too big? There are no benchmarks that are set in stone, but that $100 billion mark certainly makes it difficult for a fund manager to acquire a position in a stock and dispose of it without dramatically running up the stock on the way up and depressing it on the way down. It also makes the process of buying and selling stocks with any kind of anonymity almost impossible.
The Bottom Line
Selecting a mutual fund may seem like a daunting task, but knowing your objectives and risk tolerance is half of the battle. If you follow this bit of due diligence before selecting a fund, you will increase your chances of success.
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Getting Started In Stocks
So youve decided to invest in the stock market. Congratulations! In his 2005 book The Future for Investors, Jeremy Siegel showed that, in the long run, investing in stocks has handily outperformed investing in bonds, Treasury bills, gold or cash. In the short term, one or another asset may outperform stocks, but overall stocks have historically been the winning path.
Tutorial: Stock Basics
But there are so many ways to invest in stocks. Individual stocks, mutual funds, index funds, ETFs, domestic, foreign - how can you decide what is right for you? This article will address several issues that you, as a new (or not-so-new) investor, might want to consider so that you can rest more easily while letting your money grow.
Risk Taker, Risk Averse or in the Middle?
You may be eager to get started so that you, too, can make those fabulous returns you hear so much about, but slow down and take a moment to contemplate some simple questions. The time spent now to consider the following will save you money down the road.
What kind of person are you? Are you a risk taker, willing to throw money at a chance to make a lot of money, or would you prefer a more sure thing? What would be your likely response to a 10% drop in a single stock in one day or a 35% drop over the course of a few weeks? Would you sell it all in a panic?
The answers to these and similar questions will lead you to consider different types of equity investments, such as mutual or index funds versus individual stocks. If you are naturally not someone who takes risks, and feel uncomfortable doing so but still want to invest in stocks, the best bet for you might be mutual funds or index funds. This is because they are well diversified and contain many different stocks. This reduces risk - and doesnt require individual stock research. (For more insight, read Personalizing Risk Tolerance, Mutual Fund Basics and The Lowdown On Index Funds.)
Have much time and interest do you have for investing?
Should you invest in funds, stocks or both? The answer depends on how much time you wish to devote to this endeavor. Careful selection of mutual or index funds would let you invest your money, leaving the hard work of picking stocks to the fund manager. Index funds are even simpler in that they move up or down according to the type of company, industry or market they are designed to track.
Individual stock investing is the most time consuming as it requires you to make judgments about management, earnings and future prospects. As an investor, you are attempting to distinguish between a money-making stock and financial disaster. You need to know what they do, how they make their money, the risks, the future prospects and much more.
Therefore, ask yourself how much time you have to devote to this enterprise. Are you willing to spend a couple of hours a week, or more, reading about different companies, or is your life just too busy to carve out that time? Investing in individual stocks is a skill, which, like any other, takes time to develop. (For more on this research, read Introduction To Fundamental Analysis.)
Eggs in One Basket
It is best that you not be exposed to only one type of asset. For instance, dont put all of your money in small biotech companies. Yes, the potential gain can be quite high, but what will happen to your investment if the Food and Drug Administration starts rejecting a higher percentage of new drugs? Your entire portfolio would be negatively impacted. (For related reading, see The Ups And Downs Of Biotechnology.)
It is better to be diversified across several different sectors such as real estate (a real estate investment trust is one possibility), consumer goods, commodities, insurance, etc., rather than focusing on one or two or three, as above. Consider diversifying across asset classes, as well, by keeping some money in bonds and cash, rather than being 100% invested in stocks. How much to have in these different sectors and classes is up to you, but being invested more broadly lessens the risk of losing it all at any one time. (For more insight, check out Introduction To Diversification.)
A Portfolio for Beginners
If you are just starting out, think seriously about investing most of your money in a couple of index funds, such as one tracking the broad market (e.g. the S
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The Risks Of Investing In Emerging Markets
Investing is always risky business; corporate scandals regularly surface in the news, corporate bonds are frequently downgraded, accounting fraud is often revealed and market imperfections such as the flash crash continuously bring a level of uncertainty. Even the most stable domestic blue chip companies will face times of tremendous volatility.
Emerging markets offer numerous benefits to investors such as elevated economic growth rates, higher expected returns and diversification benefits. However, there are a number of important risks to consider before investing in regions outside of the developed world. (Emerging markets provide new investment opportunities, but there are risks - both to residents and foreign investors. See What Is An Emerging Market Economy?)
1) Foreign Exchange Rate Risk
Foreign investments in stocks and bonds will typically produce returns in the local currency of the investment. As a result, investors will have to convert this local currency back into their domestic currency. An American who purchases a Brazilian stock in Brazil will have to buy and sell the security using the Brazilian real. Therefore, currency fluctuations can impact the total return of investment. If, for example, the local value of a held stock increased by 5%, but the real depreciated by 10%, the investor will experience a net loss in terms of total returns when selling and converting back to U.S. dollars.
2) Non-Normal Distribution
North American market returns arguably follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be valuated using the same type of mean-variance analysis. Also, because emerging markets are undergoing constant changes, it is almost impossible to utilize historical information in order to draw proper correlations between events and returns.
3) Lax Insider Trading Restrictions
Although most countries claim to enforce strict laws against insider trading, none have proved to be as rigorous as America in terms of prosecuting unfair trading practices. Insider trading and various forms of market manipulation introduce market inefficiencies, whereby equity prices will significantly deviate from their intrinsic value. Such a system can be subject to extreme speculation, and can also be heavily controlled by those holding privileged information.
4) Less Liquidity
Emerging markets are generally less liquid than those found in the developed world. This market imperfection results in higher broker fees and an increased level of price uncertainty. Investors who try to sell stocks in an illiquid market face substantial risks that their orders will not be filled at the current price, and the transactions will only go through at an unfavorable level. Additionally, brokers will charge higher commissions, as they have to make more diligent efforts to find counterparties for trades. Illiquid markets prevent investors realizing the benefits of fast transactions.
5) Difficulty Raising Capital
A poorly developed banking system will prevent firms from having the proper access to financing that is required to grow their businesses. Attained capital will usually be issued at a high required rate of return, increasing the companys weighted average cost of capital (WACC). The major concern with having a high WACC is that fewer projects will produce a high enough return to yield a positive net present value. Therefore, financial systems found in developed nations do not allow companies to undertake a higher variety of profit-generating projects. (This asset class has left much of its unstable past behind. Find out how to invest in it, in Investing In Emerging Market Debt.)
6) Poor Corporate Governance System
A solid corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater voice in the firm than shareholders. Furthermore, when countries have restrictions on corporate takeovers, management does not have the same level of incentive to perform in order to maintain job security. While corporate governance in the emerging markets has a long road to go before being considered fully effective by North American standards, many countries are showing improvements in this area in order to gain access to cheaper international financing.
7) Increased Chance of Bankruptcy
A poor system of checks and balances and weaker accounting audit procedures increase the chance of corporate bankruptcy. Despite that bankruptcy is common in every economy, such risks are most common outside of the developed world. Within emerging markets, firms can more freely cook the book to give an extended picture of profitability. Once the corporation is exposed, it experiences a sudden drop in value. This is not to say that such occurrences do not happen in North America and Europe.
Because emerging markets are viewed as being more risky, they will have to issue bonds that pay higher interest rates. The increased debt burden further increases borrowing costs and strengthens the potential for bankruptcy.
8) Political Risk
Political risk refers to uncertainty regarding adverse political decisions. Developed nations tend to follow a free market discipline of low government intervention, whereas emerging market businesses are often privatized upon demand. Some additional factors that contribute to political risk are: possibility of war, tax increase, loss of subsidy, change of market policy, inability to control inflation and laws regarding resource extraction. Major political instability can also result in civil war and a shutdown of industry, as workers either refuse or are no longer able to do their jobs. (Find out how these worldly offerings can spice up your portfolio. Check out Go International With Foreign Index Funds.)
Conclusion
Investing in emerging markets can produce substantial returns to ones portfolio. However, investors must be aware that all high returns must be judged within the risk and reward framework. The aforementioned risks are some of the most prevalent that must be assessed prior to investing. Unfortunately, however, the premiums associated with these risks can often only be estimated, rather than determined on a concrete basis.
Introduction To International REITs
Investing in real estate investment trusts (REITS) has long been an excellent way for investors to diversify stock portfolios. In 2007, the global real estate market represented more than $900 billion of equity capitalization and was growing, according to the National Association of Real Estate Investment Trusts (NAREIT). For the longest time, publicly-traded real estate investment trusts were only available in the areas like the U.S. or Australia; now, more foreign countries are adopting similar structures.
Tutorial: Exploring Real Estate Investments
If youre an investor who owns U.S. REITs, you are only seeing part of the total picture. In fact, a shift toward an international REIT portfolio may be more suitable. Expanding an investment portfolio to include international real estate could open the door to potential return opportunities while further dampening portfolio risk. As is said in real estate, its all about location, location, location.
Breakdown of Global REIT Market
Before we begin to dissect the characteristics and benefits of investing in foreign REITs, let us first recap the REIT universe as a whole. A REIT is a corporation that purchases, owns and manages real estate properties and/or mortgage loans. The REIT structure is unique in that REITs are given special tax status that allows them to avoid corporate tax, as long as 90% of the income is distributed to investors. Although the REIT structure avoids double taxation to shareholders, tax losses cannot be passed through. (To read more REIT basics, see What Are REITs? and ourExploring Real Estate Investments tutorial.)
The global real estate securities market has grown significantly as both developed and developing countries move to create REIT or REIT-like corporate structures. Prior to 1990, however, only the U.S., the Netherlands, Australia and Luxembourg had adopted REIT-like structures. In 2007, according to Dimensional Fund Advisors, the global REIT market was dominated by the U.S. (55%), Australia, Great Britain and Japan. Therefore, non-U.S. REITS make up almost half of the global REIT market. The global REIT universe continues to expand; therefore, investors who limit their REIT positions to U.S.-only funds will also likely limit their opportunities. (Keep reading on this subject in The Emergence Of Global Real Estate.)
Benefits of REITs
One of the benefits of REITs when compared to direct equity real estate investments is that investors have the ability to more effectively and efficiently diversify their real estate portfolios because REITs tend to be more liquid. Of course, the biggest advantage offered by REITs is the diversification benefit. Investors strive to locate asset classes that offer low correlations to other positions in their portfolios. The lower the correlation, the lower the idiosyncratic risk. (To learn more about the benefits of diversification, see Introduction To Diversification and Risk And Diversification.)
The chart below illustrates the low correlation that REITs have to other U.S. core indexes over an extended period of time.
Monthly Return Correlation Coefficient: January 1979 to December 2006
-- Equity REIT Index S
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.
Why Expense Ratios Are Important To Investors
The most valuable pieces of advice ever shared regarding investing of any kind, in ascending order of importance:
1. Fundamental analysis is crucial. Technical analysis is akin to fortune telling by interpreting patterns in tea leaves.
2. Its not a game or a hobby. Spend hours researching an investment when others are spending minutes. Spend days when others are spending hours. Done right, youll still enjoy a stupendous return on your time.
3. You make your money going in.
Its straightforward math, and easy to overlook or dismiss in its simplicity. An overpriced asset is that much harder to gain a return on than an underpriced or properly priced one. Wait for a real estate bubble (or, say, the hoopla surrounding a social networking sites much-anticipated initial public offering) to subside and then buy; yourmargin for error and potential for return should increase correspondingly.
The Price of Management
Were not talking about normal price fluctuations, here, or the inherent unpredictability that comes with almost any investment. Rather, were looking at whats essentially a surcharge on the price of the investment, levied before you buy. For example, take two new cars with the same model, same color and same options. One dealer sells the first vehicle for $22,000, out the door. The other sells the identical vehicle for $22,000, but with a $495 non-negotiable advertising and marketing assessment. Do you need to be told to buy the former? Its like purchasing a residential air filter in Vancouver, Washington (and paying 8% state sales tax) instead of going across the river and buying the same thing in Portland (Oregon levies no sales tax).
This is how it goes with mutual funds, the financial product of choice for most casual and many sophisticated investors. While no two funds are indistinguishable, two similarly constituted funds can come with price tags that differ considerably. Why? Varying expense ratios.
Its understandable that a mutual funds price costs more than the prices of its components. It costs money to create a fund. The fund has to be set up, registered and maintained. The firm that created it and that hired its managers has to be compensated. However, to what tune? The U.S. Securities
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Institutional Knowledge/Research
In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a companys disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given companys management team than the average individual investor. (Read more about the role of Reg FD in Defining Illegal Insider Trading.)
Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge.
This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time. (You can piece together your own analysis if you have the right information. Read Do-It-Yourself Analyst Predictions to find out how.)
This is compounded by the fact that analysts can sit and wait for new information ,while the average Joe has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.
Keeping Tabs on Institutions Is Tough
Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.
Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter.
In fact, take T. Rowe Price as an example. According to the companys website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. Thats big. This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.
What happens in between? Frankly, those looking to mimic the institutions portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market. (Learn some ways you can keep track of institutional investment activities in Keeping An Eye On The Activities Of Insiders And Institutions.)
Trading Costs Can Be Huge, and Treatment May Vary
By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.
Funds often receive favorable treatment. In fact, its not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock – whereas individual investors will typically pay 5-10 cents per share.
In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points. (ReadPatience Is A Traders Virtue and A Look At Exit Strategies for a discussion of setting entry and exit points.)
In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall.
Bottom Line
While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.
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4 Basic Facts To Know About IRAs
You might have heard a lot about individual retirement accounts (IRAs) but know very little about what they are or how they can help you reach your retirement goal. Instead of bogging you down with a whole of lot of technicalities, lets take a look at the basics of the IRA. What do you need to know before you get started? (For related reading, see 11 Things You May Not Know About Your IRA.) An individual retirement account or IRA is a vehicle set up to help you reach your retirement goals. Weve all heard that having all of our financial eggs in one basket is a bad idea. So the Internal Revenue Service (IRS) set up the IRA with similar tax benefits as a 401(k) that you may have at work. Its a good idea to have both a 401(k) and an IRA to remain diversified.
The Limits
The IRS allows you to deposit up to $5,000 per year if youre under the age of 50 and $6,000 per year if youre over 50. These maximums will stay in place for the 2012 tax year but may change in future years. You must also have earned income to contribute to an IRA, but that could include a spouse if youre married.
Two Types
What can quickly turn people off to the IRA is the fact that there are two different types of IRAs . The traditional IRA doesnt require that you pay taxes on your gains until you start taking distributions. (Distribution is the term used to describe the withdrawals you make once you reach retirement age.) The traditional IRA keeps more money in your account over time and that allows the money to compound at a faster rate.
The Roth IRA requires that you pay taxes now, at your current rate, because the money youre contributing was already taxed before you received your check. This allows your earnings to grow tax fee, and if you anticipate being in a higher tax bracket in the future, the Roth is probably your best choice. (For additional reading, see Roth Vs. Traditional IRA: Which Is Right For You?)
Eligibility
With both IRAs there are eligibility requirements. With the traditional IRA, you can only deduct your contributions if your family earnings fall below certain maximums and if youre covered under an employee sponsored plan like a 401(k). According to the Vanguard Group, if your traditional IRA isnt deductible, a Roth IRA is the better choice. With the Roth, your contributions are never deductible and there are income limits. If youre single and make more than $125,000 in 2012, you arent eligible to open a Roth.
Fact 4: The Costs
In order to open an IRA , youll need a bank or investment broker. Some of the discount brokers offer no-fee IRAs other than the commissions charged to buy and sell within the account. Other brokers will charge a yearly management fee even if they arent managing the account for you. Look for a no fee IRA. If youre charged a 1% management fee, that could equate to a 30% lower balance over a 30 year period. So keeping fees to a minimum is key.
Whether its a Roth or traditional IRA , get started. The money that is sitting in your savings account earning little to no interest could work harder for you in an IRA with safe investment choices. Dont know how to invest the money? Ask a fee only advisor for some help. Many are happy to charge you a one-time fee and a fee for an annual consultation. (To learn more, check out Paying Your Investment Advisor - Fees Or Commissions?)
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6 Proven Methods For Selling Stocks
Choosing a time to sell a stock can be a very difficult task. It is especially difficult because, for most traders, it is hard to separate their emotions from their trades. The two human emotions that generally affect most traders with regards to selling a stock are greed and fear of regret. The ability to manage these emotions is key to becoming a successful trader.
Rising Profits
For example, many investors dont sell when a stock has risen 10 to 20% because they dont want to miss out on more returns if the stock shoots to the moon. This is due to their greed and the hope that the stock they picked will be a big winner. On the flip side, if the stock fell by 10 to 20%, a good majority of investors still wont sell because of their fear of regret. If they sell and the stock proceeds to rebound significantly, theyll be kicking themselves and regretting their actions.
So when should you sell your stock? This is a fundamental question that investors constantly struggle with. You need to separate out the emotion from your trading decisions. Fortunately, there are some commonly used methods that can help an investor make the process as mechanical as possible. In this article, I will look at six general strategies to help decide when to sell your stock.
Valuation-Level Sell
The first selling category well look at is called the valuation-level sell. In the valuation level sell strategy, the investor will sell a stock once it hits a certain valuation target or range. Numerous valuation metrics can be used as the basis, but some common ones that are used are the price-to-earnings (P/E) ratio, price-to-book (P/B), and price-to-sales (P/S). This approach is popular among value investors who buy stocks that are undervalued. It can be a good signal to sell when a stock becomes overvalued based on certain valuation metrics.
As an illustration of this method, suppose an investor holds stock in Wal-Mart that they bought when the P/E ratio was around 13 times earnings. The trader looks at the historical valuation of Wal-Mart stock and sees that the five-year average P/E is 15.5. From this, the trader could decide upon a valuation sell target of 15.5 time earnings as a fixed sell signal. So the trader has used a reasonable hypothesis to take the emotion out of his decision making. (For more on the P/E, see Profit With The Power Of Price-To-Earnings.)
Opportunity Cost Sell
The next one well look at is called the opportunity cost sell. In this method, the investor owns a portfolio of stocks and would sell a stock when a better opportunity presents itself. This requires a constant monitoring, research and analysis on both your own portfolio and potential new stock additions. Once a better potential investment has been identified, the investor would reduce or eliminate a position in a current holding that isnt expected to do as well as the new stock on a risk-adjusted return basis.
Deteriorating Fundamentals Sell
The deteriorating fundamental sell rule will trigger a stock sale if certain fundamentals in the companys financial statements fall below a certain level. This sell strategy is slightly similar to the opportunity cost in the sense that a stock sold using the previous strategy has likely deteriorated in some way. When basing a sell decision on deteriorating fundamentals, many traders will focus mainly on the balance sheet statement with emphasis on liquidity and coverage ratios. (Learn more about the balance sheet in Breaking Down The Balance Sheet.)
For example, suppose an investor owns the stock of a utilities company that pays a relatively high and consistent dividend. The investor is holding the stock mainly because of its relative safety and dividend yield. Furthermore, when the investor bought the stock, its debt-to-equity ratio was around 1.0 and its current ratio was around 1.4.
In this situation, a trading rule could be established so that the investor would sell the stock if the debt/equity ratio rose over 1.50, or if the current ratio ever fell below 1.0. If the companys fundamentals deteriorated to those levels – thus threatening the dividend and the safety - this strategy would signal the investor to sell the stock.
Down-from-Cost and Up-from-Cost Sell
The down-from cost sell strategy is another rule-based method that triggers a sell based on the amount, in percent, that youre willing to lose. For example, when an investor purchases a stock he may decide that if the stock falls 10% from where he bought it at, he would sell the stock.
Similar to the down-from cost strategy, the up-from cost strategy will trigger a stock sale if the stock rises a certain percentage. Both the down-from-cost and up-from-cost methods are essentially a stop-loss measure that will either protect the investors principal or lock in a specific amount of profit. The key to this approach is selecting an appropriate percentage that triggers the sell by taking into account the stocks historical volatility and the amount you would be willing to lose.
Target Price Sell
If you dont like using percentages, the target price sell method uses a specific stock value to trigger a sell. This is one of the most widely used ways by which investors sell a stock, as seen by the popularity of the stop-loss orders with traders and investors. Common target prices used by investors are typically ones based on valuation model outputs such as the discounted cash flow model. Many traders will base target price sells on arbitrary round numbers or support and resistance levels, but these are less sound than other fundamental based methods.
Bottom Line
Learning to accept a loss on your investment is one of the hardest things to do in investing. Oftentimes, what makes investors successful is not just their ability to choose winning stocks, but also their ability to sell stocks at the right time.
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6 Dangerous Moves For First-Time Investors
Thanks to online discount brokerages, anyone with an Internet connection and a bank account can be up and trading stocks within a week. This ease of access is great because it encourages more people to explore investing for themselves, rather than depending on mutual funds or money managers. However, there are some common mistakes that first time investors have to be aware of before they try picking stocks like Buffett or shorting like Soros. (To learn more, see Billionaire Portfolios: What Are They Hiding?)
Jumping In Head First
The basics of investing are quite simple in theory – buy low and sell high. In practice, however, you have to know what is low and what is high in a market where everything hinges on different readings of a variety of ratios and metrics. What is high to the seller is considered low (enough) to the buyer in any transaction, so you can see how different conclusions can be drawn from the same market information. Because of the relative nature of the market, it is important to study up a bit before jumping in. (To learn more, see Stochastics: An Accurate Buy And Sell Indicator.)
At the very least, know the basic metrics such as book value, dividend yield, price-earnings ratio (P/E) and so on, and understand how they are calculated and where their major weaknesses lie. While you are learning, you can see how your conclusions work out by using virtual money in a stock simulator. Most likely, youll find that the market is much more complex than a few ratios can express, but learning those and testing them on a demo account can help lead you to the next level of study. (Watching metrics like book value and P/E are crucial to value investing. Get acquainted with 5 Must-Have Metrics for Value Investing.)
Playing Penny Stocks
At first glance, penny stocks seem like a great idea. With as little as $100, you can get a lot more shares in a penny stock than a blue chip that might cost $50 a share. And, if the two blue chip shares you bought went up $1 youd only make $2, whereas if 100 shares of a $1 stock went up a $1 you would double your money. Unfortunately, what penny stocks offer in position size and potential profitability has to measure against the volatility that they face. Penny stocks can shoot up. It happens all the time - but they can also crash in moments, and are exceptionally vulnerable to manipulation and illiquidity. Getting solid information on penny stocks can also be difficult, making them a poor choice for an investor who is still learning. (To learn more, read The Lowdown On Penny Stocks.)
Going All In with One Investment
Investing 100% of your capital in a specific market, whether it is the stock market, commodity futures, forex or even bonds is not a good move. Although you may eventually decide to throw diversification to the wind and put all your available capital into these markets once you are familiar with them, it is better to risk a little bit of capital at a time. This way, the lessons learned along the way are less costly, but still valuable. (Diversification entails calculating correlation, learn more about it by reading Diversification: Protecting Portfolios From Mass Destruction.)
Leveraging Up
Leveraging your money by using a margin is similar to going all in, but much more damaging. Using leverage magnifies both the gains and the losses on a given investment. Some forms of leverage, such as options, have a limited downside or can be controlled by using specific market orders, as in forex. Learning to control the amount of capital at risk comes with practice, and until an investor learns that control, leverage is best taken in small doses (if at all). (Read more with Leverages Double-Edged Sword Need Not Cut Deep.)
Investing Cash Reserves
Studies have shown that cash put into the market in bulk rather than incrementally has a better overall return, but this doesnt mean you should invest to the point of illiquidity. Investing is a long-term business whether you are a buy-and-hold investor or a trader, and staying in business requires having cash on the sidelines for emergencies and opportunities. Sure, cash on the sidelines doesnt earn any returns, but having all your cash in the market is a risk that even professional investors wont take. If you only have enough cash to invest or have an emergency cash reserve, then youre not in a position financially where investing makes sense. (To learn more about liquiditys importance, read Understanding Financial Liquidity.)
Chasing News
Trying to guess what will be the next Apple, a revolutionary produce or a rumor of earth shaking earnings, investing on news is a terrible move for first time investors. The best case scenario is that you get lucky, and then keep doing it until your luck fails. The worst case scenario is that you get stuck jumping in late (or investing on the wrong rumor) time and time again before you give up on investing. Rather than following rumors, the ideal first investments are in companies you understand and have a personal experience dealing with. This connection makes it easier to stomach the time and research that investing demands. (For more on the psychology of trading, read How The Power Of The Masses Drives The Market.)
The Bottom Line
When you are starting to invest, it is best to start small and take the risks with money you are prepared to lose. As you gain confidence and become more adept at evaluating stocks and reading the market sentiment, you can start making bigger investments. None of these investments are bad in and of themselves, but they do tend to be very unforgiving towards rookie mistakes. Leverage, penny stocks, news trading, etc. can all become part of your investing strategy as you learn, should you choose it. The trick is learning to invest in more stable markets before you jump into the wilder areas.
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Get Organized With An Investment Analysis Form
When youre thumbing through annual reports, proxy statements and analyst ratings of multiple companies, the numbers can start to blur together. On top of that, once youve taken a look at all the financials a company has to offer, you can find yourself wondering what the significance is of the figures youve been looking at. Its information overload and its to be expected in any situation where fairly abstract ideas, like solvency ratios and assets per share, are thrown about in large quantities. In this article, well show you how to organize all the company information youve gathered into a readable and useful format.
Just sitting down with a bunch of financial statements isnt a very efficient or effective way of determining whether or not a company is a good investment decision. Youve got to organize your thoughts - otherwise youre just going to be spinning your wheels. Thats why creating your own investment analysis form can be one of the most valuable investment tools in your arsenal. An investment analysis form is a tool that you can use to help gather numbers and essential information needed to make an investment decision in one easy-to-use format.
Simplify Your Research
An investment analysis form is the perfect place to record key figures and pieces of information about your company as you find them in your research. This can be done on a customized form on a sheet of paper or on the computer through a spreadsheet program.
An investment analysis form allows you to better interpret your data systematically, as all of the information is collected into a standardized format. Because information is plugged in uniformly, youre guaranteed not to miss anything that you have deemed important.
An investment analysis form also allows an investor to simplify his or her research by only looking at information that is relevant to the investment decision , while throwing out any superfluous data. There are a lot of reasons why you might run into extraneous information in your research, but unless you make sure that its kept out of your investment criteria, its difficult to say whether or not unimportant information is influencing an important decision.
You can bet that investment professionals dont just go at a 10-K without a plan, and neither should you.
Collect Key Figures
Information Within the Form
The first step in developing your own investment analysis form is determining what you want to include in it. There are some figures that are essential and some that will be specific to your individual investing style.
Things like recent stock price, earnings per share (EPS), price/earnings ratio and total debt are pretty universal. Dont have an investment form that is missing an essential piece of financial information - anything that you would expect to see on the stock quote page of your favorite financial website should probably be included.
Numbers arent the only thing that belongs on the form. Youll definitely want places to write in things like products, addressed and unaddressed risk, legal troubles and the like. Your personal instincts and impressions after doing your research will be invaluable when you go back to looking at the stock a day or a year down the road, so make sure that you have a place to write them down. If you do a lot of investment research , its even easier to forget your impressions about a certain stock. Thats when having all those comments right at your fingertips is such a benefit. (Learn why it is helpful to keep a log of your instincts and actions, read Lessons From A Traders Diary.)
Now that youve got the essentials and the write-ins taken care of, dont forget the simple stuff. Have a place for the company name, the symbol and the date you did your research. Include things like state of incorporation, investor relations contact and a phone number for the main circuit board. While it may seem like a lot, it sure comes in handy when you need to reach someone to voice your concerns or just to get the latest financials from the company.
The process of creating an investment form is not a one-time deal, as you will likely make many changes over time as you hone your analysis skills.
Creating the Form
There are a couple of ways to set up your form. You can take a pen and paper and set up your spaces to write in information or, for the technically inclined, you can put it together on your computer using anything as simple as a word processor or as complex as professional page layout software.
If youd prefer to go paperless, using a spreadsheet program like Microsoft Excel can offer you quite a bit of flexibility. If you prefer to use the old-school paper method, take your form template to your closest copy center and go copy crazy. Make enough copies so that you wont have to worry about running out in the near future. That way, when they are finally ready for some analyzing, youll have all the blank copy forms youll need.
Analyze Your Investments
Once youre all set up with a form of your own, youll probably find that collecting your thoughts is a lot easier than it used to be. If you can interpret a stock quote online, you should have no problem interpreting the data youd want to include on your form. It just simplifies the process of investment analysis.
Where the idea of an investment analysis form really shines is when youre trying to scale across investments . Having information available to you in an organized way for multiple companies makes a comparison of two companies a much less impractical task and can help cement your understanding of what attributes make for an attractive investment. Just dont forget that an investment analysis form is just an aide. It wont tell you whether a particular stock is a smart investment, but it can help you organize your thoughts and data so that you can make that determination for yourself.
Conclusion
Scouring through piles of 10-Ks can be an unpleasant and confusing task, especially for a less experienced investor, but with the right tools for the job, making use of the information you collect can be all the easier. Creating your own investment analysis form can enable you to interpret the information you deem important in selecting an investment without losing your head in a sea of numbers.
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When Stock Prices Drop, Wheres The Money?
Have you ever wondered what happened to your socks when you put them into the dryer and then never saw them again? Its an unexplained mystery that may never have an answer. Many people feel the same way when they suddenly find that their brokerage account balance has taken a nosedive. So, where did that money go? Fortunately, money that is gained or lost on a stock doesnt just disappear. Read to find out what happens to it and what causes it.
Disappearing Money
Before we get to how money disappears, it is important to understand that regardless of whether the market is in bull (appreciating) or bear (depreciating) mode, supply and demand drive the price of stocks, and fluctuations in stock prices determine whether you make money or lose it.
So, if you purchase a stock for $10 and then sell it for only $5, you will (obviously) lose $5. It may feel like that money must go to someone else, but that isnt exactly true. It doesnt go to the person who buys the stock from you. The company that issued the stock doesnt get it either. The brokerage is also left empty-handed, as you only paid it to make the transaction on your behalf. So the question remains: where did the money go?
Implicit and Explicit Value
The most straightforward answer to this question is that it actually disappeared into thin air, along with the decrease in demand for the stock, or, more specifically, the decrease in investors favorable perception of it. (For more on what drives stock price , see Stocks Basics)
But this capacity of money to dissolve into the unknown demonstrates the complex and somewhat contradictory nature of money. Yes, money is a teaser - at once intangible, flirting with our dreams and fantasies, and concrete, the thing with which we obtain our daily bread. More precisely, this duplicity of money represents the two parts that make up a stocks market value: the implicit and explicit value.
On the one hand, money can be created or dissolved with the change in a stocks implicit value, which is determined by the personal perceptions and research of investors and analysts. For example, a pharmaceutical company with the rights to the patent for the cure for cancer may have a much higher implicit value than that of a corner store.
Depending on investors perceptions and expectations for the stock, implicit value is based on revenues and earnings forecasts. If the implicit value undergoes a change - which, really, is generated by abstract things like faith and emotion - the stock price follows. A decrease in implicit value, for instance, leaves the owners of the stock with a loss because their asset is now worth less than its original price. Again, no one else necessarily received the money; it has been lost to investors perceptions.
Now that weve covered the somewhat unreal characteristic of money, we cannot ignore how money also represents explicit value, which is the concrete worth of a company. Referred to as the accounting value (or sometimes book value), the explicit value is calculated by adding up all assets and subtracting liabilities. So, this represents the amount of money that would be left over if a company were to sell all of its assets at fair market value and then pay off all of liabilities. (For more insight, read Digging Into Book Value and Value By The Book.)
But you see, without explicit value, implicit value would not exist: investors interpretation of how well a company will make use of its explicit value is the force behind implicit value.
Disappearing Trick Revealed
For instance, in February 2009, Cisco Systems Inc. (Nasdaq:CSCO) had 5.81 billion shares outstanding, which means that if the value of the shares dropped by $1, it would be the equivalent to losing more than $5.81 billion in (implicit) value. Because CSCO has many billions of dollars in concrete assets, we know that the change occurs not in explicit value, so the idea of money disappearing into thin air ironically becomes much more tangible. In essence, whats happening is that investors, analysts and market professionals are declaring that their projections for the company have narrowed. Investors are therefore not willing to pay as much for the stock as they were before.
So, faith and expectations can translate into cold hard cash, but only because of something very real: the capacity of a company to create something, whether it is a product people can use or a service people need. The better a company is at creating something, the higher the companys earnings will be and the more faith investors will have in the company.
In a bull market, there is an overall positive perception of the markets ability to keep producing and creating. Because this perception would not exist were it not for some evidence that something is being or will be created, everyone in a bull market can be making money. Of course, the exact opposite can happen in a bear market .
To sum it all up, you can think of the stock market as a huge vehicle for wealth creation and destruction.
Disappearing Socks
No one really knows why socks go into the dryer and never come out, but next time youre wondering where that stock price came from or went to, at least you can chalk it up to market perception.
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Get A Hold On Mishandled Accounts
Investors often look to professionals to help them navigate the markets and provide a certain level of service, but there are times when they may feel that an account is being mishandled. As tempting as it may be to find someone to blame for monetary losses, they are often the result of market conditions and investors must be prepared for such risks. However, arbitration or other avenues may be warranted if evidence suggests that a broker recommended an unsuitable investment, committed fraud, or charged excessive commissions by churning the account. In this article, well help you to decide whether your account has been mishandled and if you do need to act on the complaint. (To learn more, see Paying Your Investment Advisor - Fees Or Commissions?)
Your First Steps
If you feel that your broker has not acted in your best interest, try to exhaust all possible remedies with the investment company. After quantifying the loss, schedule a meeting with the primary contact at the investment firm to have an extensive discussion, and listen to the brokers side of the story. If this process does not yield adequate information, escalate the complaint to the next level of management until some type of resolution is reached. This may include various outcomes, including simply waiting for the markets to improve to ending all discussions and proceeding with legal action.
If the dispute is with a broker, you probably already agreed to settle through arbitration when you began working with the firm. In this case, the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (NASD), would handle the arbitration process from start to finish. The groups dispute resolution forum helps resolve matters between investors and securities firms, as well as industry-related issues between individual registered representatives and their firms. (To learn more, see Broker Gone Bad? What To Do If You Have A Complaint and When A Dispute With Your Broker Calls For Arbitration.)
If You Need Legal Representation
As with any potentially lucrative legal proceeding, many legal advisors offer free consultations. Consulting an attorney opens up an outside perspective and can help confirm the appropriate forum for resolving a dispute. This is a good time to begin building a short list of potential litigators, should the need arise. If an arbitration path is appropriate, the list will shrink, as more attorneys handle court cases than arbitration.
While the entire process is simplified in order for any one who has a grievance to file a claim and proceed, the majority of customers pursue their claims in conjunction with a legal team that includes at least one attorney and an expert witness. It is also a good time to set reasonable expectations with potential outcomes and time frames. Do not count on large settlements that include punitive damages, as such generous judgments are rarely rendered. Be prepared to wait months or even years before the arbitration date is set. Depending on the size of the claim and the legal participants, anticipate that arbitration that is not completed in the originally scheduled time frame may be postponed to accommodate participant and panel members schedules.
The Arbitration Process
The table below presents the number of cases handled by FINRA on an annual basis. Typically, the caseload increases in years following volatile financial markets where investors have suffered losses. Caseloads hit historically high levels in 2003, approximately two years after what the tech bubble burst and the stock market plunged.
Year Cases
2002 7,704
2003 8,945
2004 8,201
2005 6,074
2006 4,614
2007 3,238
If arbitration appears to be the best course of action, visit the FINRA website and search pending cases with the investment firm or registered representative in question. The listing will provide a summary and itemization of any pending or closed cases against the firm and its representative or advisor. It will not, however, include every issue or any cases that expunged the record as part of the settlement.
If the search is for a registered investment advisor (RIA) rather than someone who works for a brokerage firm, you will be redirected to the Securities And Exchange Commission (SEC) website, or possibly to a state-sponsored site if the advisor is state licensed. If the search is for a registered representative or a brokerage firm, FINRAs BrokerCheck program will search data from the Central Registration Depository (CRD) registration and licensing database, which gathers data reported on industry registration and licensing forms. BrokerCheck reports professional background information on currently registered brokers, registered securities firms and previously registered parties. One section provides vital information regarding events reported at the CRD, which is required by the securities industry registration and licensing process. Any number of financial disclosures can be listed here, including bankruptcies or unpaid liens. The listing might also contain formal investigations, customer disputes, disciplinary actions and criminal charges or convictions.
Filing a Complaint
If you determine that the portfolio was mishandled, the next step is to file a complaint. FINRA suggests doing so as soon as possible to avoid a delay in arbitration or mediation. Mediation, which can serve as a supplement or replacement for arbitration depending on the outcome, is a voluntary process in which both parties can settle their disputes in a non-binding format. For most claims under $25,000, the process is resolved primarily through written statements filed by each party to FINRA. At any point the claimant, respondent, or arbitrator may request a hearing. These smaller cases can be assigned to a single arbitrator and may settle fairly quickly.
Claim amounts greater than $25,000 are usually assigned to a three-person arbitration panel. Because they typically settle in-person and involve more formalities, they tend to take longer. FINRA offers a complete online claim filing process, and this is where most investors get bogged down. While FINRA has streamlined the process for the layman to follow, it is still a legal proceeding with required documents such as the statement of claim. Many frustrated investors will pursue the services of an attorney at this point.
Evaluate Your Progress
This stage of the process is a good time to step back, evaluate your progress, and set time frames and expectations. Keep in mind, however, that the relationship between you and the representative or advisor has changed. While customers sometimes stay with the company against which they have filed claims, most do not. Depending on the claim or loss, they have probably moved to another firm, liquidated their holdings or made other arrangements. The process from this point on becomes a legal proceeding, although it is slightly less formal than a typical court proceeding; you should view this process as a resolution-in-progress.
Conclusion
FINRA provides a framework for licensing, registration, education, monitoring and policing of the brokerage community to ensure the public receives the best service. While the vast majority of financial service professionals provide excellent service, some accounts are mishandled and FINRA has the process available for anyone to pursue what he or she believes is a valid claim. It is important to remember that all decisions made by either the sole arbitrator or the combined panel are binding and that the judgments are enforceable, as they would be in a court. Finally, consider that while the investor has every right to pursue a claim, doing so carries costs such as filing fees, arbitration and/or mediation fees, and if the panel decides a case is frivolous, legal and other costs will apply.
BarChart Technical Analysis NITE-LYNX $MNGGF
http://www.barchart.com/technicals/stocks/MNGGF
The 6 Most Common Portfolio Protection Strategies
The key to successful long-term investing is the preservation of capital. Warren Buffett, arguably the worlds greatest investor, has one rule when investing - never lose money. This doesnt mean you should sell your investment holdings the moment they enter losing territory, but you should remain keenly aware of your portfolio and the losses youre willing to endure in an effort to increase your wealth. While its impossible to avoid risk entirely when investing in the markets, these five strategies can help protect your portfolio.
Diversification
One of the cornerstones of Modern Portfolio Theory (MPT) is diversification. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company as opposed to systematic risk, which is the risk associated with investing in the markets generally.
Non-Correlating Assets
According to some financial experts, stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk. Unfortunately, systematic risk is always present and cant be diversified away. However, by adding non-correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end-result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks; when one asset is down, another is up.
Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least thats the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategys effectiveness. (See why investors today still follow this old set of principles that reduce risk and increase returns through diversification. Check out Modern Portfolio Theory: Why Its Still Hip.)
Leap Puts and Other Option Strategies
Between 1926 and 2009, the S
This link will help thou $BNIKF BarChart Technical Analysis NITE-LYNX
http://www.barchart.com/technicals/stocks/BNIKF
Dont Go Broke Buying Bankrupt Stocks
Sometimes, when stocks drop precipitously, they can easily over do it on the downside, as panic-selling ensues. These large declines can provide an attractive entry point for investors. The problem is that the biggest declines in stocks often occur the day that a company files for bankruptcy. Does that mean that bankrupt stocks can be a good buy? No, although some people dont realize that. Before buying that company that just filed Chapter 11, know the facts, and find out why any amount of money put in is bound to be lost.
When a Company Liquidates
Companies do not want to go bankrupt. Management will lose their jobs, and usually have equity at risk in the company. Companies declare or get forced into bankruptcy as a last resort, because they are having trouble paying their debt and need to gain protection from creditors. If the company liquidates or reorganizes, it needs to pay back everyone else in line before the common shareholders.
The hierarchy of claims goes like this: Bondholders including all classes (ie. subordinated, unsubordinated, secured, unsecured) have first claim to any assets or payments. After that the company may need to make payments for taxes, employees, trustees, etc. Then comes preferred equity holders, and, if there are any, the common equity holders get the leftovers. Its unlikely that shareholders receive anything.
When a Company Restructures
Even when the company will remain a going concern after emerging from chapter 11, the old shares are generally canceled with no payment to holders. New shares are issued, generally as a form of payment to debt holders.
An example of this was Delta Airlines. Delta filed Chapter 11 in 2005 and, following the filing, common shares traded over the counter on the pink sheets. Under its plan of reorganization, Delta was to issue new shares upon emergence from bankruptcy and cancel the old shares, with holders receiving no value. Delta even set up an online Restructuring FAQs for Investors, where they specifically outlined how old shareholders will receive nothing. The website stated:
Under the proposed plan of reorganization, current holders of Delta common stock would receive no distribution, and the securities would be canceled upon the effective date of the plan. Delta has indicated for some time that the company expected its common stock would not have any value under any plan of reorganization the company might propose, which is not uncommon in Chapter 11 proceedings.
The company also explicitly pointed out: Since the expected value of the Company will be less than creditors claims, we will not be able to exchange old stock for new stock.
Despite this clear declaration that holders of old stock would receive nothing, shares exchanged hands at 13 cents just a week before the shares were set to be canceled. Thirteen cents doesnt seem like a lot of money , but for those who were buying 10,000 shares, the loss a week later was a very real $1,300.
Why Bankrupt Stocks Dont Trade at Zero
As weve seen with Delta, the residual value of the shares is zero, so why doesnt every stock trade at zero after declaring bankruptcy? Stocks generally get close to zero on the day of the bankrupt, but can rise afterwards - sometimes even doubling or tripling. This affords some lucky individuals big gains. It is basically equivalent to a lottery ticket and generally has no basis whatsoever. So speculators, much like those who ride other penny stocks , make quick trades in the stocks trying to make big profits, but they also experience big losses. This type of strategy makes little sense with bankrupt stocks, as someone is buying something worth nothing, and hoping to sell it to someone else for more. It is an extreme example of the greater fool theory.
The other reason why a bankrupt stock wont trade at zero is because in rare cases some value may emerge for the common shareholders to claim. This will occur in a situation where the company is able to sell assets for higher than expected prices and can pay off everyone in line, and still have some left over. This, I remind you, is very rare. As stated above, the reason a company declares or gets forced into bankruptcy is because it cannot afford to pay its creditors. (Instead of investing in equity, some investors invest in distressed debt to make a profit; learn more in our article Distressed Debt An Avenue To Profit In Corporate Bankruptcy.)
What About Price-to-Book Value?
A commonly used metric to judge the value of a company is its book value. When looking at book value, the stock of a bankrupt company may look compelling, as it will trade for a small fraction of book value. This, however, cannot be used to determine that there is value in the stock. First, book value contains many things that are of little or no value during bankruptcy, such as goodwill. On top of this, any assets that get sold off in a bankruptcy proceeding will likely receive distressed prices, as buyers will not pay up for assets in liquidation.
The Bottom Line
Dont buy bankrupt stocks. Unless you have some great research on the stock and the bankruptcy proceedings, and have truly figured out that the company can generate enough cash to pay all claims and then some, there is no reason to do it. While buying a stock that was trading at $20 and is now at 20 cents may seem compelling, the vast majority of the time that 20 cents is worth nothing. So why throw away money and look like a fool? If youre looking for something else to buy, I have a great price on a bridge in Brooklyn. For related reading, check out Taking Advantage of Corporate Decline.
BarChart Technical Analysis NITE-LYNX $FRCN
http://www.barchart.com/technicals/stocks/FRCN
Real Estate Vs. Stocks: Which Ones Right For You?
Over the years, we have heard the comparisons as to which is the better investment : real estate or stocks. Both have their advantages and disadvantages, and there are several aspects of each that make them unique investments in their own way. To make money with either investment requires that you understand the positives and negatives of both.
Real Estate
Real estate is something that you can physically touch and feel – its a tangible good and, therefore, for many investors, feels more real. Maybe this partially accounts for the high return on the investment, as from 1978-2004, real estate has had an average return of 8.6%. For many decades this investment has generated consistent wealth and long term appreciation for millions of people.
How it Works
Generally, there are two main types of real estate: commercial and residential. While other types exist (mobile home parks, strip malls, apartment buildings, office buildings, store fronts and single family homes), they generally fall into those two categories. Making money in real estate isnt as cut-and-dry. Some people take the home flipping route – searching for distressed properties, refurbishing them and selling them for a profit at a higher market value . Others look for properties that can be rented in order to generate a consistent income.
Generally, a down payment of up to 20% of the purchase price can be made, and the rest can be financed. This gives you leverage, meaning that you can invest in different types of properties with less money down, helping to build your net worth or income that you could make off the properties. While this can be a positive, if this leverage is used incorrectly, you may owe more on the properties than they are actually worth.
Positives
There are many positive benefits to investing in real estate, including depreciation (writing off wear and tear of a commercial property), tax deductions and finally, you can sell the property through what is know as a 1031 exchange, and will not have to pay capital gains taxes, as long as you invest the money into a similar kind of property type.
Negatives
Like all investments , real estate also has its drawbacks. Most importantly, the investment is illiquid. When you invest in a property, you usually cannot sell it right away. In many cases, you may have to hold the property for several years to realize its true profit potential. Also, the closing cost can add up to thousands of dollars, and include taxes, commissions, and fees. Also, real estate prices have a tendency to fluctuate. While long-term prices generally increase, there are times when prices could go down or stay flat. If you have borrowed too much against the property, you may have trouble making the payment with a property that is worth less money than the amount borrowed on it.
Finally, its often hard to get diversified if investing in real estate. However, diversification is possible in real estate, provided that you do not concentrate on the same community and have a variety of different types of property. That being said, there is an additional way that you can be able to diversify in real estate through real estate investment trusts (REITs), under which you can purchase a trust that is invested in a large portfolio of real estate, and will offer you a dividend as a shareholder. However, in general, stocks offer more diversification because you can own many different industries and areas across the entire economy. (Learn more about REITs in our article Investing In Real Estate.)
Stocks
From 1978-2006, stocks have delivered an average return of 13.4%. They can be more volatile than real estate but over the long run they have provided a much better return than real estates 8.6% average.
How They Work
With a stock , you receive ownership in a company. When times are good, you will profit. During times of economic challenges, you may see diminishing funds as the earnings of the company drop. Taking a long-term approach and being balanced in many areas can help build your net worth at a much greater rate, compared with real estate.
As with real estate, financing in stocks allows you to use margin as leverage to increase the overall amount of shares that you own. The downside is that, if the stock position falls, you could have what is known as margin call. This is where the equity, in relation to amount borrowed, has fallen below a certain level and money must be added to your account to bring that amount back up. If you fail to do this, the brokerage firm can sell the stock to recover the amount loaned to you.
Positives
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account – tax-free - until you start to withdraw the money. As well, many stocks can do considerably better than real estate in one year. Due to the volatility of some stocks, it is not unusual to see companies that are averaging 20% or even 50% growth in one year.
Negatives
Stocks can be very volatile, especially when the economy or the company is facing challenges. Also, stocks are often emotional investments, and your decisions within the market can often be irrational. Finally, bankruptcy is always in the back of the active stock investors mind – as it should be, as your investment will be dissolved in this instance.
Conclusion
In general, stocks may have the advantage in more categories than real estate. However, real estate seems to be better when it comes to stability and tax advantages. A good compromise may be to own a REIT , which combines some of the benefits of stocks with some of the benefits of real estate. While each area has its own benefits and drawbacks, to decide which one would work well for you depends on your overall financial situation and level of comfort.
$ZERO BarChart Technical Analysis NITE-LYNX
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