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3 Essential Rules For New Investors
The investing landscape can be extremely volatile, and changes year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, and the nature of the industry, it is not that simple to be simple, but it can certainly be done. First, we will take a look at the potential difficulties of understanding investments, and then well look at how new investors can invest safely, suitably and sensibly.
How Much Do We Really Understand?
One could argue that the only asset that is fully understandable is cash in the bank, or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment.
Moving a bit up the risk ladder, we get to bonds. Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they dont pay much. Municipal bonds pay a little more and are usually tax exempt, but are not going to satisfy the average investors retirement needs. So to really earn anything, you need a variety of bonds, probably some corporate ones, plus, arguably some foreign ones. Yet, these start to become complex and more risky, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues. (Learn more in the Bond Basics Tutorial.)
The same applies to stocks, mutual funds and so on. Even real estate funds have proven to be less reliable and straightforward than many people might think. Direct real estate purchases are more understandable in one sense – what you see is what you get. But then again, there can be unknowns relating to the market, taxation, the location, disclosure by the seller and so on.
Similarly, alternative investments, like hedge funds, can be extremely complex. Infrastructure, too, is without doubt a great idea in principle, but the nitty-gritty of investing in it is not such a sure thing. No matter how sound the principle of a particular investment, there is almost always someone or something out there that can make it go wrong. And as for certificates of deposit (CD), they are probably the hardest type of investment to understand. Given yield curves, expectations and potential early withdraw penalties, they may be the easiest to missell. (Analyzing a hedge fund will help you determine whether its a good investment - and a good fit. Read Hedge Fund Due Diligence, for more.)
Tracker funds, on the other hand, are relatively simple to understand – you are indeed just buying the market, but the markets themselves are not so easy to deal with and understand. Furthermore, the tracker market is becoming more sophisticated and complex. This all sounds very daunting. But in fact, one can still invest simply and understandably, at low cost and with a good, diversified portfolio that is likely to perform well over time.
How Can We Invest Sensibly, Suitably and Simply?
The above section certainly implies that we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. One can really invest in a straightforward manner, and understand what one is doing.
Many veteran investors have simple diversified portfolios, and look more at asset allocation. Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg, of Kiplinger, has said in his Value Added Web Column that: Most people wish they didnt have to be investors, and that they lead busy enough lives without having to worry about stocks, bonds and mutual funds. Goldberg therefore recommends sticking with index funds that simply mirror the market and only attempt to be average. He even argues that one only needs three index funds, one covering the U.S. equity market, another with international equities and the third tracking a bond index. (Use these rules to guide you on the road to financial freedom, check out The 10 Commandments Of Investing.)
Trackers are sometimes better than actively managed funds. Lower fees, low turnover and a combination of available investor education makes index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of good managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.
A good piece of advice is to start searching through Investopedia.coms tutorial section, namely to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.
It is interesting to note the book title, How Buffett Does It: 24 Simple Investing Strategies from the Worlds Greatest Value Investor (James Pardoe, McGraw-Hill, 2005), about the worlds greatest pro. Buffett himself comments that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But one does not have to fall for this.
Conclusions
The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not even understand in principle. A small number of index funds seems a very good solution. (You might want to check out Getting Started In Stocks.)
Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in some mixed fund which has served them well, there is a better chance that it will continue to do so. On the other hand, if you get a phone call from someone who you met in a pub last week and who wants to give you a hot tip as a big favor, be more skeptical.
Likewise, there are many independent financial advisors around who get paid only for their time and not on commission. Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes, but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand after all, the losses are not so disastrous. Always bear in mind that too many bits and pieces also create complexity which can lead to errors.
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How Dividends Work For Investors
During the dotcom boom of the late 1990s, the notion of dividend investing was laughable. Back then, everything was going up in double-digit percentages, and nobody wanted to fool around with the meager 2-3% gain from dividends. After all, we were in the new economy: the rules had changed and companies that paid dividends were too old economy.
As Bob Dylan once sang, The times, they are a-changin. After the bull market of the 90s ended, the fickle mob once again found dividends attractive. For many investors, dividend-paying stocks have come to make a lot of sense. In this article, well explain what dividends are and how you can make them work for you. (For background reading, see The Power Of Dividend Growth.)
Background on Dividends
A dividend is a cash payment from a companys earnings; it is announced by a companys board of directors and distributed among stockholders. In other words, dividends are an investors share of a companys profits, given to him or her as a part-owner of the company. Aside fromoption strategies, dividends are the only way for investors to profit from ownership of stock without eliminating their stake in the company.
When a company earns profits from operations, management can do one of two things with the profits. It can choose to retain them - essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The other alternative is to distribute a portion of the profits to shareholders in the form of dividends. (Management can also opt to repurchase some of its own shares - a move that would also benefit shareholders. Read more about it in The Lowdown on Stock Buybacks.)
A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a companys growth slows, its stock wont climb as much, and dividends will be necessary to keep shareholders around. This growth slowdown happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and growth rates that outperform the market an impossible combination.
The changes witnessed in Microsoft (Nasdaq:MSFT) in 2003 are a perfect illustration of what can happen when a firms growth levels off. In January 2003, the company finally announced that it would pay a dividend: Microsoft had so much cash in the bank that it simply couldnt find enough worthwhile projects to spend it on - you cant be a high-flying growth stock forever!
The fact that Microsoft started to pay dividends did not signal the companys demise; it simply indicated that Microsoft had become a huge company and had entered a new stage in its life cycle, which meant it probably would not be able to double and triple at the pace it once did.
Dividends Wont Mislead You
By choosing to pay dividends, management is essentially conceding that profits from operations are better off being distributed to the shareholders than being put back into the company. In other words, management feels that reinvesting profits to achieve further growth will not offer the shareholder as high a return as a distribution in the form of dividends.
There is another motivation for a company to pay dividends: a steadily increasing dividend payout is viewed as a strong indication of a companys continuing success. The great thing about dividends is that they cant be faked. They are either paid or not paid, increased or not increased.
This isnt the case with earnings, which are basically an accountants best guess of a companys profitability. All too often, companies must restate their past reported earnings because of aggressive accounting practices, and this can cause considerable trouble for investors, who may have already based future stock price predictions on these (unreliable) historical earnings. (To learn more about evaluating earnings, read Earnings: Quality Means Everything.)
Expected growth rates are also unreliable. A company can talk a big game about wonderful growth opportunities that will pay off several years down the road, but there are no guarantees that it will make the most of its reinvested earnings. When a companys robust plans for the future (which impact its share price today) fail to materialize, your portfolio will very likely take a hit.
However, you can rest assured that no accountant can restate dividends and take back your dividend check. Moreover, dividends cant be squandered away by the company on business expansions that dont pan out. The dividends you receive from your stocks are 100% yours. You can use them to do anything you like: pay down your mortgage, spend it as discretionary income or buy the stock of a company you think has better growth prospects.
Who Determines Dividend Policy?
The companys board of directors decides what percentage of earnings will be paid out to shareholders, and then puts the remaining profits back into the company. Although dividends are usually dispersed quarterly, it is important to remember that the company is not obligated to pay a dividend every single quarter. In fact, the company can stop paying a dividend at any time, but this is rare, especially for a firm with a long history of dividend payments. (To learn more about this problem, read Is Your Dividend At Risk?)
If people were used to getting their quarterly dividends from a mature company, a sudden stop in payments to investors would be akin to corporate financial suicide. Unless the decision to discontinue dividend payments was backed by some kind of strategy shift, say investing all retained earnings into robust expansion projects, it would indicate that something was fundamentally wrong with the company. For this reason, the board of directors will usually go to great lengths to keep paying at least the same dividend amount.
How Stocks That Pay Dividends Resemble Bonds
When assessing the pros and cons of dividend-paying stocks, you will also want to consider their volatility and share price performance as compared to those of outright growth stocks that pay no dividends.
Because public companies generally face adverse reactions from the marketplace if they discontinue or reduce their dividend payments, investors can be reasonably certain they will receive dividend income on a regular basis for as long as they hold their shares. Therefore, investors tend to rely on dividends in much the same way that they rely on interest payments from corporate bonds and debentures.
Since they can be regarded as quasi-bonds, dividend-paying stocks tend to exhibit pricing characteristics that are moderately different from those of growth stocks. This is because they provide regular income, similar to a bond, but still provide investors with the potential to benefit from share price appreciation if the company does well.
Investors looking for exposure to the growth potential of the equity market, combined with the safety of the (moderately) fixed income provided by dividends, should consider adding stocks with high dividend yields to their portfolio. A portfolio with dividend-paying stocks is likely to see less price volatility than a growth stock portfolio. (This is why dividends are often considered to be a good recessionary investment. Read Dividend Yield For The Downturn to learn more.)
Conclusion
A company cant keep growing forever. When it reaches a certain size and exhausts its growth potential, distributing dividends is perhaps the best way for management to ensure that shareholders receive a return from the companys earnings. A dividend announcement may be a sign that a companys growth has slowed, but it is also evidence of a sustainable capacity to make money. This sustainable income will likely produce some price stability when paid out regularly as dividends. Best of all, the cash in your hand is proof that the earnings are really there, and you can reinvest or spend them as you see fit.
The Value Line Investment Survey
Have you ever opened the statement that your mutual fund company sent to you, then looked at the returns and thought, I could do better than that?
Its an increasingly common feeling, as the returns generated by many equity mutual funds often leave investors frustrated. If you want to try your hand at picking stocks but dont know where to start, the Value Line Investment Survey can help.
The Survey
The Value Line Investment Survey consists of professional research and recommendations on approximately 1,700 stocks. According to Value Line, this represents … approximately 95% of the trading volume of all stocks traded in U.S. markets … The Survey also provides weekly updates on the financial markets, recommended portfolios, developments involving covered securities and special topical reports. For would-be stock pickers, Value Line provides an easy way to start your research.
How to Get Started
Bearing in mind that conducting your own stock research is a time-consuming task, the first step in getting familiar with the tools Value Line offers is to set aside a few hours of reading time. You will need to study the materials closely in order to understand how to use them before you will be ready to invest any cash.
Prior to delving into the literally thousands of pages of stock research at your fingertips, start by reviewing The Complete Guide to Using The Value Line Investment Survey. In roughly 40 pages, this slim volume explains Value Lines ranking system (stocks are rated from one to five in a variety of categories) provides line-by-line explanations for the information provided in each of the research reports. At the back of the booklet is a detailed glossary of investment terms that includes definitions for terms ranging from bond ratings to unit labor costs.
Next, youll want to read, A Quick Study Guide. This guide explains the information included in the two binders that serve as primary research tools for investors using the hard copy version of Value Line. (An online service is also available.) The first binder contains the Summary and Indexand Ratings and Reports. The second binder contains Selection and Opinion. The Quick Study Guide also explains how to use the research to choose stocks for your portfolio.
Binder 1: Summary and Index
Starting with the first binder, the Summary and Index provides an overview of the stock screens Value Line provides, including lists of stocks with the lowest price-to-earnings ratio, the highest dividend yields, the highest annual total revenues and a host of other choices. These screens help investors identify stocks that align well with theirpersonal investment goals. For example, investors seeking income may look for stocks that offer high dividend payments, while investors seeking growth may seek stocks that have the highest appreciation potential. If this is your first effort at picking stocks, this portion of the Survey could be of particular interest to you. In addition, the Summary and Index catalogs all of the covered stocks and provides the page number where the research reports can be found.
It also provides key statistics for the universe of covered stocks, including price-to-earnings ratio, dividend yields and appreciation potential. These statistics provide information about the universe and the direction it has been moving in, as well as providing a baseline for comparing an individual stock against the universe.
The Ratings and Reports section provides stock research on approximately 1,700 companies. The research includes an analysts report that provides a brief overview of the company, a review of its financial health and a recommendation regarding its attractiveness to investors. The data portion of the report provides a detailed statistical analysis, including a price target, transactions by company officials (buying/selling), transactions by institutions, chart of historical returns, sales figures, earnings data and much more. Perhaps the best thing about the research section, particularly if you are a novice, is its ranking system.
Every stock in the survey is ranked on a scale of one to five in three different areas: timeliness, safety and technical. A rank of one denotes stocks that are expected to outperform the rest of the Value Line universe. Timeliness refers to performance expectations for the next six to twelve months. Safety compares the securitys price stability against its peers, and the Technical ranking compares 10 price trends to provide price return potential for a three to six month period. An alphabetical listing of all covered stocks, including key statistics and the ranking numbers, is particularly convenient for investors seeking a specific rating in one or more categories.
Binder 2: Weekly Selection and Opinion
The second binder contains the Weekly Selection and Opinionsection, which includes an economic outlook, market commentary and research on selected topics. Additionally, it includes evaluations of four model portfolios, one targeting short-term growth, one for long-term growth, one for income and, lastly, one for both growth and income. The evaluations highlight both successful selections and failures, which serves as an important reminder.
While the Value Line Investment Survey is a convenient, easy-to-use tool that is particularly helpful to novice investors, investing is not an endeavor that comes with any guarantees. The information you read in the Survey is well researched and impressively packaged, but there is no guarantee that it is correct. Like any other stock research, the insight provided by Value Line does not mean that you cant lose money on an investment that you make using the research. As with all security purchases, let the buyer beware
Using the Data
Taken as a whole, the Value Line Investment survey provides all the tools an investor needs to develop a picture of the current economic landscape, learn about stock analysis and identify securities that are appropriate for a variety of investment objectives. By matching the results of the research with your personal investment needs, you should be able to put together enough information to choose a stock or build an entire portfolio.
How to Get It
The Value Line Investment Survey is available by subscription. A one-year subscription is just over $500 for the online version and just under $600 for the print version. For an additional fee, the firm also offers research on mutual funds, exchange traded funds, convertible securities and more. You can get them all for just under $1,000.
Interestingly, many large libraries receive the print version of the Value Line Investment Survey and provide it to patrons for free. This provides an opportunity to learn about, use and thoroughly evaluate the materials before plunking down the cash for a personal subscription conveniently delivered to your house.
Next Steps
The Value Line Investment Survey is not the only professional research that you can easily access. In fact, it is just the first in a long list of tools. After you have read, researched and mastered the Value Line tool set, you can expand your repertoire of investment tools by using the research reports provided through websites associated with online brokerage accounts. These sites provide access to research reports similar to those offered by Value Line. It is worth noting that reports from various research providers often contradict each other.
The Bottom Line
While these contradictions may be frustrating, think of research as data gathering. You can take in data from as many sources as possible and use that data to formulate your own opinion. Relying on any single source of data is unlikely to be a wise decision, as there are no guarantees that the researchers behind your data source will always make the right call. Of course, if reading these research reports is too time consuming, too scary or too frustrating, you can always buy a mutual fund or hire a professional financial advisor to provide investment recommendations.
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Do You Understand Investment Risk?
A study conducted by Englands Financial Services Authority (FSA) in 2004 called Consumer Understanding Of Financial Risk has shed some light on how well people understand their investments. Such understanding or, in some cases, the lack of understanding, leads to specific types of behavior. It is important for both investors and providers to be aware of the differences. In this article, well go over this study and what it can teach investors about their own understanding of their personal finances.
Types of Investors
The respondents in the study were divided into three main groups:
• Trusters
were defined as unsophisticated investors who primarily rely on their advisors.
• Partners are those with an intermediate level of sophistication who work together with their advisors to some extent.
• Controllers are sophisticated and often experienced investors who rely on their own understanding and make their own decisions. This simple categorization provides considerable insight into the nature of investors, what they do and expect, and the associated risks and opportunities that exist for both buyers and sellers. (Learn more in What Is Your Risk Tolerance?)
Education and Financial Sophistication Are Not the Same Thing
It is important to note that general or even business education doesnt necessarily translate into specific knowledge about the world of investment. A business graduate is certainly likely to know something about investments, but this knowledge may be very theoretical and, therefore, less applicable to the graduates own experiences. Conversely, a doctor who happens to be very interested in getting the most bang for his buck on his investments may turn out to have a relatively sophisticated understanding of investing. Likewise, retired people with no formal financial education or qualifications may spend hours pouring over the financial pages of the newspaper every day. In this case, they may know more than their advisors about day-to-day developments.
Lets look in more detail at each of the three groups.
Trusters Rely On Others
Not surprisingly, the lower the level of sophistication, the less people understand about the risks to which their money is exposed and the more naive they tend to be about what their advisors or investment companies can really do for them. The FSA study points out that this naiveté can lead to excessive reliance on people in the industry, which can open the door for potential abuse. Alternatively, it may lead nervous and distrusting people to adopt a savings approach, which may be too risk averse to benefit the investor. (For related reading, see Determining Risk And The Risk Pyramid.)
When investors lack understanding of their investments, this often means that they are uninformed about what is meant by high, medium and low risk, the three standard categories prevalent in much of the investment literature. The problem is compounded by the failure of many brokers to present people with clear options with clear risk labels. Investors often think that anything to do with shares is risky, or that fund managers generally buy shares with such astuteness and expertise that there is little risk involved. Generally speaking, the reality is that the greater the value of equities that an investor has in his or her portfolio, the greater the amount of risk the person is taking on compared to leaving that money in a savings account.
While many investors understand the principles of diversification and risk well enough to know it is bad to put all of their eggs in one basket, they do not always know how to avoid this in practice. Trusters, for example, were shown to have a poor understanding of asset classes and very little, if any, awareness of the range of products available in the market. As a result, they tend to delegate most of the responsibility to others, which predictably leads to somewhat mixed results. (For more insight, see Introduction To Diversification and The Importance Of Diversification.)
Partners Make Mutual Decisions
Partners tend to have a medium level of sophistication and often want to be involved in the decision-making process. They generally read newspapers or magazines in and attempt to follow the markets. They also rely on advisors for help, but certainly not for the basic-level financial matters. They are interested in the second opinion that brokers or advisors provide, and also seek professional assistance to ensure that paperwork is completed correctly and that they understand any applicable legal jargon.
The main difficulty with partners is finding the right balance between control and delegation. While some advisors do not welcome client input, and others tend to think customers know more than they really do, it is essential for the investor-advisor roles to be quite clear to both parties. It may be best to have some form of written agreement - even if its an informal one - that highlights the nature of each players respective roles.
Controllers Want to Run the Show
Controllers are sophisticated investors (or at least think they are!) and prefer to take charge of the investing process. They are very interested in the financial sector and have a good understanding of both products and markets. They are aware of and understand the array of products that are available and they know what they want. They also spend a considerable amount of time researching products and markets, and they actively send off for financial statements, buy the latest books, and even attend investment seminars and conferences. This does not necessarily make them risk friendly, but they understand risk and know how to construct an optimal portfolio. Such investors often purchase on execution only, which means that they dont seek an advisors advice.
With respect to controllers who think they are sophisticated, there are certainly those who ought to delegate more of their investing tasks to a professional. Investors who seriously overestimate their knowledge or abilities can get into trouble.
Who Are You and Who Are You Dealing With?
The FSA study reinforces the need for informed financial planning; it also suggests the vulnerability of investors who are either too trusting or not trusting enough. For trusters, and to a lesser extent, partners, ease of understanding is fundamental and checks need to be built into any investment process to ensure that peoples personal and financial circumstances and willingness to take risk are taken into account. If investors are to be served well, what they know and, more importantly, what they do not know, must form a fundamental component of the advisory process. Advisors must take the level of investor knowledge and understanding very seriously.
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Knowing Your Rights As A Shareholder
Say you just bought stock in Disney (NYSE:DIS). As a part owner of the company does this mean you and the family can hit Disneyland for free this summer? Why is it that Anheuser-Busch (NYSE:BUD) shareholders dont get a case of beer each quarter? (Forget the dividends!) Although these perks are highly unlikely, they do raise a good question: what rights and privileges do shareholders have? While they may not be entitled to free rides and beer, many investors are unaware of their rights as shareowners. In this article, we discuss what privileges come with being ashareholder and which do not.
Levels of Ownership Rights
Before getting into the nitty-gritty of shareholder rights, lets first look at a companys pecking order. Every company has a hierarchical structure of rights that accompany the three main classes of securities that companies issue: bonds, preferred stock and common stock (To learn more, see our Stocks Basics Tutorial.)
The priority of each security is best understood by looking at what happens when a company goes bankrupt. You may think that as an owner youd be first in line for getting a portion of the companys assets if it went belly up. After all, you did pay for them. In reality, as a common shareholder you are at the very bottom of the corporate food chain when a company liquidates; you are the corporate equivalent of a hyena that eats only after the lions have eaten their share. During insolvency proceedings, it is the creditors who first get dibs on the companys assets to settle their outstanding debts, then the bondholders get first crack at those leftovers, followed by preferred shareholders and finally the common shareholders . This hierarchy forms according to the principle of absolute priority.
In addition to the rules of absolute priority, there are other rights that differ with each class of security. For example, usually a companys charter states that only the common stockholders have voting privileges and preferred stockholders must receive dividends before common stockholders. The rights of bondholders are determined differently because a bond agreement, or indenture, represents a contract between the issuer and the bondholder. The payments and privileges the bondholder receives are governed by the indenture (tenets of the contract).
Risks and Rewards
Sounds pretty bad for common shareholders, doesnt it? Dont be fooled, common shareholders are still the part owners of the business and if the business is able to turn a profit, then common shareholders gain. The liquidation preference we described makes logical sense: shareholders take on a greater risk (they receive next to nothing if the firm goes bankrupt) but they also have a greater reward potential through exposure to share price appreciation when the company succeeds, whereas there are usually fewer preferred stocks held by a select few. As such, preferred stocks generally experience less price fluctuation.
Common Shareholders Six Main Rights
1. Voting Power on Major Issues
This includes electing directors and proposals for fundamental changes affecting the company such as mergers or liquidation. Voting takes place at the companys annual meeting. If you cant attend, you can do so by proxy and mail in your vote.
2. Ownership in a Portion of the Company
Previously we discussed the event of a corporate liquidation where bondholders and preferred shareholders are paid first. However, when business thrives, common shareholders own a piece of something that has value. Said another way, they have a claim on a portion of the assets owned by the company. As these assets generate profits, and as the profits are reinvested in additional assets, shareholders see a return in the form of increased share value as stock prices rise.
• The Right to Transfer Ownership
Right to transfer ownership means shareholders are allowed to trade their stock on an exchange. The right to transfer ownership might seem mundane, but the liquidity provided by stock exchanges is extremely important. Liquidity is one of the key factors that differentiates stocks from an investment like real estate. If you own property, it can take months to convert your investment into cash. Because stocks are so liquid, you can move your money into other places almost instantaneously.
• An Entitlement to Dividends
Along with a claim on assets, you also receive a claim on any profits a company pays out in the form of a dividend . Management of a company essentially has two options with profits: they can be reinvested back into the firm (hopefully increasing the companys overall value) or paid out in the form of a dividend. You dont have a say in what percentage of profits should be paid out - this is decided by the board of directors. However, whenever dividends are declared, common shareholders are entitled to receive their share.
• Opportunity to Inspect Corporate Books and Records
This opportunity is provided through a companys public filings, including its annual report. Nowadays, this isnt such a big deal as public companies are required to make their financials public. It can be more important for private companies.
• The Right to Sue for Wrongful Acts
Suing a company usually takes the form of a shareholder class-action lawsuit. A good example of this type of suit occurred in the wake of the accounting scandal that rocked WorldCom in 2002, after it was discovered that the company had grossly overstated earnings, giving shareholders and investors an erroneous view of its financial health. The telecom giant faced a firestorm of shareholder class-action suits as a result.
Shareholder rights vary from state to state, and country to country, so it is important to check with your local authorities and public watchdog groups. In North America, however, shareholders rights tend to be more developed than other nations and are standard for the purchase of any common stock. These rights are crucial for the protection of shareholders against poor management.
Corporate Governance
In addition to the six basic rights of common shareholders, it is vital that you thoroughly research the corporate governance policies of a company. These policies are often crucial in determining how a company treats and informs its shareholders.
Shareholder Rights Plan
Despite its name, this plan differs from the standard shareholder rights outlined by the government (the six rights we touched on). Shareholder rights plans outline the rights of a shareholder in a specific corporation. A companys shareholder rights plan, it is usually accessible in the investors relations section of its corporate website or by contacting the company directly.
In most cases, these plans are designed to give the companys board of directors the power to protect shareholder interests in the event of an attempt by an outsider to acquire the company. To prevent a hostile takeover, the company will have a shareholder rights plan that can be exercised when another person or firm acquires a certain percentage of outstanding shares.
The way a shareholder rights plan may work can be best demonstrated with an example: lets say Corys Tequila Co. notices that its competitor, Joes Tequila Co., has purchased more than 20% of its common shares. A shareholder rights plan might then stipulate that existing common shareholders have the opportunity to buy shares at a discount to the current market price (usually a 10-20% discount). This maneuver is sometimes referred to as a flip-in poison pill. By being able to purchase more shares at a lower price, investors get instant profits and more importantly, they dilute the shares held by the competitor, whose takeover attempt is now more difficult and expensive. There are numerous techniques like this that companies can put into place to defend themselves against a hostile takeover.
Sometimes There are Little Extras
Are you still looking for other perks? Although free beer may be a little far-fetched there are companies that offer shareholders little extras. For instance, Anheuser-Busch does offer its shareholders discounted rates to some of the companys entertainment parks, among other things. Other companies have been known to give their shareholders small tokens of their appreciation along with their annual reports. For example, AT
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Translating Ticker Talk
Ticker symbols offer quite a bit of information to savvy investors who know what to look for when they see a ticker. In addition to identifying a company, a ticker may indicate the exchange on which a company is traded, whether that company is delinquent in terms of its Securities and Exchange Commission (SEC) filings, or if a company is currently undergoing bankruptcy proceedings. With so much information available in just a few characters, its imperative that investors learn the basics of stock ticker symbols. Here we translate ticker talk into plain English.
What Is a Ticker?
First and foremost, the word ticker refers to a series of letters or numbers identifying a particular security on a particular exchange. Stock tickers are the most familiar types of ticker symbols, though options, futures contracts and other types of securities also have ticker symbols.
A few examples of stock tickers include:
Figure 1
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You may notice that the number of characters differs for these tickers. For example, why does AT
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Investing Basics: Flight To Quality
Investing in stocks comes with the prospect of earning big returns, but it can also carry some considerable risks. At times of financial market stress, investors will often flee from risky assets and into investments that are perceived as very safe. Investors will act as a herd and try to rid themselves of any risk in what is termed a flight to quality. Whether or not an investor takes part in the flight, it is important to understand the concept, its indicators and its implications for the market.
What is a flight to quality?
A flight to quality occurs when investors rush to less risky, more liquid investments. Cash and cash equivalents, such as Treasury bills and notes, are key examples of the high-quality assets investors will seek. Investors try to allocate capital away from assets with any perceived risk into the safest possible instruments they can find. Investors usually tend to do this en masse and the effects on the market can be quite drastic. (Knowing what the market is thinking is the best way to determine what it will do next. Read Gauging Major Turns With Psychology.)
The Causes
The causes for a flight to quality are usually quite similar, and normally follow or are concurrent with some level of distress in the financial markets. Fear in the market generally leads investors to question their risk exposure and whether asset prices are justified by their risk/reward profiles.
While every market has its own intricacies, most upswings and downturns are somewhat similar: a sharp downturn follows what, in retrospect, were unjustifiable asset prices. A lot of the time the asset prices were unjustified because many risk factors such as credit problems were being ignored. Investors question the health of companies they are invested in and may decide to take profits from their riskier investments , or even sell at losses in order to move into lower-risk alternatives. Unfortunately, most investors dont get out at the early stage. Many join the flight to quality after things start to turn sour and leave themselves open to even bigger losses. (The option to bolster after-tax stock returns through tax-loss harvesting can reverse investor gloom. Check out Tax-Loss Harvesting For An Unsteady Market.)
Once major issues in the market come to light, the bubble begins to burst and panic occurs in the market as participants reprice risk. Sharp declines in asset prices add to the panic, and force people to flee toward very low-risk assets where they feel their principal is safe, without regard for potential return. A flight to quality is often a pretty abrupt shift for financial markets; as a result, indicators such as fear and shrinking yields on quality assets arent noticed until the flight has already begun.
Negative T-Bill Yield
An extreme example of a flight to quality occurred during the 2008 credit crisis. U.S. T-bills are perceived as some of the highest quality, lowest risk assets. The U.S. government is considered to have no default risk, meaning that Treasuries of any maturity have no risk of principal loss. T-bills are also issued with maturities of 90 days, so the short-term nature makes interest rate risk minimal, and, if held to maturity, non-existent.
T-bill interest rates are largely dependent on the federal funds target rate. When the Federal Reserve consistently lowered rates during 2008, eventually setting the federal funds target rate at a range of 0-0.25% on December 16, 2008, T-bills were certain to follow the trend and return next to nothing to their owners. (For more on T-bills, see the Money Market Tutorial.)
But, could they actually return less than nothing? As the flight to quality drove institutions to shed any sort of risk, the demand for T-bills quickly outpaced supply, even as the Fed was quick to create new supply. After taking a bloodbath in nearly every asset class available, institutions tried to close their books with only the highest, most conservative assets (aka T-bills) on their balance sheets. (Learn about the components of the statement of financial position and how they relate to each other in Reading The Balance Sheet.)
The flood of demand for T-bills, which were already trading at near-zero yields , caused the yield to actually turn negative. On December 9, 2008, investors bought T-bills yielding -0.01%, guaranteeing that they would receive less money three months later. Why would any institution accept that? The main reason is safety. If an institution bought $1 million worth of T-bills at the -0.01% rate, three months later their loss would about to about $25. (For more on what happened, see Why Money Market Funds Break The Buck.)
In a time of market panic and flight to quality, investors will take that very small nominal loss in exchange for the safety of not being exposed to the larger potential losses of other assets. Negative T-bill yields are not characteristic of every time the market experiences a flight to quality, but an extreme case of where demand forces down the yields of high-quality assets. (Learn more in The Fall Of The Market In The Fall Of 2008.)
Dont Panic
A flight to quality is logical to a certain point as investors reprice market risk, but can also have many adverse consequences. First, it can help exacerbate a market downturn. As investors grow fearful of stocks that have experienced sharp declines, they are more inclined to dump them, which helps worsen the decline. Investors suffer again as their fear will prevent the buying of risky assets, which after the declines may be very attractive. The best thing for an investor to keep in mind is to not panic and be the last person selling their stocks and moving into cash when stocks are likely hitting lows.
The consequences read through to businesses also, and can affect the health of the economy, possibly prolonging a downturn or recession. During and following a market crash and flight to quality, businesses may grasp cash similar to investors. This low-risk, fear-driven strategy may prevent businesses from investing in new technologies, machines, and other projects that would help the economy.
Conclusion
Just like with bubbles and crashes, a flight to quality of some degree during a market cycle is pretty much inevitable, and impossible to prevent. As investors become jaded with the risky assets, they will seek out one thing and one thing only: safety.
Is there a way to profit from a flight to quality? Not unless you can predict what everyone else will do and do the opposite. Even then, you need to time it perfectly to avoid being trampled by the herd. It may be hard, but dont panic.
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5 Essential Things You Need To Know About Every Stock You Buy
Investing is easy but investing successfully is tough. Statistics show that the majority of retail investors, those who arent investment professionals, lose money every year. There could be a variety of reasons why, but there is one that every investor with a career outside of the investment market understands: they dont have time to research a large amount of stocks and they dont have a research team to help with that monumental task. (For related reading, check out The 4 Basic Elements Of Stock Value.)
For that reason, investments made after little research often result in losses. Thats the bad news. The good news is that, although the ideal way to purchase a stock is after a large amount of research, an investor can cut down on the amount of research by looking at these select items:
What They Do
Jim Cramer, in his book Real Money, advises investors to never purchase a stock unless they have an exhaustive knowledge of how they make money. What do they manufacture? What kind of service do they offer? In what countries do they operate? What is their flagship product and how is it selling? Are they known as the leader in their field? Think of this as a first date. You probably wouldnt go on date with somebody if you had no idea who they were. If you do, youre asking for trouble.
This information is very easy to find. Using the search engine of your choice, go to their company website and read about them. Then, as Cramer advises, go to a family member and educate them on your potential investment. If you can answer all of their questions, you know enough.
Price/Earnings Ratio
Imagine for a moment you were in the market for somebody who could help you with your investments. You interview two people. One person has a long history of making people a lot of money. Your friends have seen a big return from this person and you cant find any reason why you shouldnt hand this guy your investment dollars. He tells you that for every dollar he makes for you, hes going to keep 40 cents leaving you with 60 cents.
The other guy is just getting started in the business. He has very little experience and, although he seems promising, he doesnt have much of a track record of success. The advantage to this guy is that hes cheaper. He only wants to keep 20 cents for every dollar he makes you - but what if he doesnt make you as many dollars as the first guy?
If you understand this example, you understand the P/E or price/earnings ratio. If you notice that a company has a P/E of 20, this means that investors are willing to pay $20 for every $1 per earnings. That might seem expensive but not if the company is growing fast.
The P/E can be found by comparing the current market price to the cumulative earnings of the last 4 quarters. Compare this number to other companies similar to the one youre researching. If your company has a higher P/E than other similar companies, there had better be a reason. If it has a lower P/E but is growing fast, thats an investment worth watching. (If these numbers have you in the dark, these easy calculations should help light the way, seeHow To Find P/E And PEG Ratios.)
Beta
Beta seems like something difficult to understand, but its not. In fact, and can be found on the same page as the P/E Ratio on a major stock data provider such as Yahoo or Google. Beta measures volatility or how moody your companys stock has acted over the last 5 years. Think of the S
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Open Your Eyes To Closed-End Funds
Fixed-income investors are often attracted to closed-end funds because many of the funds are designed to provide a steady stream of income, usually on a monthly or quarterly basis as opposed to the biannual payments provided by individual bonds.
Perhaps the easiest way to understand the mechanics of closed-end mutual funds is via comparison to open-end mutual and exchange-traded funds with which most investors are familiar. All these types of funds pool the investments of numerous investors into a single basket of securities or fund portfolio. While at first glance it may seem like these funds are quite similar - as they share similar names and a few characteristics - from an operational perspective, they are actually quite different. Here well take a look at how closed-end funds work, and whether they could work for you.
Open-End Vs. Closed-End
Open-end fund shares are bought and sold directly from the mutual fund company. There is no limit to the number of available shares because the fund company can continue to create new shares, as needed, to meet investor demand. On the reverse side, a portfolio may be affected if a significant number of shares are redeemed quickly and the manager needs to make trades (sell) to meet the demands for cash created by the redemptions. All investors in the fund share costs associated with this trading activity, so the investors who remain in the fund share the financial burden created by the trading activity of investors who are redeeming their shares.
On the other hand, closed-end funds operate more like exchange-traded funds. They are launched through an initial public offering (IPO) that raises a fixed amount of money by issuing a fixed number of shares. The fund manager takes charge of the IPO proceeds and invests the shares according to the funds mandate. The closed-end fund is then configured into a stock that is listed on an exchange and traded in the secondary market. Like all shares, those of a closed-end fund are bought and sold on the open market, so investor activity has no impact on underlying assets in the funds portfolio. This trading distinction can be an advantage for money managers specializing in small-cap stocks, emerging markets, high-yield bonds and other less liquid securities. On the cost side of the equation, each investor pays a commission to cover the cost of personal trading activity (that is, the buying and selling of a closed-end funds shares in the open market).
Like open-end and exchange-traded funds, closed-end funds are available in a wide variety of offerings. Stock funds, bond funds and balanced funds provide a full range of asset allocation options, and both foreign and domestic markets are represented. Regardless of the specific fund chosen, closed-end funds (unlike some open-end and ETF counterparts) are all actively managed. Investors choose to place their assets in closed-end funds in the hope that the fund managers will use their management skills to add alpha and deliver returns in excess of those that would be available via investing in an index product that tracked the portfolios benchmark index.
Pricing and Trading: Take Note of the NAV
Pricing is one of the most notable differentiators between open-end and closed-end funds. Open-ended funds are priced once per day at the close of business. Every investor making a transaction in an open-end fund on that particular day pays the same price, called the net asset value (NAV). Closed-end funds, like ETFs, have an NAV as well, but the trading price, which is quoted throughout the day on a stock exchange , may be higher or lower than that value. The actual trading price is set by supply and demand in the marketplace. ETFs generally trade at or close to their NAVs.
If the trading price is higher than the NAV, closed-end funds and ETFs are said to be trading at a premium. When this occurs, investors are placed in the rather precarious position of paying to purchase an investment that is worth less than the price that must be paid to acquire it.
If the trading price is lower than the NAV, the fund is said to be trading at a discount. This presents an opportunity for investors to purchase the closed-end fund or ETF at a price that is lower than the value of the underlying assets. When closed-end funds trade at a significant discount, the fund manager may make an effort to close the gap between the NAV and the trading price by offering to repurchase shares or by taking other action, such as issuing reports about the funds strategy to bolster investor confidence and generate interest in the fund.
Closed-End Funds Use of Leverage
Closed-end funds have another quirk unique to their fund structure. They often make use of borrowings, which, while adding an element of risk when compared to open-end funds and ETFs, can potentially lead to greater rewards. This leverage is the main reason why closed-end funds typically generate more income than open-end and exchange-traded funds.
Why Closed-End Funds Arent More Popular
According to the Closed-End Fund Association, closed-end funds have been available since 1893, more than 30 years prior to the formation of the first open-end fund in the U.S. Despite their long history, however, closed-end funds are far outnumbered by open-ended funds in the market.
The relative lack of popularity of closed-end funds can be explained by the fact that they are a somewhat complex investment vehicle that tends to be less liquid and more volatile than open-ended funds. Also, few closed-end funds are followed by Wall Street firms or owned by institutions. After a flurry of investment banking activity surrounding an initial public offering for a closed-end fund, research coverage normally wanes and the shares languish.
For these reasons, closed-end funds have historically been, and will likely remain, a tool used primarily by relatively sophisticated investors.
The Bottom Line
Investors put their money into closed-end funds for many of the same reasons that they put their money into open-end funds. Most are seeking solid returns on their investments through the traditional means of capital gains, price appreciation and income potential. The wide variety of closed-end funds on offer and the fact that they are all actively managed (unlike open-ended funds) make closed-end funds an investment worth considering. From a cost perspective, the expense ratio for closed-end funds may be lower than the expense ratio for comparable open-ended funds.
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Human Capital: The Most Overlooked Asset Class
December 11 2011| Filed Under » Investing Basics, Students, Young Investors
When most people think about asset classes, things like stocks, bonds, real estate and commodities come to mind. Investment advisors spend countless hours researching the risk/return profiles and correlations of these common asset classes, in an attempt to construct efficient investment portfolios for their clients.
Tutorial: Basic Financial Concepts
However, if you are a young to middle-aged investor, the importance of these asset classes pales in comparison to an asset class called human capital. Human capital is intangible and cannot be directly purchased or sold. For this reason, it does not get much financial press. If you are between the ages of 18 and 50, or you still act like you are, you may be interested in what human capital can do for you and how you can use it to grow and protect your financial capital.
What Is Human Capital?
If you learned about human capital in business school, it was probably defined from a business owners perspective, but what about from an individual investors perspective? To an individual investor, human capital is the present value of all future wages. When you are young, it is usually the most valuable asset that you own. Human capital is also your best protection against inflation. With a strong professional skill set, you will always command a fair wage, no matter how inflated your local currency becomes.
Anything you do to increase your ability to earn higher future wages could be considered investing in your human capital. The monetary and time-consuming investments that you make early in life, like obtaining a higher education, on-the-job training and learning better social skills, can increase your personal human capital. (To learn more about investing in your human capital, read Invest In Yourself With A College Education and Five Ways To Fund Your College Education.)
How Does It Affect Your Financial Capital Allocation?
Over your lifetime, your human and financial capital should go in opposite directions. As you age, you have the opportunity to use your human capital to increase your financial capital. It is an opportunity because financial capital is not a given; it is earned though wages, savings and smart investment decisions. (For more on this, see Young Investors: What Are You Waiting For?)
During your working career, the risk characteristics of your human capital should affect how you allocate your financial capital. Factors like job stability, income volatility and the industry sector in which you work should all be considered when selecting an asset allocation for your financial capital. Below are two examples of how the risk characteristics of your human capital can affect the asset allocation of your financial capital.
Example 1 - Investing in Company Stock
A highly specialized chemical engineer working in the oil industry would not want to have a portfolio heavily weighted in the energy sector, or even more obviously, her employers stock. Career specialization makes human capital concentrated and risky, from an industry standpoint. As such, the engineer can compensate for this risk by investing her financial capital in industries and companies with little or no correlation to her human capital.
For example, investing more of her financial capital into sectors like health care or telecommunications, could offer diversification and help her better manage the overall risks of her investment portfolio. (Learn more about investing in company stock in Your Employers Stock: Should You Buy In?)
Example 2 - Income Volatility and Investment Risk
A real estate broker would face more human capital risk than a pharmacist. The real estate broker may have a higher appetite for financial risk, but his wages are more volatile, more difficult to replace and less secure than the pharmacists. This extra risk makes the brokers income stream less valuable. All else being equal, he should compensate for this extra human capital risk, by owning a higher percentage of more liquid, less volatile, financial assets, relative to the pharmacists.
Protecting Your Human Capital
Like any other asset class, there are risks associated with your human capital. The two main risks are death or disability risk and professional competency risk.
Death or Disability Risk
When you are a young adult, it is very important to protect your human capital with both life and disability insurance policies. Doing so will protect you and your family against a possible human capital shortfall, due to an untimely death or a career-halting illness. This is especially true if your expected future financial obligations are high. As you get older, your need to hedge your human capital with insurance, should decrease. Decisions regarding protecting your human capital with life and disability insurance should be made in conjunction with the overall asset allocation decisions in your investment portfolio. (To learn more about term life and disability insurance, see Buying Life Insurance: Term Versus Permanent and The Disability Insurance Policy: Now In English.)
Professional Competency Risk
Your ability to earn future wages depends heavily on your professional competency. Becoming too comfortable with your career could pose a hidden risk to your human capital. Like many other valuable assets, human capital needs to be constantly monitored. You should always have goals for life-long learning and should stay current with industry trends and new technologies, to protect against this risk.
The Bottom Line
To young and middle-aged investors, human capital offers inflation protection and is a very important asset that should not be overlooked. All investment decisions should take into account the characteristics of both your human and financial capital. Your human capital should be protected with insurance and always open to further investment, through more education and on-the-job training. Famed investor Warren Buffett once said, The best investment you can make is always in yourself. It has never been a good idea to be on the other side of Mr. Buffetts trade. (To read more about Buffetts ideologies, check out Warren Buffett: The Road To Riches and Think Like Warren Buffett.)
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Understanding The Ticker Tape
Youve seen them on business programs or financial news networks: a flashing series of baffling letters, arrows and numbers scrolling along the bottom of your TV screen. While many people simply block out the ticker tape, others use it to stay on top of market sentiment and track the activity of certain stocks. What exactly is that cryptic script reeling by? It obviously tells us something about stocks and the markets, but how does one understand the ticker tape and use it to his or her advantage?
Brief History
Firstly, a tick is any movement, up or down, however small, in the price of a security. Hence, a ticker tape automatically records each transaction that occurs on the exchange floor, including trading volume, onto a narrow strip of paper or tape.
The first ticker tape was developed in 1867, following the advent of the telegraph machine, which allowed for information to be printed in easy-to-read scripts. During the late 19th century, most brokers who traded at the New York Stock Exchange (NYSE) kept an office near it to ensure they were getting a steady supply of the tape and thus the most recent transaction figures of stocks. These latest quotes were delivered by messengers, or pad shovers, who ran a circuit between the trading floor and brokers offices. The shorter the distance between the trading floor and the brokerage, the more up-to-date the quotes were.
Ticker-tape machines introduced in 1930 and 1964 were twice as fast as their predecessors, but they still had about a 15 to 20 minute delay between the time of a transaction and the time it was recorded. It wasnt until 1996 that a real-time electronic ticker was launched. It is these up-to-the-minute transaction figures - namely price and volume - that we see today on TV news shows, financial wires and websites; while the actual tape has been done away with, it has retained the name.
Due to the nature of the markets, investors from all corners of the globe are trading a variety of stocks in different lots and blocks at any given time. Therefore what you see one minute on a ticker could change the next, particularly for those stocks with high trading volume, and it could be some time before you see your ticker symbol appear again with the latest trading activity.
Reading the Ticker Tape
Heres an example of a quote shown on a typical ticker tape:
Ticker Symbol The Unique Characters used to identify the company.
Shares Traded The volume for the trade being quoted. Abbreviations are K = 1,000, M = 1 million and B = 1 billion
Price Traded The price per share for the articular trade (the last bid price).
Change Direction Shows whether the stock is trading higher or lower than the previous days closing price.
Change Amount The difference in prie from the previous days close.
Throughout the trading day, these quotes will continually scroll across the screen of financial channels or wires, showing current, or slightly delayed, data. In most cases the ticker will quote only stocks of one exchange, but it is common to see the numbers of two exchanges scrolling across the screen.
You can tell where a stock trades by looking at the number of letters in the stock symbol. If the symbol has three letters, the stock likely trades on the NYSE or American Stock Exchange (AMEX). A four-letter symbol indicates the stock likely trades on the Nasdaq. Some Nasdaq stocks have five letters, which usually means the stock is foreign. This is designated by an F or Y at the end of the stock symbol. To learn more, see Why do some stock symbols have three letters while others have four?
On many tickers, colors are also used to indicate how the stock is trading. Here is the color scheme most TV networks use:
Green indicates the stock is trading higher than the previous days close.
Red indicates the stock is trading lower than the previous days close.
Blue or white means the stock is unchanged from the previous closing price.
Before 2001, stocks were quoted as a fraction, but with the emergence of decimalization all stocks on the NYSE and Nasdaq trade as decimals. The advantage to investors and traders is that decimalization allows investors to enter orders to the penny (as opposed to fractions like 1/16).
Which Quotes Get Priority?
There are literally millions of trades executed on more than 10,000 different stocks each and every day. As you can imagine, its impossible to report every single trade on the ticker tape. Quotes are selected according to several factors, including the stocks volume, price change, how widely they are held and if there is significant news surrounding the companies.
For example, a stock that trades 10 million shares a day will appear more times on the ticker tape than a small stock that trades 50,000 shares a day. Or if a smaller company not usually featured on the ticker has some ground-breaking news, it will likely be added to the ticker. The only times the quotes are shown in predetermined order are before the trading day starts and after it has finished. At those times, the ticker simply displays the last quote for all stocks in alphabetical order.
The Bottom Line
Constantly watching a ticker tape is not the best way to stay informed about the markets, but many believe it can provide some insight. Tick indicators are used to easily identify those stocks whose last trade was either an uptick or a downtick. This is used as an indicator of market sentiment for determining the markets trend.
So next time youre watching TV or surfing a website with a ticker, youll understand what all those numbers and symbols scrolling across your screen really mean. Just remember that it can be near impossible to see the exact price and volume at the precise moment it is being traded. Think of a ticker tape as providing you with a general picture of a stocks current activity.
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Financial Advice With Zero Return
Many people rely on financial advisors, either independent ones or those employed at banks. The good ones will at least ensure that you have a sensibly diversified portfolio and that it stays that way. However, a recent study indicates that many advisors do not increase the actual investment returns on an ongoing basis.
What Advisors Do and Dont
An investigation conducted at the University of Frankfurt in Germany reveals that neither portfolios advised by banks nor independent advisors, do any better than those for which no advice was given. Finance professor Andreas Hackethal explains that the main problem is the failure of advisors to correct systematic investment errors sufficiently, while at the same time, they generate additional costs. (For related reading, see Diversifying Your Portfolio.)
Furthermore, this work almost certainly applies to the United States. According to Hackethal, an investigation by Bergstresser et. al in the U.S., demonstrated that mutual funds sold through U.S. broker channels underperform other mutual funds. They take this as indirect evidence that brokers or advisors do not add value for clients.
The Frankfurt-based study used client data from a large German bank and from an online broker that specializes in providing independent advice. The survey sample that was given advice, performed no better than the execution-only group.
The researchers also confirm that banks (and certain other advisors) have the wrong incentive structures, so that the advisory process all too often helps only the seller and not the investor. (To learn more, read Paying Your Investment Advisor - Fees Or Commissions?)
Investor Reluctance to Obtain and Follow Good Advice
Good advisors are clearly hard to find, but they are indeed out there. However, Hackethal found a widespread client reluctance to use good, skilled advice, preferring to rely on their own generally mediocre investment skills. A staggering 95% of those questioned were not even interested in free independent advice from an advisor with no incentive, at all, to recommend specific products.
Equally amazing is the fact that of the remaining 5%, only half actually followed the advice that they were given. Of this tiny group, half again followed the advice only half-heartedly, even though the recommendations would have led to substantially better returns.
It seems to be mainly wealthy, experienced investors who really appreciate the value of good advice from the right people. Yet, almost anyone would benefit from a second, objective opinion on what to do with their hard-earned savings.
The Solutions
The Frankfurt researchers do not believe that more governmental regulation is the answer either. In particular, given the above consumer attitudes to advice, purely seller-side regulation seems doomed to fail. For instance, Hackethal doubts that simply providing more information in the form of brochures, for example, will help much. It will take a lot more to achieve the necessary transparency and learning effects … with respect to investment risks and opportunities.
Clearly, somehow, investor attitudes towards advice need to change and the incentive structures in the industry as well. In addition, investment selling processes at banks may need to be overhauled in a more general sense. There is a compelling need to establish just why, in so many instances, the advisory process fails to work for the investor.
There are undoubtedly independent and bank advisors who can and will help people get more bang (and bank) for their buck. What is lacking is an understanding of the difference between good, mediocre and really bad advice. Above all, far greater market transparency is essential, so that people are able to draw the appropriate distinctions between a fine investment, a rip-off and the various shades of gray between the two extremes. At present, too many investors just do not know who they are dealing with. As Hackethal puts it the person sitting opposite them could be excellent or an outright crook. The clients just dont know. (Learn more on how to Find The Right Financial Advisor.)
An Important Benefit Remains - with Genuinely Independent Advisors
Independent financial advice can, however, at least prevent excessively risky, undiversified portfolios. That is, even if an advisor does not lead to better returns, if they can prevent you from having a high risk portfolio that rockets in a boom and plummets in a bear market, that can be worth a lot. This is a separate issue and needs to be kept in mind. The above research dealt with better investment performance, not with avoiding disastrous losses in a crash.
The Bottom Line
Financial advice can be pretty ineffectual for two main reasons. Firstly, when the incentive structures are wrong, the advice benefits mainly or only the bank or broker. Secondly, investors are remarkably reluctant either to seek out or follow objective advice from a third party. Overcoming this highly unsatisfactory situation entails a combination of changed structures and attitudes on both the buyer and seller sides of the market. This is not easy to achieve, and regulation alone will certainly not do it. The industry needs to take a long, hard look at what it is doing, both wrong and right.
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Buy-And-Hold Investing Vs. Market Timing
If you were to ask 10 people what long-term investing meant to them, you might get 10 different answers. Some may say 10 to 20 years, while others may consider five years to be a long-term investment . Individuals might have a shorter concept of long term, while institutions may perceive long term to mean a time far out in the future. This variation in interpretations can lead to variable investment styles.
For investors in the stock market , it is a general rule to assume that long-term assets should not be needed in the three- to five-year range. This provides a cushion of time to allow for markets to carry through their normal cycles.
However, whats even more important than how you define long term is how you design the strategy you use to make long-term investments . This means deciding between passive and active management. Read on to learn more.
Long-Term Strategies
Investors have different styles of investing, but they can basically be divided into two camps: active management and passive management. Buy-and-hold strategies - in which the investor may use an active strategy to select securities or funds but then lock them in to hold them long term - are generally considered to be passive in nature. Figure 1 shows the potential benefits of holding positions for longer periods of time. According to research conducted by Charles Schwab Company in 2012, between 1926 and 2011, a 20-year holding period never produced a negative result.
Source: Schwab Center for Financial Research
Figure 1: Range of S
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Losing Money? Dont Blame Your Broker
Wall Street has been home to more than its fair share of scandals dealing with everything from accounting, research and access, and initial public offerings. Maybe youve just lost a fortune in the market. The money is gone, and it must be somebodys fault. There must be some way to get the money back. The next step seems obvious: sue your broker.
While it is true that you may be able to recover some or all of your losses based on broker misdeeds or misinformation, keep in mind your broker and other outside forces frequently arent solely to blame. All too often, the real culprit is staring back at you every time you look in the mirror. In this article, well look at some of the things an investor should do ensure a healthy, lawyer-free relationship with his or her broker.
A Sucker Is Born Every Minute
One of capitalisms most astounding aspects is how legions of people willingly hand over their money to complete strangers without making so much as a single telephone call to verify the strangers claims of credibility.
After giving their wallets to the stranger, these people simply sit back and wait for the money to start pouring in. And if they dont get rich and lose a portion of their initial investment, they call a lawyer and sue. On occasion, they even win the lawsuit! Win or lose though, they still feel wronged. They are victims. They have been taken advantage of by unscrupulous capitalists ... or have they?
Your Obligations As An Investor
Becoming an investor gives you certain rights. When you buy stock in a public company, for example you are entitled to a number of opportunities and rewards.
However, as an intelligent investor (or, at least as somebody who would prefer not to be victimized), you also have an obligation to do all you can to learn about the person or organization you trust with your money and the investments your money will be used to purchase. Before blindly handing over your cash, the first step is making sure youve made a strong effort to hire the right kind of help.
Start by conducting some due diligence of your own. It is the safest way to protect your investments. After all, nobody cares about your money as much as you do! It doesnt take a genius to check references and ask questions about a broker. And, of course, the only dumb question is the one that wasnt asked.
Hiring someone to give advice doesnt absolve an investor of the responsibility for accepting that advice. Once the decision has been made to hire outside help, the investors obligation to pay attention and remain fully engaged in the process doesnt disappear.
As an investor:
• Every piece of paper that you are given must be read.
• Every disclosure document must be reviewed until you understand it.
• Every item that you find confusing must be questioned.
• Every investment that you make must be researched until you are positive that you completely understand it.
• Never sign anything that you dont understand, and always get a copy of everything that you do sign.
(For additional information about the sometimes naive expectations of investors, check out Do You Understand Investment Risk?)
What If You Did Your Homework, But Still Found Trouble?
If you have chosen well, the person providing financial advice to you has a fiduciary obligation to give you good advice. Despite that obligation, nobody is right every time. Before you blame your advisor for your losses, be sure you know your rights and responsibilities. If you have truly been a responsible investor, but still feel youve been the victim of a scam, you can take your issue to arbitration, or, in the most extreme case, consult a lawyer and head off to court.
Of course, the reality of litigation is often less rewarding than most people would hope. The process takes time and, if you actually get any money back, you may not get enough to cover the full amount of your loss. To put the odds in your favor, tread slowly and carefully any time money is involved. Set realistic expectations and, if it looks too good to be true, it probably is.
3 Questions To Find Your Trading Plan
You have put in the work creating a trading plan or possibly spent money on supposedly great strategies, but you still cannot seem to turn a trading profit. Or maybe you are starting out in trading and investing and want to be cautious before you start putting real money on the line. No matter what level you are at, before you trade - or if are already trading and struggling - you should have a trading plan. That plan needs to be tailored to you and your needs; a plan that is not will likely result in a drain on your trading account.
The following three questions can save you a lot of grief. Run through these questions during your planning stages to make sure your plan will serve you well. If it cannot pass this three question test, it should not be used.
SEE: Day Trading Strategies For Beginners
Why Ask These Questions?
Executing a plan is not just about the design itself, it is about the person executing that plan. Someone can search their whole life for a great trading system, not realizing it is themselves that need work, not the system. Therefore, these questions take the plan and the trader into account, making sure the two fit together. No matter how good a trading plan, it is useless if the trader cannot personally stick to it or implement it properly.
These three questions will help to clarify the traders objectives for the trading plan, take inventory of the consequences which may arise by executing the plan, and determine if they will be able to even stick with their plan, given their personality.
1. Does the Plan Allow Me to Achieve the Outcome I Want?
Sounds simple enough, but not so fast.
An outcome needs to be specific and measurable. Stipulating I want to be rich is not concise enough. What is the ultimate goal that you want your trading plan to bring you? Is the outcome feasible and reasonable? Can the plan you currently have actually produce that, or given the realities of the plan is it likely to fall short of the outcome you desire?
The plan and outcome must also balance short-term and long-term goals. While the long-term goal may be to be financially independent, continually trying to make as much money as possible in the short-term with high risk trades could jeopardize the long-term goal. Short-term goals must work in harmony with the long-term goals, not against them. Brainstorm what you want your trading plan to produce and make sure that the plan works to satisfy both the short and long-term desired outcomes.
2. What Are the Consequences and Risks of My Plan, and Can I Deal with Them?
In this step we strip away the fantasy and focus on reality. The fact is most traders lose money - even very smart ones - so how is your plan different? All plans have risk; what is the downside of the strategies you have employed? Go through the plan and write down all of the risks and pitfalls you see.
Now, also consider consequences outside of trading. Will realizing your plan mean you spend less time with family or friends? Will it mean cutting back on certain expenses? Will it create more stress (less stress) or cut into other work time?
Once all the potential risk and pitfalls of your strategy have been fully and honestly addressed, can you realistically handle all the potential consequences of trading this plan? If so, proceed. If not, rework the plan making sure the consequences of your plan are within your personal tolerance.
3. Does the Plan Account for Me Being Me?
This is the most important question, as ultimately you must be able to implement the plan. A plan means nothing if you cannot execute it.
If you cannot sit in front of a screen for more than 30 minutes, no matter how good your plan is you will likely not be a good day trader. Or, if you cannot sleep at night with an open position, your swing trading plan will likely do you no good. You will continually struggle to adhere to it.
We each have different traits and tendencies. If you have a gambling streak, account for this in your plan - maybe have a demo account off to the side (or have a play money poker game open) so you can satisfy your gambling craving without losing real money. Plan and account for everything.
Be brutally honest, and make sure your trading plan accounts for the market and yourself. Accept yourself for your tendencies, and make sure that the plan can actually be employed by you based on who you are. Do not sugar coat anything, as doing so could result in problems down the road.
If the plan is easy to implement for you and fits with who you are, use the plan. If you do not think you will be able to stick to it, come up with a plan you can follow.
The Bottom Line
A trading plan is only as good as the trader who implements it. The plan and trader must mesh, or the trader will be unable to implement the plan and it will be useless. To make sure the trading plan fits, the trader must pass the plan through three questions: Does the plan achieve the outcome I want? Can I handle the consequences of the plan? Does the plan account for me being me? If the plan can pass through all of these questions, the trader has a much better chance of being able to actually follow through with their investment strategy and is more likely to experience success in the markets
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J.D. Rockefeller: From Oil Baron To Billionaire
John D. Rockefeller still ranks as one of the richest men in modern times. According to Forbes Magazines Most Wealthy Historical Figures 2008, his adjusted fortune of more than $300 billion rivals the relative wealth controlled by the Pharaohs of ancient Egypt or the Roman emperors. Rockefeller remains one of the great figures of Wall Street - reviled as a villain, applauded as an innovator and universally recognized as one of the most powerful men in history. Read on for a look at his life and achievements.
Son of a Peddler
Rockefeller was born on July 8, 1839. His father led a nomadic life selling goods across the country while his mother raised the children. Rockefeller received an unusually good education for his time and found work as a clerk at a commission house at the age of 16. He left thecommission house to form a partnership at the age of 24.
Oil Refiner
The first thing that distinguished Rockefeller from others was his understanding of risk. He knew that speculators in oil had the potential for huge profits if they hit a deposit, but they were also losing money when they didnt. Instead of getting into the speculation business, Rockefeller chose the refining business, where the profits were smaller but more stable
Putting all of his money into his first refining business, Rockefeller transformed it by emphasizing what we now call research and development (R
How To Invest In Corporate Bonds
When investors buy a bond, they are lending money to the entity that issues the bond. The bond is a promise to repay the face value of the bond (the amount loaned) with an additional specified interest rate within a specified period of time. The bond, therefore, may be called an I.O.U.
Bond Types
The various types of bonds include U.S. government securities, municipals, mortgage and asset-backed, foreign bonds and corporate bonds.
Corporate bonds are issued by companies and are either publicly traded or private. Bond rating services such as Standard
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4 Ways Bonds Can Fit Into Your Portfolio
February 02, 2012 | Filed Under » Bonds, Fixed Income, Interest Rates, Investing Basics, Portfolio Management
Since the early 1980s, interest rates have been on a secular decline. Since the credit crisis, governments across the world have worked to flood global financial markets with liquidity, which includes low interest rates, to try and stoke economic growth. This has served to push most interest rates to all-time lows, be it those paid on government securities, mortgage rates or the rates that banks borrow from and lend to each other. (For related reading, see Forces Behind Interest Rates.)
See: Bond Basics
With interest rates across the board so low, there is a pretty wide consensus that they will trend up in 2012 and beyond. Because bond prices move in the opposite direction of interest rates, investors holding bonds have a good chance of losing money on their holdings over the next few years. However, as with any asset class, there are pockets of the market where investors should be able to protect their principal and earn reasonable rates of returns in their bond portfolios. Below are four ways that bonds can fit into your investment profile during 2012.
Municipal Bonds
About a year ago, market strategist Meredith Whitney boldly predicted that municipal bonds in the United States would eventually see hundreds of billions of dollars in defaults, as local municipalities struggle with lower tax revenue due to the credit crisis and also find it difficult to operate after years of generous retirement benefit promises and relatedoperating costs. Other strategists echoed her negative sentiment, which served to send many investors fleeing from municipal bond funds and individual bond positions.
Lower demand has served to push bond prices down and rates up. The rate on an AAA-rated five-year municipal bond is currently at roughly 0.79%, which is currently below the current Treasury bond yield of about 0.86% for the same maturity. Additionally, municipal bonds are generally exempt from federal taxes as well as most state and local tax rates. As a result, the tax equivalent yield is even higher, and moving into lower-rated bonds that are still investment grade could garner higher rates. A five-year A-rated municipal bond yields approximately 1.35%. (To learn more, read Avoid Tricky Tax Issues On Municipal Bonds.)
Corporate Bonds
AAA corporate bonds with a five-year maturity currently yields around 1.8%, which compared to the yield of municipal bonds with the same rating is more than double. A 20-year AAA corporate bond rate is somewhat decent at around 4.45%, though it requires locking up your money in a security that doesnt reach maturity until two decades later. As with the municipal bonds, sacrificing quality but still sticking in the investment grade category can allow for some pick up in yield. For instance, those brave enough to invest in bonds issued by banks and other financial institutions, can find yield to maturities of as much as 9%.
High-Yield Bonds
Sticking on the braver side of the bond market, high-yield bonds - which is a euphemism for junk bonds - offer plenty of opportunity to gamble for yields that can match the returns of stocks. A current perusal of some high-yield bonds, which are of a much lower credit rating than the investment grade bonds mentioned above, offer yield to maturities into the double digits. Clearly, the bonds with yields in the teens on up carry significant default risk, meaning investors can lose all of their money if the firm falls into further financial distress or ends up declaringbankruptcy. (Also, check out Junk Bonds: Everything You Need To Know.)
Convertible Bonds
Convertible bonds are an interesting subset of the bond market in that they combine features of traditional bonds with stocks. Like a bond, convertibles usually have a maturity date and pay a regular coupon, which should appeal to income-minded investors. They also tend to trade like a bond in a weak market environment or when company fundamentals are weak. But they also have the upside of a stock as they are convertible into the underlying companys stock. As such, they can trade much like a stock as it reflects the performance of the stock they are convertible into. Coupon rates vary and are generally quite low, but, again, offer more upside if the underlying stock performs well.
The Bottom Line
The bond market generally does not favor investors these days. The fact that companies, governments and municipalities are jumping at the chance to issue debt at low interest rates speaks to the fact that rates are at historic lows. Recently, a 10-year Treasury bond was issued with a coupon rate below 2%, which is the first time rates were ever this low. Despite the challenging overall outlook for the asset class, there are plenty of opportunities to find ways for bonds to fit into your portfolio.
Invest Without Stress
Many investors get a lot of anxiety chasing mutual fund returns, hoping that history repeats itself while they are in the fund. In fact, a fund which has already yielded large returns has less of a chance to do so again when compared with its peer group. A better idea, rather than stressing out over the vagaries of the financial markets, is to look for wisdom in time-tested, academic methods. Once your high-quality investment plan is set up, relax. Let your investment compound, understanding that the plan is rooted in knowledge, not hype.
Good Soil
As with growing a garden, you want to invest in good soil (strategy). Accordingly, you can expect there to be some rainy days (bear market) with the sunny (bull market). Both are needed for overall growth. Once a garden (money) starts to grow, dont uproot it and replant, lest it wither and die. Set up your investment wisely and then let it grow.
Academic research creates good soil. The body of knowledge about the market goes through a rigorous review process where primary goal is truth or knowledge rather than profit. Thus, the information is disinterested - something you should always look for in life to make wise decisions.
Greatly distilling this body of knowledge, here are a few key points to remember when it comes to investing in the stock market .
Risk and Return
This concept is similar to the saying there is no free lunch. In money terms, if you want more return, you are going to have to invest in funds that have a greater probability of going south (high risk). Thus, the law of large numbers really comes into play here, since investing in small, unproven companies may yield better potential returns, while larger companies which have already undergone substantial growth may not give you comparable results.
Market Efficiency
This concept says that everything you need to know about conventional investments is already priced into them. Market efficiency supports the concept of risk and return; thus, dont waste your time at the library with a Value Line investment unless it provides entertainment value. Essentially, when you look at whether or not to invest in a large corporation, it is unlikely that you are going to find any information different from what others have already found. Interestingly, this also gives insight into how you make abnormal returns by investing in unknown companies like Bobs Tomato Shack, if you really have the time and business acumen to do the front-line research.
Modern Portfolio Theory
Modern portfolio theory (MPT) basically says that you want to diversify your investments as much as possible in order to get rid of company- or stock-specific risk, thus incurring only the lowest common denominator - market risk. Essentially, you are using the law of large numbers in order to maximize returns while minimizing risk for a given market exposure.
Now here is where things get really interesting! We just found the way to optimize your risk-return tradeoff for a given market level of risk by being well diversified in your investments. However, you can further adjust the investment risk downwards by lending money (investing some of it in risk-free assets) or upwards by borrowing it (margin investing).
Best Market Portfolio
Academics have created models of the market portfolio , consisting of a weighted sum of every asset in the market, with weights in the proportions that the assets exist in the market. Many think of this as being like the S
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Profit By Understanding Fundamental Trends
Fundamental trends are movements in the overall economy- in either a single country or the entire world - that help to shape financial markets and consumer trends. Investment dealers, business owners and even governments analyze these trends in order to predict future corporate growth and consumer preferences.
Missing a fundamental trend or interpreting one incorrectly can result in volatility in the markets and inflated stock and commodity prices. (With the market in constant change on a per second basis it is import to know what effect this has on returns, to learn more Volatilitys Impact On Market Returns.)
What Makes a Trend Fundamental?
Many factors influence financial markets. Some of those factors are temporary in nature, including war, spikes in costs of inputs and political instability. These short term trends can have dramatic impacts on share prices and liquidity in the markets.
Fundamental trends, however, are more permanent in nature. They show shifts in underlying views, technologies and knowledge and will move the markets more slowly yet more enduringly.
Living Standards in China
An example of a fundamental trend happening in the world this decade is the rising lifestyle standards in China and the skyrocketing consumer demand there for Western goods. The demand in China for cars, meat, electronics and appliances stems both from increasing exposure to Western advertising and an overall increase in the Chinese standard of living. What makes this a fundamental trend is that there is no going back. Once a country raises its standard of living and becomes more globally aware, it changes consumer spending patterns forever. (For a greater idea of what factors increase a countries standard of living, read Standard Of Living Vs. Quality Of Life.)
Canned Food
Another, more historical, example was the innovation of food transportation by the Union army in the Civil War. Although canned food had been available prior to the war, the canning process was perfected and expanded and a complexlogistics mechanism put in place to distribute rations to the soldiers. After the war, food distribution changed forever and it could be shipped all over the Union, increasing the variety of food choices available everywhere.
Trend Drivers
The underlying drivers of fundamental trends can include leaps in innovation, scarcity of resources, national economic advancement and even changes in consumer tastes. The latter one is exemplified by the trend away from wearing animal fur. The once booming industries of trapping and farming fur animals have died out almost completely. Consumers now opt for less expensive synthetic materials for coats and other outerwear. This trend is unlikely to reverse although it may once again evolve into new directions. (Trends are always occurring; to help you identify them, check out 4 Factors That Shape Market Trends.)
The Impact of Fundamental Trends on Financial Markets
In a perfect economic world, fundamental trends would be the only market movers as they represent true and ongoing change. Although some of these trends can happen practically overnight (like the first split atom), most occur over time, thereby giving forecasters time to adapt to the changes.
The efficient market theory stipulates that fundamental trends are public knowledge and are therefore incorporated into current market and futures pricing. If this was the only input into market pricing, the financial markets would move smoothly and fluidly. However, other market influences come into play constantly. These sudden pushes and pulls on pricing can either amplify or dampen the effect of fundamental trends on the markets.
Lessons From Oil
Take, for example, the impact of federal subsidies to the oil industry. The rate of growth in consumer demand in North America for petroleum-based fuels has decreased over the past decade as more efficient vehicles are built and more environmentally-sustainable technologies come online. However, the U.S. oil industry is heavily subsidized which allows it to continue to grow and to keep prices at artificial lows. Low prices for oil keep consumers and manufacturers from investing in new technologies to move away from oil. This is an artificial boost in the arm of the industry that will not be sustainable in the long run, without continued injections of billions in tax dollars. (To learn more about the oil companies and the advantages the government gives them, check out A Guide To Investing In Oil Markets.)
The Dangers of Ignoring Fundamental Trends
Regardless of other short-term market forces, fundamental trends are still one of the most important drivers of financial markets in the long run. Stock brokers, commodity traders and even individual investors must follow these trends in order to predict future valuations. Some trends impact the entire market and some only certain industries. The latter most often occurs when there has been a technological breakthrough in manufacturing or processing, such as the invention of the cotton gin.
Fundamental trends can impact both the supply and the demand side of the markets. They can increase supply when the trend improves efficiency in production or distribution of products or services. For example, the trend towards the online provision of bookkeeping services allows providers to offer their services all across the world rather than be confined to a more local market. The ultimate result is that the price of bookkeeping services drops across the industry with the increased competition. (To learn more on how the supply side can affect the entire economy, read Understanding Supply-Side Economics.)
Demand is impacted when the trend derives from consumer preferences. An example of this is the move towards healthier and organic foods. The food industry did not start the trend but rather medical reports and health industry news sparked an increase in demand for these foods.
Companies that ignore fundamental trend analysis do so at their own risk. Those who take advantage of shifting underlying economic markers can position themselves ahead of their competitors. Watching changes in markets allows a company to shift strategy and invest in new technology to provide new products and services to new markets. Companies who forgo this analysis often find themselves the dinosaurs of their industry, doing things the same way they have always done, unaware that the market has moved on.
The Publishing Industrys Tale
An example of an industry struggling to counteract the effects of a fundamental shift is the book publishing industry. Electronic books (ebooks) had been around for many years but gathered steam from 2009-2011. Traditional publishing houses almost unilaterally rejected the ebook, postulating that it would never take over from print. While they should have been hitching a ride on the train barreling down the tracks at them, they instead argued that it was not a train at all. Many of the large publishers began dabbling in the ebook market, but they do not dominate it as their pricing and promotion strategies have not moved with the trend. (For more on companies which failed to change with the fundamental shifts in the market, read 5 Big Companies Biggest Blunders.)
The Bottom Line
Fundamental trends are an important driver of financial markets and every investor and entrepreneur should analyze them on an ongoing basis. These trends signal underlying shifts in the economy that will have a large impact on future consumption. Missing these trends can result in poor portfolio performance or an outdated business model.
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Investing In Oil And Gas UITs
The substantial rise in energy prices in the mid-2000s attracted many investors seeking aggressive growth and profits in the oil and gas industry. Although many of these investors cashed in on the gains posted by various energy and natural resources equities, exchange-traded funds (ETFs) and mutual funds , there are other alternatives available that provide more direct exposure to the energy markets.
Limited partnerships, working interests and unit investment trusts (UITs) all provide pass-through treatment of both income and deductions derived from oil and gas investments at the wellhead. This article will examine the nature and purpose of oil and gas UITs, their advantages and disadvantages, and help you decide if they should be fueling your portfolio.
Nature and Composition
By definition, oil and gas UITs are very similar to other UITs that invest in stocks or real estate. Each trust is broken down into individual units that are priced and sold to investors. Each unit represents an undivided proportional interest in all of the oil and gas properties held by the trust, and each trust has a set maturity date upon which all gains and losses from the sale of the assets are dispersed to the unit-holders.
Unlike stock unit trusts or real estate investment trusts (REITs), oil and gas UITs invest directly in either production or exploratory drilling oil and gas assets, then pass through the income and expenses realized from the actual production of oil and natural gas.
Who Should Invest in Oil and Gas UITs?
Investors who are seeking more direct, tax-advantaged exposure to oil and gas investments should consider oil and gas UITs, as the UITs can pass through deductible operational expenses and investment income that is eligible for the depletion allowance.
Energy-focused mutual funds may only buy equity interests in various oil, gas and other energy companies, but seldom offer direct participation of any kind. Energy mutual funds cannot offer pass-through treatment, and usually can only post fully taxable dividends and capital gains.
Furthermore, oil and gas UITs will not post taxable capital gains of any kind until the trust matures, unlike mutual funds that pass through capital gains annually. Aggressive investors seeking larger profits in the energy sector may also benefit from the more direct arrangement of oil and gas UITs as opposed to energy mutual funds.
Pros and Cons
One of the main advantages that holders of energy trusts enjoy is the pass-through tax status, similar to that of limited partnerships or direct working interests. As stated previously, income derived from oil and gas UITs can be eligible for the depletion deduction, and a proportional share of deductible operational expenses is passed through as well.
It should be noted that oil and gas UITs are usually riskier by nature than energy mutual funds, as any properties that cease to produce, for whatever reason, during the tenure of the trust cannot be replaced until maturity. Another factor to consider is that oil and gas units are wasting assets, as their value will automatically decline as producing properties within the trust become depleted over time. Furthermore, investor income is reduced by maintenance and operating costs associated with oil and gas production at the wellhead, such as electric fees, pumping fees and parts replacement.
Income realized from oil and gas UITs is also subject to fluctuation with the rise and fall of energy prices. This risk can be at least partially offset with an investment in both oil and gas properties within the same trust, as the prices of oil and gas do not necessarily move in lock-step.
Finally, oil and gas UITs that participate in drilling of any kind include the risk of unsuccessful development, where one or more wells that are drilled produce little or no oil or gas. This occurrence can obviously lower the value of the trust, as well as deprive the investor of income from the anticipated current production that is never realized.
How Do I Pick the Right Oil and Gas UIT?
When choosing a UIT that invests in oil and gas properties, the most important criteria for investors generally will be the level of risk inherent in the trust. Aggressive trusts that focus on exploratory drilling projects are much more speculative in nature than UITs that invest solely in producing properties. However, successful exploratory drilling also offers greater tax deductions and the potential for higher income. Moderate or conservative investors seeking a regular stream of income should probably restrict their investing to UITs that contain mature producing oil and gas fields.
The Bottom Line
Although oil and gas UITs are similar securities to REITs or trusts that invest in stocks or bonds in many respects, they offer a relatively unique set of advantages and risks to investors. Those seeking more direct exposure to the energy sector (as well as those needing tax-advantaged income) can benefit from investing in these trusts. Investors considering UITs should consult with a tax advisor to determine the efficacy of UITs given their individual tax situations.
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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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Benchmark Your Returns With Indexes
Investors look to broad indexes as benchmarks to help them gauge not only how well the markets are performing, but also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S
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