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Surviving Bear Country
A bear market refers to a decline in stock prices of at least 15-20%, coupled with pessimistic sentiment underlying the market. Clearly no stock investor looks forward to these periods. Dont despair, there is hope! In this article we will walk you through some of the most important investment strategies and mindsets that one can use to limit losses - or even make gains - while the stock market is performing in such a manner.
Be Realistic!
First off, having a realistic mindset is one the most important things to do during an economic slowdown. Remember that its normal for the stock market to have negative years - its all part of the business cycle.
After a raging bull market, its easy to forget the bad times. Take, for example, the late 1990s; it was a time of spectacular growth in the equity markets, punctuated by gains in the S
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Testing 3 Types Of Analysts
There are several types of analysts on Wall Street, and they produce different kinds of reports because they have different kinds of clients. Lets take a look at the different responsibilities required for each analyst, so that you can do your own litmus test to see which ones you need to pay attention to.
Sell-Side Analysts
These are the analysts that are dominating todays headlines. They are employed by brokerage houses to analyze companies and write in-depth research reports, conducting what is sometimes called primary research. These reports are used to sell an idea to individuals and institutional clients. Individual investors gain access to these reports mainly by having accounts with the brokerage firm. For example, to get free research from Merrill Lynch, you need to have an account with a Merrill Lynch broker. Sometimes the reports can be purchased through a third party such as Multex.com. Institutional clients (i.e. mutual fund managers) get research from the brokerages institutional brokers. (Keep reading about fund managers in Should You Follow Your Fund Manager? and Choose A Fund With A Winning Manager.
A good sell-side research report contains a detailed analysis of a companys competitive advantages and provides information on managements expertise and how the companys operating and stock valuation compares to a peer group and its industry. The typical report also contains an earnings model and clearly states the assumptions that are used to create the forecast.
Writing this type of report is a time consuming process. Information is obtained by reading the companys filings for the Securities
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Determining Risk And The Risk Pyramid
You might be familiar with the risk-reward concept, which states that the higher the risk of a particular investment, the higher the possible return. But, many investors do not understand how to determine the level of risk their individual portfolios should bear. This article provides a general framework that any investor can use to assess his or her personal level of risk and how this level relates to different investments.
Risk-Reward Concept
This is a general concept underlying anything by which a return can be expected. Anytime you invest money into something there is a risk, whether large or small, that you might not get your money back. In turn, you expect a return, which compensates you for bearing this risk. In theory the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive.
For investment securities, we can create a chart with the different types of securities and their associated risk/reward profile.
Although this chart is by no means scientific, it provides a guideline that investors can use when picking different investments . Located on the upper portion of this chart are investments that offer investors a higher potential for above-average returns, but this potential comes with a higher risk of below-average returns. On the lower portion are much safer investments, but these investments have a lower potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an investor determine how much risk he or she can handle? Every individual is different, and its hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take:
• Time Horizon
Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have $20,000 to invest today but need it in one year for a down payment on a new house, investing the money in higher-risk stocks is not the best strategy. The riskier an investment is, the greater its volatility or price fluctuations, so if your time horizon is relatively short, you may be forced to sell your securities at a significant a loss.
With a longer time horizon, investors have more time to recoup any possible losses and are therefore theoretically be more tolerant of higher risks. For example, if that $20,000 is meant for a lakeside cottage that you are planning to buy in ten years, you can invest the money into higher-risk stocks because there is be more time available to recover any losses and less likelihood of being forced to sell out of the position too early.
• Bankroll
Determining the amount of money you can stand to lose is another important factor of figuring out your risk tolerance. This might not be the most optimistic method of investing; however, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you wont be pressured to sell off any investments because of panic or liquidity issues.
The more money you have, the more risk you are able to take and vice versa. Compare, for instance, a person who has a net worth of $50,000 to another person who has a net worth of $5,000,000. If both invest $25,000 of their net worth into securities, the person with the lower net worth will be more affected by a decline than the person with the higher net worth. Furthermore, if the investors face a liquidity issue and require cash immediately, the first investor will have to sell off the investment while the second investor can use his or her other funds.
Investment Risk Pyramid
After deciding on how much risk is acceptable in your portfolio by acknowledging your time horizon and bankroll, you can use the risk pyramid approach for balancing your assets.
This pyramid can be thought of as an asset allocation tool that investors can use to diversify their portfolio investments according to the risk profile of each security. The pyramid, representing the investors portfolio, has three distinct tiers:
• Base of the Pyramid– The foundation of the pyramid represents the strongest portion, which supports everything above it. This area should be comprised of investments that are low in risk and have foreseeable returns. It is the largest area and composes the bulk of your assets.
• Middle Portion– This area should be made up of medium-risk investments that offer a stable return while still allowing for capital appreciation. Although more risky than the assets creating the base, these investments should still be relatively safe.
• Summit– Reserved specifically for high-risk investments, this is the smallest area of the pyramid (portfolio) and should be made up of money you can lose without any serious repercussions. Furthermore, money in the summit should be fairly disposable so that you dont have to sell prematurely in instances where there are capital losses.
Personalizing the Pyramid
Not all investors are created equally. While others prefer less risk, some investors prefer even more risk than others who have a larger net worth. This diversity leads to the beauty of the investment pyramid. Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base. The pyramid representing your portfolio should be customized to your risk preference.
It is important for investors to understand the idea of risk and how it applies to them. Making informed investment decisions entails not only researching individual securities but also understanding your own finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for.
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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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Why You Should Be Wary Of Target-Date Funds
Its the in thing now; everybodys doing it, so why wouldnt you? Heres how the story repeatedly plays out, especially for those who recently opened a new 401(k) or 403(b) account. The benefits manager of your company sent you a big stack of documents and told you to complete the application. You thumbed through everything, skimming the microscopic print in these pamphlets called prospectuses, and found yourself completely overwhelmed.
Luckily, as you were completing the application, you noticed that you could either pick your own investment options or choose the ready-made option that placed all of your retirement funds into a target-date fund. You didnt know what it was, but you didnt know how to pick your investment options anyway, so into this target-date fund is where your money has gone.
What Is a Target-Date Fund?
The concept is very simple. A target-date fund adjusts the assets in the fund to line up with your retirement timeline. If youre planning to retire in 15 years, you might pick a target-date fund of 2025 or 2030. The fund manager will adjust the holdings and when you near retirement age, that fund will hold a lot of bonds, instead of the more risky stocks.
You dont have to worry about adjusting your investment portfolio because the fund does it for you. If you dont have the time or desire to learn how to manage your retirement portfolio, these target-date funds might be a great idea.
As your grandparents might have said, if its too good to be true, it probably isnt and that might be the case with target-date funds.
The Whole You
First, you are more than a date. Knowing that you plan to retire in 2025 or 2030 isnt enough information to assemble your retirement portfolio; imagine a doctor asking nothing more than your age. Your investment portfolio should be crafted around your tolerance for risk, the other assets you own, your family situation, social security and more. A target-date fund doesnt take any of that into account, because its designed for a large amount instead of you, personally.
They Might Cost a Lot
According to Consumer Reports, the median expense ratio of target-date funds is 0.68%, compared to 0.71% for stock funds. That isnt bad if your plan offers a target-date fund around the median, but the median expense ratio of index funds, a fund that tracks the performance of a certain investment index, is only 0.5% and you can find index funds for as low as 0.1%.
In general, actively managed funds, funds that have a team of people picking stocks and bonds in an attempt to beat the overall market, will cost more, but over the long term they dont perform any better than an index fund that is cheaper.
Theyre Hard to Understand
Target-date funds are like a brand new car . They look good on the outside but theyre hard to figure out when you open the hood. A recent SEC study found that many people believed that a target-date fund guarantees an income stream at retirement much like an annuity or a pension.
Others believed that once the fund reached the target-date, no more allocation changes in the fund were made. Both of these facts are untrue but this, along with the fact that a 2025 fund may vary greatly between companies, makes these funds dangerous for investors to take at face value.
The Bottom Line
Regardless of what you read today or in the future, there is no one investment product that will address all of your investing needs. A combination of products that may include a target-date fund is the best way to insure your retirement needs are met. Diversification will likely always be the best way to protect and grow your portfolio.
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Is Your Broker Ripping You Off?
Despite the over-hyped stories on the news, most financial professionals are honest, hard-working people. After all, cheating clients isnt a good way to build a strong business and generate referrals; as a result, it isnt a common practice.
That said, the world of financial services can be complicated and confusing at the best of times and when you feel like you have a problem with your broker, it can seem even worse. Fortunately, with a little organization and a bit of elbow grease, most problems can be resolved.
The Process
The first step in the process is to contact your broker or financial advisor. Put your concerns in a letter and deliver it in a way that enables you to confirm receipt. Keep a copy for yourself. Many times, simple misunderstandings or miscommunication can be resolved quickly and easily. If the issue is not resolved, your copy of the letter serves as proof of your efforts to address the situation. (For related reading, see Evaluating Your Broker.)
If sending a letter does not resolve the issue to your satisfaction, the next step is to contact your brokers boss, generally referred to as a branch manager. Once again, do it in writing. If your complaint is legitimate, the branch manager has every incentive in the world to help you resolve it. Successful firms dont want unhappy clients.
If you still arent satisfied with the response you get, you can contact the firms compliance office. In todays heightened regulatory environment, compliance is something that most firms take very seriously. Send your complaint in writing, along with copies of your earlier letters. Provide details about the issue and the steps that you have taken to resolve it. Give the compliance officer 30 days to respond. Should the issue remain unresolved, the fourth step is to contact the regulators.
U.S. Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) oversees the securities market with a mandate to protect investors. If you file a complaint, the SECs Division of Enforcement will investigate by contacting the parties involved in the issue. In some cases, contact by the SEC leads to dispute resolution. In others, the SEC may take further action, such as filing a lawsuit and/or imposing sanctions. In cases where the company under investigation denies the allegations and no proof exists to contradict the denial, the SEC cannot act in place of a judge. Arbitration or legal action may be required. (To learn more about the SEC, read Policing The Securities Market: An Overview Of The SEC.)
The Financial Industry Regulatory Authority
Previously the National Association of Securities Dealers (NASD), FINRA is responsible for regulating all securities firms doing business in the United States, including registration of securities professionals, writing and enforcing securities laws, keeping the public informed and administering a dispute resolution platform. FINRAs compliance program is designed to address disputes with brokerage firms and their employees. Federal law gives FINRA the authority to discipline firms and individuals that violate the rules. However, disciplinary action is no guarantee that investors will be compensated for losses. The issues that FINRA addresses include the recommendation of unsuitable investments, unauthorized trading, failure to disclose material facts regarding an investment and unauthorized withdrawals from an investors account. FINRA also provides an investor complaint application that allows individual investors to submit a complaint regarding a brokerage firm or broker who has conducted business improperly.
State Securities Regulator
In the United States, each state has its own securities regulator. Contacting your states regulator is another avenue to explore when a dispute arises.
Understand the System
A significant number of investors set themselves up for disappointment because they dont understand their investments and they dont understand the regulatory system. Losing money on an investment is not always a reason to call for help. You need to read the fine print and make sure you understand everything your advisor has proposed for your portfolio - including the potential for a decline in value - before you agree to make the investment. Buying something that you dont understand and then trying to get your money back if the investment loses money is often a recipe for disaster.
The other important issue to remember is that regulators investigate breaches of industry rules and regulations. They do not assist with the recovery of lost money. Even if you have been the victim of an unscrupulous individual, litigation may be required to recover assets.
Mediation and Arbitration
Mediation is an informal, voluntary process whereby an independent third party facilitates a settlement between the parties involved in a dispute. Mediation is a voluntary process, and the outcome is non-binding.
Arbitration is another option. Some types of securities accounts include an agreement in which both parties agree to settle their differences in arbitration should a dispute arise. If you made such an agreement when you opened your account, the arbitrators will apply the applicable laws to your case. In some instances, the entire dispute is handled through written correspondence and records, so be sure to keep copies of all documents that will be relevant to your case. Arbitration decisions are final and binding.
Litigation - The Last Resort
If you have a legitimate compliant and it remains unresolved after you have followed all of the steps in the process in an effort to address it, contact an attorney. Litigation is often a slow and expensive process, and there is no guarantee that you will get the solution that you are seeking.
A far better choice than litigation is to make every effort to avoid this path altogether. Before you invest, learn about the various types of financial services professionals that are available to assist you. Some upfront research can save you a great deal of heartache, and money, later on.
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How To Manage Your Company Stock
If you work for a larger corporation theres a good chance that you have access to company stock as part of your compensation package. Your company may issue stock options or you may have access to company stock in your 401(k) retirement plan or an employee stock purchase plan. Heres what you need to know about managing company stock.
Its Not Different
When you think about your company stock, do you see it as a different kind of investment than you would make in the stock market? Does it feel more stable and secure to you since you know so much about the company? Holding company stock as part of your overall investment portfolio is no different than buying the stock of another company through your brokerage account.
The truth is that you likely have very little knowledge of news and events that would directly affect the price of the stock. Its illegal for company management to give you advance knowledge of coming events and if youre one of the decision makers that has access to the knowledge, youre aware of the tight restrictions you have when trading your stock.
Dont adopt a false sense of security because you work there. History is filled with past employees of now bankrupt companies that were left holding worthless company stock, (Enron, Lehman Brothers, etc.)
Dont Own More Than 10%.
If your main investment dollars are in a 401(k), no more than 10% of your 401(k) should be in company stock and some experts advise much less. If you have investments outside of your 401(k), your company stock should make up no more than 10% of your entire portfolio. How would you feel if you lost 10% of your portfolio? If that scares you, trim your company stock down to 5% or even less.
How About Company Stock Options?
Many employees make the mistake of letting their stock options gain too much value, because they dont understand how they work. They also dont understand that the value of stock options degrade over time. If youre awarded stock options, typically you receive a certain amount of options that have to go through a vesting period - this means that you cant exercise these options right away. Once youre able to exercise the options, you want the options to be above the strike price before you exercise.
Employee stock options not only have a minimum amount of time that goes by before you exercise the option, theres also a maximum. Count these options as part of your overall portfolio and although you shouldnt let this part of your portfolio become too large, when to exercise the options is complicated and best done with the help of a trusted financial adviser. Make sure they discuss the tax implications with you.
Should You Sell?
According to Reuters, purchasing company stock is on the decline and for good reason. For investors without the time or experience to manage individual stocks, mutual funds, some exchange traded funds and index funds are better, more diversified alternatives to owning single company stocks, even if the company happens to be your employer. If you dont have a high level of stock market knowledge, owning company stock outside of stock options is a bad idea.
The Bottom Line
The company stock you own in one of the many forms should not violate the rules of good diversification. No more than 10% of your portfolio should be in any one stock even if the company supplies your paycheck. Also remember that like any investment, company stock comes with the same risk as any other single stock. Dont hold a false sense of security since the company happens to employ you.
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10 Risks That Every Stock Faces
There are many sector specific and even company specific risks in investing. In this article, however, we will look at some universal risks that every stock faces, regardless of its business.
Commodity Price Risk
Commodity price risk is simply the risk of a swing in commodity prices affecting the business. Companies that sell commodities benefit when prices go up, but suffer when they drop. Companies that use commodities as inputs see the opposite effect. However, even companies that have nothing to do with commodities, face commodities risk. As commodity prices climb, consumers tend to rein in spending, and this affects the whole economy, including the service economy. (For related reading, see Commodity Prices And Currency Movements.)
Headline Risk
Headline risk is the risk that stories in the media will hurt a companys business. With the endless torrent of news washing over the world, no company is safe from headline risk. For example, news of the Fukushima nuclear crisis, in 2011, punished stocks with any related business, from uranium miners to U.S. utilities with nuclear power in their grid. One bit of bad news can lead to a market backlash against a specific company or an entire sector, often both. Larger scale bad news - such as the debt crisis in some eurozone nations in 2010 and 2011 - can punish entire economies, let alone stocks, and have a palpable effect on the global economy.
Rating Risk
Rating risk occurs whenever a business is given a number to either achieve or maintain. Every business has a very important number as far as its credit rating goes. The credit rating directly affects the price a business will pay for financing. However, publicly traded companies have another number that matters as much as, if not more than, the credit rating. That number is the analysts rating. Any changes to the analysts rating on a stock seem to have an outsized psychological impact on the market. These shifts in ratings, whether negative or positive, often cause swings far larger than is justified by the events that led the analysts to adjust their ratings. (For related reading, see What Is A Corporate Credit Rating?)
Obsolescence Risk
Obsolescence risk is the risk that a companys business is going the way of the dinosaur. Very, very few businesses live to be 100, and none of those reach that ripe age by keeping to the same business processes they started with. The biggest obsolescence risk is that someone may find a way to make a similar product at a cheaper price. With global competition becoming increasingly technology savvy and the knowledge gap shrinking, obsolescence risk will likely increase over time.
Detection Risk
Detection risk is the risk that the auditor, compliance program, regulator or other authority will fail to find the bodies buried in the backyard until it is too late. Whether its the companys management skimming money out of the company, improperly stated earnings or any other type of financial shenanigans, the market reckoning will come when the news surfaces. With detection risk, the damage to the companys reputation may be difficult to repair – and its even possible that the company will never recover if the financial fraud was widespread (Enron, Bre-X, ZZZZ Best, Crazy Eddies and so on). (For related reading, see Detecting Financial Statement Fraud.)
Legislative Risk
Legislative risk refers to the tentative relationship between government and business. Specifically, its the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investors holdings in that company or industry. The actual risk can be realized in a number of ways - an antitrust suit, new regulations or standards, specific taxes and so on. The legislative risk varies in degree according to industry, but every industry has some.
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In theory, the government acts as cartilage to keep the interests of businesses and the public from grinding on each other. The government steps in when business is endangering the public and seems unwilling to regulate itself. In practice, the government tends to over-legislate. Legislation increases the public image of the importance of the government, as well as providing the individual congressmen with publicity. These powerful incentives lead to a lot more legislative risk than is truly necessary.
Inflationary Risk and Interest Rate Risk
These two risks can operate separately or in tandem. Interest rate risk, in this context, simply refers to the problems that a rising interest rate causes for businesses that need financing. As their costs go up due to interest rates, its harder for them to stay in business. If this climb in rates is occurring in a time of inflation, and rising rates are a common way to fight inflation, then a company could potentially see its financing costs climb as the value of the dollars its bringing in decreases. Although this double trap is less of an issue for companies that can pass higher costs forward, inflation also has a dampening effect on the consumer. A rise in interest rates and inflation combined with a weak consumer can lead to a weaker economy, and, in some cases, stagflation. (Learn which tools you need to manage the risk that comes with changing rates. For more, see Managing Interest Rate Risk.)
Model Risk
Model risk is the risk that the assumptions underlying economic and business models, within the economy, are wrong. When models get out of whack, the businesses that depend on those models being right get hurt. This starts a domino effect where those companies struggle or fail, and, in turn, hurt the companies depending on them and so on. The mortgage crisis of 2008-2009 was a perfect example of what happens when models, in this case a risk exposure model, are not giving a true representation of what they are supposed to be measuring.
The Bottom Line
There is no such thing as a risk-free stock or business. Although every stock faces these universal risks and additional risks specific to their business, the rewards of investing can still far outweigh them. As an investor, the best thing you can do is to know the risks before you buy in, and perhaps keep a bottle of whiskey and a stress ball nearby during periods of market turmoil.
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Is Warren Buffett Really A Value Investor?
Hes one of the most famous investors of all time and has certainly earned his nickname of The Oracle of Omaha. Warren Buffett has long been hailed as a value investor. But is that statement still accurate?
TUTORIAL: P/E Ratio
What Is Value Investing?
Value investing can mean a number of different things, but is generally meant to refer to a class of investors who look for investments trading at a price below where certain valuation fundamentals suggest they should be trading at. For example, a stock can trade at a price-to-earnings (P/E) or price-to-book (P/B) value below its peers or the market average in general. Overall, value investing is an investment philosophy of finding undervalued securities that should eventually increase in value to be closer in line with (or above) the metrics of rivals or stock market averages.
On the flip side, growth investors are said to be more interested in the growth potential of a security whose underlying company has above-average sales or profit expansion prospects. Given this higher growth potential, a growth investor may be willing to pay above-average P/E, P/B or other valuation metrics compared to rivals or the market in general.
The value investing crowd has its origins in the 1934 text Security Analysis by Benjamin Graham and David Dodd and has been further developed by Warren Buffett, a past student of Graham who has also preached that a security eventually trades up to its intrinsic value. Buffett championed Grahams approach to buy a security with a satisfactory margin of safety, or, in Grahams words, a favorable difference between price on the one hand and indicated or appraised value on the other. (This simple measure can help investors determine whether a stock is a good deal. For more, see Value Investing Using The Enterprise Multiple.)
Where Does Buffett Fit?
In this context, Buffett is considered a value investor. More specifically, he relies on estimating a firms future cash flows and discounting them back to the present to get an estimated intrinsic value for a company when it comes to investing in its stock. Intrinsic value is a theoretical value assuming one could know a firms future cash flows with certainty, so the reality is that it is a very subjective measure and investors may come to widely varying estimations of intrinsic value, even when looking at the same set of data, valuation metrics, etc.
But in the context of value versus growth investing, Buffett is actually a bit of both. In his words, growth and value investing are joined at the hip and that understanding is required to find a company and underlying stock with solid growth prospects and a market value well below intrinsic value. The best illustration of this is the growth of Berkshire Hathaways non-insurance businesses over the past four decades. Below is a chart that Buffett provided in Berkshires 2010 shareholder letter:
Period Annual Earnings Growth
1970-1980 20.8%
1980-1990 18.4%
1990-2000 24.5%
2000-2010 20.5%
Over this time period, earnings growth averaged 21% annually while Berkshires stock price grew at an annual compounded rate of 22.1%, almost completely mirroring the growth in earnings. In this respect, Buffett is the ultimate growth investor because earnings grew about twice the level of the stock market during this period. In Buffetts words from this years shareholder letter, market prices and intrinsic value often follow very different paths - sometimes for extended periods - but eventually they meet. (Find out how Mr. Markets mood swings can mean great opportunities for you. See Take On Risk With A Margin of Safety.)
The Bottom Line
Again, perhaps the most appropriate conclusion to make is that Buffett is both a value and growth investor. At the outset of making an investment, it is reasonable to conclude that he uses a margin of safety by purchasing a stock with valuation metrics that are well below average. But overall, growth has to be there so that the firm can eventually trade up closer to its intrinsic value and growth potential must be well above average to double the markets return over the long haul.
To be a truly successful investor, individuals must take both a value and growth perspective when it comes to spotting undervalued investments and outperforming the market over time. Valuation multiples including P/E and P/B ratios are a good starting point, but at the end of the day it is also necessary to estimate a firms growth prospects and cash flows going forward, and come to an independent determination of intrinsic value.
When Stock Prices Drop, Wheres The Money?
Have you ever wondered what happened to your socks when you put them into the dryer and then never saw them again? Its an unexplained mystery that may never have an answer. Many people feel the same way when they suddenly find that their brokerage account balance has taken a nosedive. So, where did that money go? Fortunately, money that is gained or lost on a stock doesnt just disappear. Read to find out what happens to it and what causes it.
Disappearing Money
Before we get to how money disappears, it is important to understand that regardless of whether the market is in bull (appreciating) or bear (depreciating) mode, supply and demand drive the price of stocks, and fluctuations in stock prices determine whether you make money or lose it.
So, if you purchase a stock for $10 and then sell it for only $5, you will (obviously) lose $5. It may feel like that money must go to someone else, but that isnt exactly true. It doesnt go to the person who buys the stock from you. The company that issued the stock doesnt get it either. The brokerage is also left empty-handed, as you only paid it to make the transaction on your behalf. So the question remains: where did the money go?
Implicit and Explicit Value
The most straightforward answer to this question is that it actually disappeared into thin air, along with the decrease in demand for the stock, or, more specifically, the decrease in investors favorable perception of it. (For more on what drives stock price , see Stocks Basics)
But this capacity of money to dissolve into the unknown demonstrates the complex and somewhat contradictory nature of money. Yes, money is a teaser - at once intangible, flirting with our dreams and fantasies, and concrete, the thing with which we obtain our daily bread. More precisely, this duplicity of money represents the two parts that make up a stocks market value: the implicit and explicit value.
On the one hand, money can be created or dissolved with the change in a stocks implicit value, which is determined by the personal perceptions and research of investors and analysts. For example, a pharmaceutical company with the rights to the patent for the cure for cancer may have a much higher implicit value than that of a corner store.
Depending on investors perceptions and expectations for the stock, implicit value is based on revenues and earnings forecasts. If the implicit value undergoes a change - which, really, is generated by abstract things like faith and emotion - the stock price follows. A decrease in implicit value, for instance, leaves the owners of the stock with a loss because their asset is now worth less than its original price. Again, no one else necessarily received the money; it has been lost to investors perceptions.
Now that weve covered the somewhat unreal characteristic of money, we cannot ignore how money also represents explicit value, which is the concrete worth of a company. Referred to as the accounting value (or sometimes book value), the explicit value is calculated by adding up all assets and subtracting liabilities. So, this represents the amount of money that would be left over if a company were to sell all of its assets at fair market value and then pay off all of liabilities. (For more insight, read Digging Into Book Value and Value By The Book.)
But you see, without explicit value, implicit value would not exist: investors interpretation of how well a company will make use of its explicit value is the force behind implicit value.
Disappearing Trick Revealed
For instance, in February 2009, Cisco Systems Inc. (Nasdaq:CSCO) had 5.81 billion shares outstanding, which means that if the value of the shares dropped by $1, it would be the equivalent to losing more than $5.81 billion in (implicit) value. Because CSCO has many billions of dollars in concrete assets, we know that the change occurs not in explicit value, so the idea of money disappearing into thin air ironically becomes much more tangible. In essence, whats happening is that investors, analysts and market professionals are declaring that their projections for the company have narrowed. Investors are therefore not willing to pay as much for the stock as they were before.
So, faith and expectations can translate into cold hard cash, but only because of something very real: the capacity of a company to create something, whether it is a product people can use or a service people need. The better a company is at creating something, the higher the companys earnings will be and the more faith investors will have in the company.
In a bull market, there is an overall positive perception of the markets ability to keep producing and creating. Because this perception would not exist were it not for some evidence that something is being or will be created, everyone in a bull market can be making money. Of course, the exact opposite can happen in a bear market .
To sum it all up, you can think of the stock market as a huge vehicle for wealth creation and destruction.
Disappearing Socks
No one really knows why socks go into the dryer and never come out, but next time youre wondering where that stock price came from or went to, at least you can chalk it up to market perception.
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Do Your Investments Have Short-Term Health?
For companies, being able to meet short-term financial obligations is an integral part of maintaining operations and growing in the future. After all, if its not able to meet todays debts, a company might not live to see another day! Thats why its essential for investors to know how to evaluate a companys short-term financial health. Here we take you through a few of the ratios that are the foremost tools for doing so.
The Basics of Liquidity
A large factor determining a companys short-term financial health is liquidity, the definition of which depends on context. In stock trading , liquidity is the degree to which the market is willing to buy a particular stock. As a characteristic of an asset, liquidity refers to the ease with which an asset can be converted into cash. This is the definition of liquidity we are interested in.
Lets compare two different kinds of assets: a building and a money market account. Even if these two assets are valued at $100,000 on a companys financial statement, their liquidities have different implications for the companys short-term health. The money market account, an asset referred to as a cash equivalent, can be converted into cash within a day or two, if not immediately. The building, however, is very illiquid. For the company to get its cash, it must sell the building, which could take months, if not years.
Essentially, a companys short-term liquidity determines how well it can make its necessary payments (cash outflows) - which include employee wages, interest and supplier costs - given the revenue it generates (cash inflows). If a company has no cash equivalents, its inflows need to match or exceed cash outflows. So, if a company has a bad month and it has no supply of liquid assets like a money market account , it will be unable to make its necessary payments.
The Current Ratio
The first ratio we will look at is the current ratio, which compares all of a companys current assets to all of its current liabilities. In general, the term current means less than one year. So, current assets include cash, accounts receivable, inventory, prepaid expenses and other assets that can be converted to cash within one year. Current liabilities include short-term debt, interest, accounts payable and any other outstanding liabilities that are due within a years time.
When calculating this ratio, you are essentially trying to determine whether a company can meet its short-term obligations. It will likely be able to do so if the ratio is above 1; if the ratio is less than 1, the company is likely to fall short. We say likely because although a ratio of 1 or greater indicates that the company has more current assets than current liabilities, it may be inappropriate to judge certain industries by a rigid standard.
For industries that generally have a large portion of current assets tied up in inventory, a ratio of 1.5 or even 2 might be a better standard. When analyzing the current ratio, as when looking at any ratio, an investor should make comparisons between companies that operate in the same industry. Different industries have different business needs, so investors must modify their analyses accordingly.
Finally, bigger is not necessarily better in the case of the current ratio. A really high ratio, 10 for example, should probably sound some alarm bells, because it indicates that the company has a large amount of current assets that could - and probably should - be invested back into the company. Although a company with a very high current ratio may be stable in the short term, it probably has no means of sustaining its long-term growth and performance.
The Acid Test or Quick Ratio
The acid test is a more rigorous version of the current ratio. It indicates whether a firm, without selling inventory, has enough short-term assets to cover its immediate liabilities. Companies with ratios of less than 1 cannot pay their current liabilities without selling inventories and should be viewed with extreme care. An acid test that is much lower than the current ratio signals that current assets are highly dependent on inventory - retail is a type of business in which this would occur. In general, a ratio of 1 is considered satisfactory, although, as with the current ratio, the acid test should be compared only within a similar industry.
Interest Coverage
Interest coverage indicates what portion of debt interest is covered by a companys cash flow. A ratio of less than 1 means the company is having problems generating enough cash flow to pay its interest expenses. Ideally, you want the ratio to be over 1.5. A company with no long-term debt doesnt have any interest expense; this situation causes the current ratio to give enviable results. Companies with a poor interest coverage ratio can improve it by improving cash flow and/or lowering interest expenses by paying off debt.
This ratio is popular not only among investors, but also with creditors, who want to see that a companys short-term health is strong and that the company has sufficient cash flow to make principal and interest payments.
Another notable fact about the ratio is that sometimes different numerators will be used. For example, some analysts or creditors will use EBITDA in place of EBIT.
Activity Ratios
There are a few different activity ratios, but essentially, their main function is to help determine the companys cash flow cycle, giving a picture of how efficiently assets are being used. Almost any current account can be analyzed in terms of this cycle, but the three most common activity ratios each measure one of the following:
1. How long a company takes to collect receivables
2. How long a company takes to sell inventory
3. How long it takes to pay suppliers
The calculation of activity ratios is a little complex, but to give you an idea of how these ratios work, well look at the activity ratio dedicated to accounts receivable. Suppose that a company has total credit sales of $22 million. At the beginning of the year, accounts receivable is at $4.5 million, and at the end its $1.5 million. By using the accounts receivable turnover ratio we can determine that the companys receivables turn over at a rate of approximately 7.3 times per year. This means receivables remain outstanding for an average of 50 days. Here the calculations are represented mathematically:
Although we only demonstrate one activity ratio calculation here, the others are calculated in a similar fashion. All it takes is some research into the company and some number crunching.
Lets look at an example to put this all into context. Suppose that the above company has to pay suppliers within 90 days of purchase and suppose that, by calculating another activity ratio, we find the company holds inventory for 80 days. As the companys accounts receivable remain outstanding for 50 days, we find it has a cash cycle of 130 days (80 50). In other words, from the time it purchases its product from the supplier, the company takes approximately 130 days to collect payment from the customer.
The supplier, however, requires a payment within 90 days of the purchase. This 40-day discrepancy may create short-term liquidity problems for the company. This means investors should conduct more research to determine whether there is justification for this difference, and whether it is likely to cause hardship for the company. Examining activity ratios and determining a companys cash flow cycle are important elements of determining a companys short-term health and should be analyzed in conjunction with the other short-term liquidity ratios.
Conclusion
By honing in on crucial aspects of a companys financial health, ratios shed light on how well a company will do in the short term. More importantly, they help investors determine whether a company has the stability to get through unexpected problems today. If a company cannot maintain operations in the short term, it will not have the ability to provide investors with any benefits in the long term.
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10 Tips For The Successful Long-Term Investor
While it may be true that in the stock market there is no rule without an exception, there are some principles that are tough to dispute. Lets review 10 general principles to help investors get a better grasp of how to approach the market from a long-term view. Every point embodies some fundamental concept every investor should know.
1. Sell the losers and let the winners ride!
Time and time again, investors take profits by selling their appreciated investments, but they hold onto stocks that have declined in the hope of a rebound. If an investor doesnt know when its time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice. The following information might help:
• Riding a Winner - Peter Lynch was famous for talking about tenbaggers, or investments that increased tenfold in value. The theory is that much of his overall success was due to a small number of stocks in his portfolio that returned big. If you have a personal policy to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a sell-after-I-have-tripled-my-money mentality has ever had a tenbagger. Dont underestimate a stock that is performing well by sticking to some rigid personal rule - if you dont have a good understanding of the potential of your investments , your personal rules may end up being arbitrary and too limiting. (For more insight, see Pick Stocks Like Peter Lynch.)
• Selling a Loser - There is no guarantee that a stock will bounce back after a protracted decline. While its important not to underestimate good stocks, its equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because its also an acknowledgment of your mistake. But its important to be honest when you realize that a stock is not performing as well as you expected it to. Dont be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses. (For related reading, check out To Sell Or Not To Sell.)
2. Dont chase a hot tip.
Whether the tip comes from your brother, your cousin, your neighbor or even your broker, you shouldnt accept it as law. When you make an investment, its important you know the reasons for doing so; do your own research and analysis of any company before you even consider investing your hard-earned money. Relying on a tidbit of information from someone else is not only an attempt at taking the easy way out, its also a type of gambling. Sure, with some luck, tips sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run. (Find what you should pay attention to - and what you should ignore in Listen To The Markets, Not Its Pundits.)
3. Dont sweat the small stuff.
As a long-term investor, you shouldnt panic when your investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitablevolatility of the short term. Also, dont overemphasize the few cents difference you might save from using a limit versus market order.
Granted, active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself. (Learn the difference between passive investing and apathy in Ostrich Approach To Investing A Bird-Brained Idea.)
4. Dont overemphasize the P/E ratio.
Investors often place too much importance on the price-earnings ratio (P/E ratio). Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesnt necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued. (For further reading, see our tutorial Understanding the P/E Ratio.)
4. Resist the lure of penny stocks .
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way youve lost 100% of your initial investment . A lousy $5 company has just as much downside risk as a lousy $75 company. In fact, a penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.
6. Pick a strategy and stick with it.
Different people use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick with it. An investor who flounders between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors should avoid. Take Warren Buffetts actions during the dotcom boom of the late 90s as an example. Buffetts value-oriented strategy had worked for him for decades, and - despite criticism from the media - it prevented him from getting sucked into tech startups that had no earnings and eventually crashed. (Want to adopt the Oracle of Omahas investing style? See Think Like Warren Buffett.)
7. Focus on the future.
The tough part about investing is that we are trying to make informed decisions based on things that have yet to happen. Its important to keep in mind that even though we use past data as an indication of things to come, its what happens in the future that matters most.
A quote from Peter Lynchs book One Up on Wall Street (1990) about his experience with Subaru demonstrates this: If Id bothered to ask myself, How can this stock go any higher? I would have never bought Subaru after it already went up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that. The point is to base a decision on future potential rather than on what has already happened in the past.
8. Adopt a long-term perspective.
Large short-term profits can often entice those who are new to the market. But adopting a long-term horizon and dismissing the get in, get out and make a killing mentality is a must for any investor. This doesnt mean that its impossible to make money by actively trading in the short term. But, as we already mentioned, investing and trading are very different ways of making gains from the market. Trading involves very different risks that buy-and-hold investors dont experience. As such, active trading requires certain specialized skills.
Neither investing style is necessarily better than the other - both have their pros and cons. But active trading can be wrong for someone without the appropriate time, financial resources, education and desire.
9. Be open-minded.
Many great companies are household names, but many good investments are not household names. Thousands of smaller companies have the potential to turn into the large blue chips of tomorrow. In fact, historically, small-caps have had greater returns than large-caps; over the decades from 1926-2001, small-cap stocks in the U.S. returned an average of 12.27% while the Standard
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Top-Down Analysis: Finding The Right Stocks And Sectors
The top-down investment strategy is based on determining the health of the economy (and whether you want to even be investing at that time), the strength of different sectors and then picking the strongest stocks within those sectors to maximize returns. In this article you will learn how to pinpoint the hottest sectors leading the market higher (or lower in a bear market) and how to find stocks within those sectors that will potentially maximize returns.
If your market analysis has determined that the market is in an uptrend and likely to continue for some time, you want to buy stocks that are showing the best potential to be big winners in the uptrend. Just because the market is moving higher does not mean that all stocks will perform well, and some will greatly outperform others. If we are in a bear market and the investor is not opposed to short selling, we can look for stocks that will likely perform the worst, therefore making a nice profit on the short positions as prices fall. For the remainder of this article we will only focus on uptrends, but the same principles apply to downtrends.
Pick the Right Sectors
If the market is moving higher, we can begin to look at different sectors to find which ones will provide us the greatest potential for profits. Certain sectors perform better than others, so if the market is heading higher, we want to buy stocks within sectors that are performing the best. In other words, we want to invest in sectors that are outperforming the overall market.
To find the hottest sectors, we will want to look at several time frames. Looking at two or three time frames will allow us to pick sectors that are not just performing well right now, but that have been showing strength over a longer time frame. The time frames looked at will vary from person to person depending on their overall time frame.
We only want to pick the sector that appears most often at or near the top of the list for top performing sectors. The top two or three sectors can be picked if some diversity is desired. It is within these sectors that we will be placing our investment dollars.
We can also view the charts of sector ETFs. The trend should be defined by a trend line, with the ETF showing strength as it rises off the trendline. But more importantly we want to narrow our focus to specific stocks.
Pick the Right Stocks
We could simply buy a basket of stocks reflecting the entire sector, and this could do reasonably well, but we can do better by just picking the best stocks within that sector. Just because a sector is moving higher does not mean that all stocks in that sector will be great performers, but a few will outperform; those are the ones we want in our portfolio.
One process for finding individual stocks is the same as the process for sector analysis. Within each sector, we want to find the stocks that are showing the greatest price appreciation. Once again, we can look at multiple timeframes to make sure the stock is moving well over time. The stocks that have performed the best over two or three timeframes are the stocks we will buy for our portfolio. Examine the charts of top performers by placing trending lines on the chart. The price trend should be defined and profit objectives based on chart patterns should indicate high gains relative to risk on the upside. (For a complete overview of other major strategies to compare to the technical top down approach, refer to our Stock-Picking Strategies Tutorial.)
It is important to note that there are some other factors to consider when buying a stock. Additional criteria to look at before you buy includes:
• Liquidity: Buying stocks with little volume makes it hard to sell at a fair price if quick liquidation is required. Unless you are a seasoned investor/trader, invest in stocks that trade over a couple hundred thousand shares a day.
• Price: Many investors shy away from high-priced stocks and gravitate towards low-priced stocks. Trade in stocks that are above $5, or preferably higher. This is not to say there are not good cheap stocks, or not bad expensive ones, but do not shy away from a stock just because it is a high price, or buy a stock just because it is cheap in dollar terms.
One additional note is that ETF trading has come a long way in recent years. If you do not want to hold multiple individual stocks, you may be able to find an ETF that will give you reasonably close results. There is no problem buying specific ETFs, if that is preferred, which can reasonably mirror what individual stocks would have been selected.
Exiting and Rotating
While going through this process cannot guarantee that you will make extraordinary returns, it does offer you a good chance to make better-than-market returns. Some monitoring of positions will be required to make sure your sectors and stocks are still in favor with the market. The investor must also be aware of overtrading, which can result in excessive commissions; this why we use multiple timeframes.
If your stocks or sectors begin to fall out of favor across the timeframes in which you were analyzing them, it is time to rotate into the sectors that are performing well. Your overall market analysis will also give you a guide of when you should exit positions. When major trend lines within the stocks being held, or sectors being watched, are broken, it is time to exit and look for new trade candidates. (Learn more about rotating sectors in our article Sector Rotation: The Essentials.)
Summary
This strategy does require some turnover of trades, as sectors and the leading stocks within those sectors will change over time. The object is to be in stocks that are leading the market higher in bull markets, and if you are not opposed to short selling, being short in the weakest stocks that are leading the market lower during bear markets. We do this by finding the hottest sectors (for a bull market) over a period of time and then finding the best performing stocks within that sector. By continually transferring assets into the best performing stocks we stand a good chance to make above average returns.
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5 ETFs Flaws You Shouldnt Overlook
Exchange-traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a popular choice. However, there are some disadvantages that investors need to be aware of before jumping into the world of ETFs. In this article, we will look at some of the disadvantages of ETFs. Good information is an investors most important tool. Read on to find out what you need to know to make an informed decision.
Trading Fees
One of the biggest advantages to ETFs is that they trade like stocks. As a result, investors can buy and sell during market hours as well as put advanced orders on the purchase such as limits and stops. Conversely, a typical mutual fund purchase is made after the market closes, once thenet asset value of the fund is calculated. (To read more about ETFs, see Introduction To Exchange-Traded Funds.)
Every time you buy or sell a stock you pay a commission; this is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investments performance. No-load mutual funds, on the other hand, are sold without a commission or sales charge, which makes them advantageous, in this regard, compared to ETFs. It is important to be aware of trading fees when comparing an investment in ETFs to a similar investment in a mutual fund. (For more about how commissions can affect your portfolio, read Dont Let Brokerage Fees Undermine Your Returns.)
If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees. And remember, actively trading ETFs like stocks can severely reduce your investment performance as commissions can quickly pile up.
Underlying Fluctuations
ETFs, like mutual funds, are often lauded for the diversification that they offer to investors. However, it is important to note that just because an ETF contains more than one underlying position doesnt mean that it cant be affected by volatility.
The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S
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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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10 Golf Tips To Help Investors Tee Off
Avid golfers appreciate the game of golf for its unhurried pace, the chance to enjoy the outdoors with clients during business hours and the addictive feeling of making a great shot.
There are actually a lot of similarities between the game of golf and investing. So, if you golf, youve already got a head start on understanding how to make your money grow. Read on to find out what the game of golf can teach you about investing.
1. Dont Let Your Mind Interfere With the Game
Golfers who let their emotions run wild will be on the fast track to having all balls in the rough, out of bounds or in the sand. In much the same way, investors cannot be ruled by their emotions. Fear, greed and overconfidence are powerful emotions that can lead an investor to make poor investment decisions.
For example, an exceptionally risk-averse investor might sell a position that has lost 10% of its value within a short period, only for it to recover shortly thereafter. Alternatively, an exceptionally confident investor might believe he can consistently beat the market - resulting in more trades, higher trading fees and lower overall gains.
2.Learn from the Masters
Avid golfers can learn a lot of tips from golf greats such as Tiger Woods or Phil Mickelson, whose golf swings have been studied by both amateur and professional golfers. Similarly, novice and sophisticated investors can learn a lot from investing giants such as Warren Buffett, Peter Lynch and George Soros.
The strategies that these investors followed vary widely, and can allow you to gauge the type of investing strategy that is best suited for your risk tolerance and goals.
3. Be Wary of Friendly Advice
Stock tips from friends are similar to golf tips from friends - you may have no way of knowing whether your friends a duffer. The hot stock tip you hear that is sure to be a winner could land your net worth in the bunker if you dont perform further research into the validity of the claim.
4. Find a Good Caddy
Unlike the hobo caddy that Adam Sandlers character used in the 1996 movie Happy Gilmore, golf pros dont use just anyone to caddy for them during a big tournament. Good caddies have a strong knowledge of the golf game, and can advise the player on various strategies that might be useful for a particular hole. Caddies also have a strong understanding of the players personality and style, and have a goal to keep the players emotions in check.
In much the same way, a good financial advisor has exceptional knowledge of the stock market and investing, and will get to know their clients in order to understand what investment strategies are the best fit for their clients future goals.
5. Watch for Red Flags
When golfing, a red flag indicates the hole, but an overlooked red flag in investing could put your investments in the hole. Before you invest your hard-earned money, be sure you read the prospectus.
6. Play the Percentages
In golf, making a conservative play and laying up in front of water is usually the best choice rather than trying to hit a hole-in-one. In the same way, buying penny stocks in order to land a tenbagger is not usually the best choice.
In essence, play the percentages. Wal-Mart (NYSE:WMT) and General Electric (NYSE:GE) were once-in-a-lifetime tenbaggers at one point, and you have a limited probability of landing a penny stock whose value increases 10 times in a short period. Furthermore, penny stocks are highly speculative due to their small market capitalization, and limited disclosure.
7. There Are No Mulligans
Unlike that second shot your partner might let you take during a friendly round of golf, there really are no mulligans allowed in professional golf games, or in the world of finance.
Take your time before you make an investment; there is no second chance if you make a poor investment decision. If youre unsure, seek the advice of a financial planner or advisor who can help you devise an investment strategy that is best suited for your situation.
8. Practice, Practice, Practice
Pro golfers such as Tiger Woods and Angel Cabrera didnt get to the Masters without a lot of practice and training - and as professional athletes, they never stop trying to improve.
Just as the driving range and countless hours on the golf course have helped the pros hone their skills, you can do the same by practicing your investing strategy with a simulated stock market game. (If you are ready to invest $100,000 risk-free, visit the Investopedia Simulator.)
9. One Good (Or Bad) Game Doesnt Indicate Future Success
One round of golf is not going to be an indicator of your overall performance at golf. If you have one bad game, it does not mean youre a terrible golfer. Your progress over a number of years playing golf is a much better indicator of success.
A quote from Peter Lynchs book One Up on Wall Street (1989) about his experience with Subaru demonstrates this: If Id bothered to ask myself, How can this stock go any higher? I would have never bought Subaru after it already went up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that.
The point is to base a decision on future potential, rather than on what has already happened in the past.
10. Fancy Equipment Doesnt Guarantee Success
Just because you decide to splurge on a custom set of clubs does not mean youll be winning tournaments and rubbing shoulders with the pros at the Masters. Nor does it increase your likelihood of landing a hole-in-one.
In the same vein, purchasing expensive trading software does not mean you will find winning investments every time. There really is no foolproof way to pick investments. Fundamental and technical analysis might glean the probability of where an investment is headed (just as that custom driver might give you a longer drive), but in essence, price movements are largely unpredictable – especially for equities. (Learn more about choosing investments in our Stock-Picking Strategies tutorial.)
Conclusion
So, the next time youre about to tee off, it might be a good time to take a step back and consider how much you already know about investing through the game of golf. With that in mind, the task of getting your investments in order might not be as daunting as you originally thought.
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Finding Your Investing Comfort Zone
To participate in the financial markets , both short-term traders and longer-term investors need to be comfortable about their holdings and their specific portfolios. In other words, if a certain position leaves you with a sense of uneasiness or the inability to sleep at night, it is not for you! Knowing the boundaries of your personal comfort zone makes it easier to maintain a portfolio that contains only suitable positions. So how do you find and establish these boundaries? Read on to find out.
Why Should I Be Comfortable?
Establishing a comfort zone is particularly important for a number of reasons:
• An uncomfortable trader or investor may allow emotions to take control of trading decisions.
•
Those who are too complacent may ignore risk.
• Determining a comfort zone helps you avoid borderline trades that usually turn out poorly.
• It helps you recognize when risk has increased.
• It encourages you to take profits when very little profit potential remains.
• It minimizes the possibility that youll be forced to make difficult decisions under pressure. Being comfortable with your positions means that high pressure situations should occur rarely.Settling Into Your Comfort Zone
Being in the comfort zone means owning a portfolio that contains only suitable, well-researched and understandable holdings.
Arriving at this type of portfolio involves going over your holdings yearly and deciding whether the reasons that you bought the stock still apply. For the stocks that dont make the cut, sell those positions, even if it results in a loss. Technically, the loss has already occurred and, except for tax reasons, turning it from a paper loss to one that is realized makes no difference. Once youve done this, you can put your money to work where you believe it will increase in value.
When choosing new stocks for you portfolio, remember that not every investment tip is a winner. In fact, its best to ignore all tips and conduct your own research.
Long-Term Investor or Trader?
Despite the inconsistency of the markets, the vast majority of investors choose to adopt a long-only approach by purchasing stocks, bonds, real estate, collectibles, etc. If you have good stock and investment selection skills, this method will do well over time. If you dont, and prefer to manage your own portfolio, different skills are required. For example, it may be worthwhile to learn how options work and how you can use them to hedge risk in stock portfolios .
At the same time, long-term investors must understand when a position is no longer suitable, either because it has run up in price very quickly, or the company is not expected to perform well in the future. You should work hard at mastering this skill - the time to recognize that some positions are too risky to hold is before disaster strikes.
The way you decide to invest in the market will determine your comfort zone. Day traders hold positions for a very short time. Swing traders hold longer, but by no means do they attempt to make long-term trades. And then there are the investors who have no specified holding period - and for many, that means they expect to hold for years. Which category you fall into will affect your comfort zone. For example, the day trader doesnt worry about sleeping well because positions are not held overnight, and the long-term investor is less concerned with timing. The one characteristic these trades should have in common is suitability for the investor, who must find both the risk and reward potential of any position acceptable.
Becoming a full-time trader is a goal for many individual investors, who see it as a glamorous road to riches, but these perceptions are false. As with any other profession, it takes education, practice, skill and discipline to succeed. In the same way that not everyone can become a professional athlete or movie star, the simple truth is that not everyone can be a full-time trader. Keep this in mind when thinking about your comfort zone - if you dont succeed in making profits as a trader, you probably wont be very comfortable.
Trading Within a Comfort Zone
Both long-term investors and traders must make important decisions. Among the questions to consider are:
• Is this a good entry point?
•
Is this an appropriate time to invest?
• Is the security fairly priced?
• How much profit do I expect to earn?
• How much capital is at risk?
• Is it possible this trade can result in a margin call?
• Whats the probability of earning a profit?Summary
Its important to invest or trade so that you are comfortable with the nature of your holdings - and thats especially true when it comes to understanding both risk and reward. Once you find your comfort zone, staying within it will help you make better investment decisions. If a security doesnt fall within the parameters of your comfort zone, its not a good investment for you.
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Institutional Knowledge/Research
In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a companys disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given companys management team than the average individual investor. (Read more about the role of Reg FD in Defining Illegal Insider Trading.)
Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge.
This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time. (You can piece together your own analysis if you have the right information. Read Do-It-Yourself Analyst Predictions to find out how.)
This is compounded by the fact that analysts can sit and wait for new information ,while the average Joe has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.
Keeping Tabs on Institutions Is Tough
Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.
Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter.
In fact, take T. Rowe Price as an example. According to the companys website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. Thats big. This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.
What happens in between? Frankly, those looking to mimic the institutions portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market. (Learn some ways you can keep track of institutional investment activities in Keeping An Eye On The Activities Of Insiders And Institutions.)
Trading Costs Can Be Huge, and Treatment May Vary
By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.
Funds often receive favorable treatment. In fact, its not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock – whereas individual investors will typically pay 5-10 cents per share.
In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points. (ReadPatience Is A Traders Virtue and A Look At Exit Strategies for a discussion of setting entry and exit points.)
In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall.
Bottom Line
While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.
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What Is A Pyramid Scheme?
A pyramid scheme is a fraudulent investing plan that has unfortunately cost many people worldwide their hard-earned savings. The concept behind the pyramid scheme is simple and should be easy to identify; however, it is often presented to potential investors in a disguised or slightly altered form. For this reason, it is important to not only understand how pyramid schemes work, but also to be familiar with the many different shapes and sizes they can take. (Many investors do not understand how to determine the level of risk their individual portfolios should bear. Find out for yourself in Determining Risk And The Risk Pyramid.)
The Scheme
As its name indicates, the pyramid scheme is structured like a pyramid. It starts with one person - the initial recruiter - who is on top, at the apex of the pyramid. This person recruits a second person, who is required to invest $100 which is paid to the initial recruiter. In order to make his or her money back, the new recruit must recruit more people under him or her, each of whom will also have to invest $100. If the recruit gets 10 more people to invest, this person will make $900 with just a $100 investment.
The 10 new people become recruiters and each one is in turn required to enlist an additional 10 people, resulting in a total of 100 more people. Each of those 100 new recruits is also obligated to pay $100 to the person who recruited him or her; recruiters get a profit of all of the money received minus the initial $100 paid to the person who recruited them. The process continues until the base of the pyramid is no longer strong enough to support the upper structure (meaning there are no more recruits). (From pyramid schemes to envelope stuffing, there are a lot of scams masquerading as legitimate part-time work.
The Fraud
The problem is that the scheme cannot go on forever because there is a finite number of people who can join the scheme (even if all the people in the world join). People are deceived into believing that by giving money they will make more money (with an investment of just $100, you will receive $900 in return). But no wealth has been created; no product has been sold; no investment has been made; and no service has been provided.
The fraud lies in the fact that it is impossible for the cycle to sustain itself, so people will lose their money somewhere down the line. Those who are most vulnerable are those towards the bottom of the pyramid, where it becomes impossible to recruit the number of people required to pay off the previous layer of recruiters. This kind of fraud is illegal in the Unites States and most countries throughout the world. It is estimated that 90% of people who get involved in a pyramid scheme will lose their money. (Lower levels of liquidity in exchange-traded funds make it harder to trade them profitably.
Fraud Disguised
Because people are attracted to the idea of making a quick buck with very little effort, many different forms of disguised pyramid schemes have succeeded in fooling people. Despite the illusion of legality presented by these revamped schemes, they are still illegal. It is thus important to recognize the characteristics of such so-called investment plans .
Many schemes will adopt the guise of gift-giving or loans that take place in investment clubs because none of these activities are technically illegal. However, the practice of donating a gift (tax free up to $10,000 in the U.S.) to someone (the recruiter), then having to recruit people into the club in order to receive a return on your investment (or your gift, rather) is essentially a pyramid scheme in disguise. (Joining an investment club isnt a get-rich-quick scheme, but it can help you learn the ropes or sharpen your investing skills. Learn more in Benefit From A Winning Investment Club.)
Multi-Level Marketing (MLM)
Legal multi-level marketing (MLM) involves being recruited in order to sell a product or service that actually has some inherent value. As a recruit, you can make a profit from the sales of the product or service, so you dont necessarily have to recruit more salespeople below you. And while you may be encouraged to recruit other salespeople whose sales would give you more profit, you can stick to just selling the product directly to the consumer if you choose.
A pyramid scheme MLM, however, will most likely sell a product with no independent value. The product could take the form of reports of some kind, for example, or mailing lists. In this kind of pyramid scheme, you would be required to recruit new members into the MLM in order to make a profit and keep the MLM alive. Joining the MLM is the only reason anyone would buy the products sold by this pyramid scheme.
Ponzi Schemes
Named after Charles Ponzi, who ran such a plot from 1919-1920, the Ponzi scheme is a fraudulent investment plan. It is not necessarily a pyramid, which is hierarchical. In a Ponzi scheme, there is one person who takes peoples money as an investment and does not necessarily tell them how their returns will be generated. As such, the peoples return on investment could be generated by anything; it could come from money taken from new investors - which means new investors essentially pay off the old investors - or even from money made by gambling in Las Vegas.
Chain Letters
Chain letters can be received electronically or through snail mail and are not illegal on their own. However, they take on the form of a pyramid scheme when the letter asks you to donate a certain amount of money (even just 5 cents) to the people on a list, then delete the name of the first person on the list, add your name, and forward the letter to a certain number of other people. The next people receiving the letter are then asked to do the same thing, so that you can receive your money as well. By forwarding the letter, you are asking people to give money with the promise of making money.
Conclusion
It is easy to see how a pyramid scheme can work, but participating in it (regardless of the form in which it is presented) involves deception and fraud because not everyone will receive the money that is promised in return.
As with any other investment plan you consider entering, it is important to ask the right questions. How will this money be invested? What is the rate of return? Who will be investing it? Talk to professionals and do your research before placing your money anywhere. And always remember that if a plan promises youll get rich quick with no risk or doesnt tell you how your money will be invested, you should raise a red flag and exercise caution before getting on board.
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How To Invest In Private Companies
The internet has revolutionized the world of retail stock investing by making vast amounts of financial information quickly and easily available to individual investors. And though still in the early stages, the advent of digital information exchange is also making it easier for more individuals to invest in privately-held companies. Just as eBay has put buyers in contact with sellers of collectibles that used to collect dust on attic shelves, today private companies are much more able to seek out buyers of their securities to allow them to raise capital. TUTORIAL: Advanced Financial Statement Analysis
The drawback to vast amounts of information is the difficultly in knowing what to focus on. Below is a comparison of private companies to public ones, overview of private company types and varieties, investment options currently available for interested investors, and a survey of other considerations to make when investing in private companies.
Private Companies versus Public Companies
Overall, it is much easier to invest in a publicly-traded firm. Public companies, especially larger ones, can easily be bought and sold on the stock market and therefore have superior liquidity and a quote market value. Conversely, it can be years before a private firm can again be sold and prices must be negotiated between the seller and buyer.
In addition, public companies must file financial statements with the Securities and Exchange Commission (SEC), making it easy to track how they are doing on a quarterly and annual basis. Private companies are not required to provide any information to the public, so it can be extremely difficult to determine their financial soundness, historical sales and profit trends.
Investing in a public company may seem far superior to investing in a private one, but there are a handful of benefits to not being public. A major criticism of many public firms is that they are overly focused on quarterly results and meeting Wall Street analyst short-term expectations. This can cause them to miss out on long-term value creating opportunities, such as investing in a product that may take years to develop, hurting profits in the near term. Private firms can be better managed for the long term as they are out of Wall Streets reach. An annual report by the World Economic Forum has detailed that productivity increases when a public firm is taken private. They can also create more jobs when run more efficiently and profitably.
Being an owner of a private firm also means sharing more directly in the underlying firms profits. Earnings may grow at a public, firm but they are retained unless paid out as dividends or used to buy back stock. Private firm earnings can be paid directly to the owners. Private owners can also have a larger role in the decision-making process at the firm, especially those with large ownership stakes.
Types of Private Companies
From an investment standpoint, a private company is defined by its stage in development. For instance, when an entrepreneur is first starting a business he or she usually receives funding from a friend or family member on very favorable terms. This stage is referred to as angel investing, while the private company is known as an angel firm. Past the start-up phase is venture capital: investing where a group of more savvy investors comes along and offers growth capital and managerial know-how and other operational assistance. At this stage a firm is seen to have at least some long-term potential.
Past this stage can be mezzanine investing, which consists of equity and debt, the last of which will convert to equity if the private company cant meet its interest payment obligations. Later-stage private investing is simply referred to as private equity and is currently a multi-billion dollar business with many large players.
For investors, the stage of development a private company is in can help define how risky it is as an investment. For instance, approximately 40% of angel investments fail and the risk falls the more developed and profitable a private company becomes. And although the goal of many private firms is to eventually go public and provide liquidity for company founders or other investors, other private business may prefer to stay private given the benefits given above. Family businesses may also prefer privacy and the handing of ownership across generations. These are important matters to become aware of when deciding to invest in a private company. (To learn more, see What Is Private Equity?)
How to Invest in Private Companies
Early-stage private investing offers the most investment opportunities but is also the most risky. As a result, joining an angel investor organization or investment group may be a good idea to make the process easier and potentially spread the investment risks across a wide group of firms. Venture funds also exist and solicit outside partners for investing capital.
As noted above, the internet has quickly become a central source to find these types of organizations, while other websites have sprung up to fill a void and put buyers and sellers of many types of private companies together. Online sources also have made it easier to at least locate basic information on a private firm. This can be done by visiting the companys websites, and reading online blogs and articles that discuss the firm and its industry.
Other resources that can be used include small or private business brokers that specialize in buying and selling these firms. Private equity is also an option, and ironically a number of the largest private equity firms are publicly traded so can be purchased by any investor. A number of mutual funds can also offer at least some exposure to private companies.
Other Considerations
Overall, it is important to reiterate that private companies are illiquid and require very long investing time frames. Most investors will also need an eventual liquidity event to cash out. This includes when the company goes public, buys out private shareholders, or is bought out by a rival or another private equity firm. And just like with any security, private companies need to be valued to determine if they are fairly valued, overvalued or undervalued.
It is also important to note that investing directly in private firms is usually reserved only for wealthy individuals. The motivation is that they can handle the additional illiquidity and risk that goes with private investing. The SEC definition calls these wealthy individuals accredited investor or qualified institutional buyer (QIB) when considering institutions.
The Bottom Line
It is now easier than ever to invest in private companies, but an investor still has to do his or her homework. Investing directly is still not going to be a viable option for most investors, but there are still ways to gain exposure to private firms through more diversified investment vehicles. Overall, an investor definitely has to work harder an overcome more obstacles when investing in a private firm as compared to a public one, but they work can be worth it as there are a number of advantages to be gained by investing in private companies.
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Peter Lynch On Playing The Market
Even though the reality of investing is often extremely disappointing or worse, the literature in the field can be outstanding. There is no shortage of excellent books, or of journalistic and academic writing. In this article, well take a look at Peter Lynchs One Up on Wall Street and get an overview of the kind of timeless advice that he provides. (For more, see Pick Stocks Like Peter Lynch.)
Tutorial: Stock Picking Strategies
Market Timing and Daring to be Different
Lynch sums up issues on market timing beautifully. His basic idea is that, not only is it difficult to predict the markets, but small investors can be both pessimistic and optimistic at all the wrong times. Basically, it can be self-defeating to try to invest in good markets and get out of bad ones. Thats not to imply that the small investor doesnt know what theyre doing, but rather that accurate market timing, especially in the short run, is unlikely. The critical point is that you dont have to be able to predict the stock market to make money with it.
Some of the best and most successful professional traders have an uncanny ability to sniff out really good stocks, before they become trendy and overpriced. According to Lynch, this is because the risks of the stock market can be reduced by proper play, just like the risks of stud poker.
Overheated Markets
What Lynch makes clear is that there are bad times to buy. This is not market timing, it is simply true that sometimes the market is dangerously high and at other times, way too low; for buyers, this can be appealingly low. Although, according to him, there is no absolute division between safe and rash places to invest, experts, or just ordinary, sensible people who take the trouble to find out, can find reliable signs of where they should be investing. When people are getting greedy, excessively risk-friendly, and are taking too many chances, the market should be avoided, or exposure to it at least reduced. (To learn more, see our Market Crashes Tutorial.)
Nothing, says Lynch, is more dangerous than extremely overpriced stocks, and it is possible to know when this is the case. There is nothing intrinsically wrong with the stocks of good companies; what is wrong is the way people invest. This can apply just as much to so-called professionals, as to the investor on the street. Likewise, for people who just do not have the time horizon for stocks, even buying blue chips would be too risky. Lynch stresses that it is important to remember that the market, like individual stocks, can move in the opposite direction of the fundamentals. If stocks, or more likely, too much of your money in them, are unsuitable for your needs and appetite for risk, dont even think about it. Diversification is the essence of sensible investing. (To learn more, see The Importance Of Diversification.)
What Most Brokers Really Do and Dont
If you are a small investor, dont expect too much attention from the industry. Lynch warns that theres an unwritten rule in the industry that, the bigger the client, the more talking the portfolio manager has to do to please him. If you are a small fish, he may not bother much at all, just leaving the money at the mercy of the market.
Its an ugly reality that most brokers just do not have the guts to buy into unknown companies. Believe it or not, the average Wall Street professional isnt looking for reasons to buy exciting stocks, and when these companies rocket up, the broker will have all manner of excuses for not having bought.
How to Do It
Lynch explains that the next investment is never like the last one and yet we cant help readying ourselves for it anyway. The economy and markets evolve in a mixture of the unpredictable and the predictable. We cannot know how the future will unfold, but we can still invest prudently and make money. The significance of this simple fact cannot be overemphasized. The trick is to buy great companies, especially those that are undervalued and/or underappreciated. Alternatively, if you pick the right stock the market will take care of itself.
There are some common characteristics of companies that should be avoided like the plague. By using such methods as cash, debt, price to earnings ratios, profit margins, book value and dividends, you can get a pretty good idea about whether a company is worth buying into.
Its also a good idea to keep checking; after all, sooner or later every popular, fast-growing industry becomes a slow-growing industry. There is a tendency to think things will never change, and while you may always want to keep some stalwarts in your portfolio, these, too, need to be monitored. (For more, see Fundamental Analysis For Traders.)
Other Classic Blunders and Seriously Dangerous Delusions
Apart from all the above, Lynch teaches that there are many disastrous things that many people think, and do, again and again, but which can easily be avoided. You dont need to time the market to believe that if its gone down so much already, it cant get much lower. By the same token, people who think they can always tell when a stock has hit the bottom, are themselves going to get hit.
In the same vein, do not believe that stocks always come back or that conservative stocks dont fluctuate much. Similarly, believing that when the stock goes up youre right, or when its down, youre wrong, can cost you a lot of money.
The Bottom Line
Lynch summarizes his book with some succinct advice: It is inevitable that there will be sharp declines in the market that present buying opportunities. To come out ahead, you dont have to be right all the time. Nevertheless, trying to predict the market in the short term is impossible. Companies dont grow without good reason and fast growers wont stay that way forever. If you dont think you can beat the market, for whatever reason, buy a mutual fund and save both the work and the money; dont count on the industry to do a great job, on your behalf.
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The Multiple Lives Of A Stock Trader
Whether they are working full- or part-time, traders are likely to experience multiple swings in their careers. Just like the markets they trade , they too will experience uptrends and downtrends in personal profits, and even the odd crash or windfall. But, over the long run, it is the trader who stays vigilant - who knows when to trade actively and when to sit on his hands - who stays in the game over the long run.
The phases a trader cycles through have different characteristics. By understanding the qualities of the market, the systems you are trading and how these might affect your personal profits, you can better adjust and hopefully minimize the effect of declining profits or losses. Psychologically, it can also help to know that almost all traders go through similar experiences, both good and bad. (If volatility and emotion are removed, passive, long-term investing comes out on top. Read Buy-And-Hold Investing Vs. Market Timing.)
The Trader Downtrend
This is very likely where most traders begin their careers. They have capital, they usually have some sort of game plan and they begin trading with full expectations of becoming wealthy from the financial markets. But alas, even though there may be a few early wins, capital often starts to deteriorate. The capital may even completely evaporate. Hopefully, many lessons are learned during this time and it can be viewed as a paid education. A trader can pay the market to learn - unfortunately, many fail to realize what the market is showing them. Instead, they get angry that the market is not going where they think it should go, or they berate themselves so much that they become crippled in making proper market analysis. (Trends are what allow traders and investors to capture profits. Find out whats behind them. Read 4 Factors That Shape Market Trends.)
Experienced traders likely went through this early education as well. Even as experienced traders, they will face times where losses seem to mount or profits are extremely hard to come by. During these times, it is the experienced traders, well, experience, that allows him or her to stay alive in the financial markets. Some do fall, however, and their former profits are distributed back to the markets. Understanding why this phenomenon occurs can help new and experienced traders avoid being wiped out, or as in the case of many, being wiped out again.
When profits are dwindling or losses are mounting, here are a few questions to ask:
• Is my trading plan complete? Does it account for all types of markets (uptrend, downtrend and flat)?
o A plan should account for all types of markets, even if that means the plan states not trading during certain times or conditions.
• Is my trading plan feasible based on current market conditions?
o Certain strategies will not work in certain market conditions. It is important to realize this and minimize trading until conditions become more favorable. A strategy that uses volatility will likely do poorly in dull markets and a breakout strategywill see more false signals in longer term, ranging markets.
• Are my position sizes exposing my capital to undue risk ?
o While risk tolerance varies, the higher the risk per trade, the less likely a trader is to last. Risking no more than 1-2% of capital on a given trade is a good rule of thumb.
• Have I been averaging down?
o There is no reason to add to a losing position. Risk is likely increasing when we average down, and it is increasing on a position that has not shown us what we expected.
• Have I been following my trading plan?
o Everything mentioned above should already be covered in the trading plan. If it is, then all you need to do is follow your plan. Remember why the rules were chosen in the first place, renew your commitment to them and take some time to re-analyze your plan and implement it.
The Trader Uptrend
Hopefully, most trader will get to experience an uptrend in their trading lives; it is the part where profits materialize and increase. In really good times, winning trades seem to come no matter what and the trader feels invincible. These are great times and should be enjoyed while they last. However, while it is easy to get caught up in the emotion of a winning streak, the trader must realize it will end. To maintain your edge, there are a few things to keep in mind and question while this good streak is going.
Why is my plan working so well right now? Can I adapt it to work better in other market conditions?
o It is possible the strategies employed meld well with the current financial climate, but is it possible these strategies could be adapted to other market environments to improve performance during those times as well?
• While good times should be taken advantage of, would an adverse market move wipe out a disproportionate amount of profits?
o During good times it is easy to take on more risk than is necessary. The feeling of invincibility can become a detriment if, when the streak finally ends, it wipes away all or a large portion of former profits. Keep risk in check, even in the good times.
• Are stops and trailing stop orders being used?
o Just because many trades have worked out recently does not mean you should abandon using stops. Always make sure risk is defined before each trade. Trailing stop orders will be beneficial to you if you have large, unrealized profits. By using a trailing stop, you will be able to realize at least some of the unrealized profits should the market turn.
Trade Actively or Sit on Your Hands
Many great traders have said that knowing when not to trade is what separates the winning traders from the losers. During a bull market, anyone can buy stocks and win, but it is the pro who knows when to back off and avoid losing those profits. This takes experience and, as we have learned, even the experienced traders get caught up, make mistakes and go through phases where they experience diminished profits or rising losses.
Thus, as outlined in the questions above, it is important to build a trading plan and trading psychology that uses the good times while not exposing oneself to financial detriment if the market turns, and also only trading when it is prudent to do so. Figuring this out can often be a simple and logical process. As an example, if the market is in an extremely tight range, even a day trader may not enter the market because the profits are too small relative to fees and risk. Therefore, at times it is better to sit on the sidelines and wait for opportunities to arise which allow traders a better chance to make significant profits.
Conclusion
It often appears that traders have many lives; some wipe out multiple accounts before finally getting it, while others experience large swings, never quite reaching the profits they want. Still others lose everything. No matter the case, trading is never a perfectly smooth vocation. By asking yourself pertinent questions and adhering to a well-prepared trading plan, many of the bumps can be avoided. For traders going through tough times, if a solid plan is implemented there is sunshine after the storm.
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The 6 Most Common Portfolio Protection Strategies
The key to successful long-term investing is the preservation of capital. Warren Buffett, arguably the worlds greatest investor, has one rule when investing - never lose money. This doesnt mean you should sell your investment holdings the moment they enter losing territory, but you should remain keenly aware of your portfolio and the losses youre willing to endure in an effort to increase your wealth. While its impossible to avoid risk entirely when investing in the markets, these five strategies can help protect your portfolio.
Diversification
One of the cornerstones of Modern Portfolio Theory (MPT) is diversification. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company as opposed to systematic risk, which is the risk associated with investing in the markets generally.
Non-Correlating Assets
According to some financial experts, stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk. Unfortunately, systematic risk is always present and cant be diversified away. However, by adding non-correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end-result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks; when one asset is down, another is up.
Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least thats the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategys effectiveness. (See why investors today still follow this old set of principles that reduce risk and increase returns through diversification. Check out Modern Portfolio Theory: Why Its Still Hip.)
Leap Puts and Other Option Strategies
Between 1926 and 2009, the S
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The Alphabet Soup Of Stocks
If youve ever watched financial TV or read financial papers, you may have heard of classifications like cyclical, growth and income stocks . As if the difference between preferred and common stocks wasnt enough, there are now more categories to add to the confusion! In this article, well try to replace the confusion with some clarity and logic.
Stocks and the Business Cycle
Many stocks can be broken into categories that denote the way in which different stocks perform during various times of the year or periods of the business cycle:
• Seasonal - These companies are characterized by the different levels of demand they face throughout the year. A snow shovel manufacturer, for example, is probably not very busy in the summer. Another seasonal effect is the increase in retail sales during the holidays. Butinvesting in seasonal stocks doesnt mean that you can automatically gain a healthy profit simply by purchasing a retail stock in the fall and selling it just after Christmas - not all seasonal stocks are guaranteed to do well, even during their peak seasons. When you analyzefinancial statements for a seasonal stock , you need to compare results to the same season of the previous year. (For related reading, see Analyzing Retail Stocks.)
• Non-Seasonal - These stocks are not affected by the change of seasons. Certain companies produce or sell goods that have what we call an inelastic demand curve. A good example is a peanut butter manufacturer - the demand for peanut butter is generally not affected by the weather or holidays.
• Cyclical - These companies, whose business activities intensely follow the business cycles of the economy, are always the first stocks to reflect a recession or an expansion. These companies dont necessarily intend to follow the business cycle, it just so happens that their products share this relationship with the economy. A good example of a company with cyclical stock would be a car manufacturer or an airline company. Luxury is one of the factors in the relationship between these stocks and the business cycle. Take Porsche, for example: when the economy is doing well, the sales of these fine automobiles rise. Conversely, when the economy goes into a slump, sales slow down.
• Non-Cyclical - This is the opposite of a cyclical stock. Profits of a non-cyclical stock do not change readily with the business cycle. These are companies that provide us with essentials, such as healthcare and food. Also referred to as defensive stocks, these stocks dont rely on the economic environment for increased sales. A perfect example is the diaper industry: regardless of whether the economy is busting or booming, parents have to buy diapers for their babies.
• Stocks and Dividends
Adding to the confusion, stocks are also classified according to their type of dividend payout schemes. Now remember, this is separate from what we have already discussed. Dividend payouts have little to do with the seasonal demands a company faces; instead, they are determined by each companys individual policies and objectives.
• Growth
- Growth stocks are known for their lack of dividends and rapidly increasing market prices. Defined by their tendency to grow faster than the market, these companies generally reinvest all earnings into infrastructure in order to maintain rapid growth, rather than directly paying out their earnings to investors. Young technology companies are often considered to be high growth, but the main characteristic of growth companies is that they believe that plowing earnings back into the research and development of new products benefits shareholders more than a dividend check every three months.
• Income - These stocks arent (usually) growth hungry, or theyve already reached their maximum growth potential. Income stocks prices do not tend to fluctuate a great deal. However, they do pay dividends that are higher than average. The value of an income stock depends on its reliability and track record in paying dividends. Generally, the longer a company has maintained dividend payments, the greater its value to investors. Historical examples of income stocks are real estate investment trusts (REITS) and utility stocks, many of which pay out annual dividends of 5% or more. (Learn how dividends benefit investors in The Power Of Dividend Growth.)Stock Slang Terms
Finally, the financial industry uses many slang terms to describe and categorize stocks. These terms arent always intuitive, but they do have their place in the financial world. Here are some of the many terms used to characterize stocks:
• Blue Chip – These are companies that are cream-of-the-crop, old-school and everlasting. Blue chips tend to be market mammoths, and have proven their ability to survive through both good times and bad. The term comes from poker, where blue chips are the ones with the highest value. These companies are generally expensive to purchase but can be safe bets. General Electric (NYSE:GE), Wal-Mart (NYSE:WMT) and IBM (NYSE:IBM) have all established themselves as blue chips.
• Penny Stock - The term penny stock is used to denote stocks that trade for less than a dollar, but can also refer to stocks that are considered very speculative. These stocks are generally new to the market, with no reputation or history to fall back on. Penny stocks present the possibility of large gains or losses. (For related reading, check out Spot Hotshot Penny Stocks.)
• Bo Derek – This is a term created by traders in the late 70s to describe the perfect stock. Back then, actress Bo Derek was considered the perfect 10. This slang term might be a little dated for a new generation of investors, as Bo Derek was famous in another era.
Conclusion
Now, how do these terms fit with one another you might ask? Well, next time you hear a cyclical income stock referred to as a real Bo Derek, youll know what it means. A stocks categorization can be varied and prone to change in different situations. Stocks that were once speculative may become blue chip, cyclical stocks can become non-cyclical due to some widespread economic changes and seasonal stocks may reduce their exposure to seasonal pressures by exporting goods. Changing times mean that dynamic companies will change their visions and goals. The important thing is to not only remember what category a stock falls under, but also how it compares to other stocks of the same group.
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