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5 Ways To Protect Your Portfolio From Volatility
Is it possible to gauge the level of anxiety in the investment markets? Certainly, and The Chicago Board of Exchange Volatility Index (VIX) measures it. The VIX reacts in real time - just as a stock does - and measures the level of volatility in the U.S. markets over the next 30 days. When the VIX is at 30, in the next 30 days the market could move as much as 2.5% in either direction, (30% divided by 12 months equals 2.5%). The VIX has hovered around 30 for the latter part of 2011, indicating that the market is still highly volatile.
Although short-term traders may call periods of high volatility great times to make money, the truth is that traders of all skill levels will face challenges in this market. What can you do to protect your portfolio against the wild stock market swings? Though it may not sound exciting to the average active trader, the best defense is to stick with conservative, boring strategies.
Hedge
Think of hedging as an insurance policy. Lets assume that you own Bank of America stock and it is now in a market decline. One way to hedge would be to purchase a put option, with a strike price below where you purchased the stock. You wont lose money on any move below your strike price. Other hedging options include short selling a stock and purchasing put options on index funds, like popular exchange traded fund SPDR S
Forces That Move Stock Prices
Have you ever wondered about what factors affect a stocks price? Stock prices are determined in the marketplace, where seller supply meets buyer demand. But unfortunately, there is no clean equation that tells us exactly how a stock price will behave. That said, we do know a few things about the forces that move a stock up or down. These forces fall into three categories: fundamental factors, technical factors and market sentiment.
Fundamental Factors
In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things: 1) An earnings base (earings per share (EPS), for example) and 2) a valuation multiple (a P/E ratio, for example).
An owner of a common stock has a claim on earnings, and earnings per share (EPS) is the owners return on his or her investment. When you buy a stock , you are purchasing a proportional share of an entire future stream of earnings. Thats the reason for the valuation multiple: it is the price you are willing to pay for the future stream of earnings.
Part of these earnings may be distributed as dividends, while the remainder will be retained by the company (on your behalf) for reinvestment. We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.
As shown in the diagram, the valuation multiple (P/E), or the stock price as some multiple of EPS, is a way of representing the discounted present value of the anticipated future earnings stream.
Copyright © 2008 Investopedia.com
About the Earnings Base
Although we are using EPS, an accounting measure, to illustrate the concept of earnings base, there are other measures of earnings power . Many argue that cash-flow based measures are superior. For example, free cash flow per share is used as an alternative measure of earnings power.
The way earnings power is measured may also depend on the type of company being analyzed. Many industries have their own tailored metrics. Real estate investment trusts (REITs), for example, use a special measure of earnings power called funds from operations (FFO). Relatively mature companies are often measured by dividends per share, which represents what the shareholder actually receives.
About the Valuation Multiple
The valuation multiple expresses expectations about the future. As we already explained, it is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are 1) the expected growth in the earnings base, and 2) the discount rate, which is used to calculate the present value of the future stream of earnings. A higher growth rate will earn the stock a higher multiple, but a higher discount rate will earn a lower multiple.
What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which in turn earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are worth less in inflationary environments).
In summary, the key fundamental factors are:
• The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)
• The expected growth in the earnings base
• The discount rate, which is itself a function of inflation
• The perceived risk of the stock.
Technical Factors
Things would be easier if only fundamental factors set stock prices! Technical factors are the mix of external conditions that alter the supply of and demand for a companys stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.) Technical factors include the following:
• Inflation - We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.
• Economic Strength of Market and Peers - Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a companys individual performance - determines a majority of a stocks movement. (There has been research cited that suggests the economic/market factors account for 90%!) For example, a suddenly negative outlook for one retail stock often hurts other retail stocks as guilt by association drags down demand for the whole sector.
• Substitutes - Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate and foreign equities. The relation between demand for U.S. equities and their substitutes is hard to figure, but it plays an important role.
• Incidental Transactions - Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official votes cast for or against the stock, they do impact supply and demand and therefore can move the price.
• Demographics - Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) middle-aged investors, who are peak earners that tend to invest in the stock market , and 2) older investors who tend to pull out of the market in order to meet the demands of retirement. The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples.
• Trends - Often a stock simply moves according to a short-term trend. On the one hand, a stock that is moving up can gather momentum, as success breeds success and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean. Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are trendy does not help us predict the future. (Note: trends could also be classified under market sentiment.)
• Liquidity - Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Wal-Marts stock is highly liquid and therefore highly responsive to material news; the average small-cap company is less so. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community). Large-cap stocks have high liquidity: they are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent liquidity discount because they simply are not on investors radar screens.
Market Sentiment
Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category because we know it matters critically, but we are only beginning to understand it. Market sentiment is often subjective, biased and obstinate. For example, you can make a solid judgment about a stocks future growth prospects, and the future may even confirm your projections, but in the meantime the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
Market sentiment is being explored by the relatively new field of behavioral finance. It starts with the assumption that markets are apparently not efficient much of the time, and this inefficiency can be explained by psychology and other social sciences. The idea of applying social science to finance was fully legitimized when Daniel Kahneman, a psychologist, won the 2002 Nobel Memorial Prize in Economics. (He was the first psychologist to do so.) Many of the ideas in behavioral finance confirm observable suspicions: that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains; and that investors tend to persist in a mistake.
Some investors claim to be able to capitalize on the theory of behavioral finance. For the majority, however, the field is new enough to serve as the catch-all category, where everything we cannot explain is deposited.
Summary
Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: technical factors and market sentiment often overwhelm the short run, but fundamentals will set the stock price in the long-run. In the meantime, we can expect more exciting developments in the area of behavioral finance since traditional financial theories cannot seem to explain everything that happens in the market.
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
What You Should Know About Inflation
Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase as reported in the Consumer Price Index (CPI), generally prepared on a monthly basis by the U.S. Bureau of Labor Statistics. As inflation rises, purchasing power decreases, fixed-asset values are affected, companies adjust their pricing of goods and services, financial markets react and there is an impact on the composition of investment portfolios.
Tutorial: All About Inflation
Inflation, to one degree or another, is a fact of life. Consumers, businesses and investors are impacted by any upward trend in prices. In this article, well look at various elements in the investing process affected by inflation and show you what you need to be aware of.
Financial Reporting and Changing Prices
Back in the period from 1979 to 1986, the Financial Accounting Standards Board (FASB) experimented with inflation accounting, which required that companies include supplemental constant dollar and current cost accounting information (unaudited) in their annual reports. The guidelines for this approach were laid out in Statement of Financial Accounting Standards No. 33, which contended that inflation causes historical cost financial statements to show illusionary profits and mask erosion of capital.
With little fanfare or protest, SFAS No. 33 was quietly rescinded in 1986. Nevertheless, serious investors should have a reasonable understanding of how changing prices can affect financial statements, market environments and investment returns.
Corporate Financial Statements
In a balance sheet, fixed assets - property, plant and equipment - are valued at their purchase prices (historical cost), which may be significantly understated compared to the assets present day market values. Its difficult to generalize, but for some firms, this historical/current cost differential could be added to a companys assets, which would boost the companys equity position and improve its debt/equity ratio.
In terms of accounting policies, firms using the last-in, first-out (LIFO) inventory cost valuation are more closely matching costs and prices in an inflationary environment. Without going into all the accounting intricacies, LIFO understates inventory value, overstates the cost of sales, and therefore lowers reported earnings. Financial analysts tend to like the understated or conservative impact on a companys financial position and earnings that are generated by the application of LIFO valuations as opposed to other methods such as first-in, first-out (FIFO) and average cost. (To learn more, read Inventory Valuation For Investors: FIFO And LIFO.)
Watch: Monetary Inflation
Market Sentiment
Every month, the U.S. Department of Commerces Bureau of Labor Statistics reports on two key inflation indicators: the Consumer Price Index (CPI) and the Producer Price Index (PPI). These indexes are the two most important measurements of retail and wholesale inflation, respectively. They are closely watched by financial analysts and receive a lot of media attention.
The CPI and PPI releases can move markets in either direction. Investors do not seem to mind an upward movement (low or moderating inflation reported) but get very worried when the market drops (high or accelerating inflation reported). The important thing to remember about this data is that it is the trend of both indicators over an extended period of time that is more relevant to investors than any single release. Investors are advised to digest this information slowly and not to overreact to the movements of the market. (To learn more, read The Consumer Price Index: A Friend To Investors.)
Interest Rates
One of the most reported issues in the financial press is what the Federal Reserve does with interest rates. The periodic meetings of the Federal Open Market Committee (FOMC) are a major news event in the investment community. The FOMC uses the federal funds target rate as one of its principal tools for managing inflation and the pace of economic growth. If inflationary pressures are building and economic growth is accelerating, the Fed will raise the fed-funds target rate to increase the cost of borrowing and slow down the economy. If the opposite occurs, the Fed will push its target rate lower. (To learn more, read The Federal Reserve.)
All of this makes sense to economists, but the stock market is much happier with a low interest rate environment than a high one, which translates into a low to moderate inflationary outlook. A so-called Goldilocks - not too high, not too low - inflation rate provides the best of times for stock investors.
Future Purchasing Power
It is generally assumed that stocks, because companies can raise their prices for goods and services, are a better hedge against inflation than fixed-income investments. For bond investors, inflation, whatever its level, eats away at their principal and reduces future purchasing power. Inflation has been fairly tame in recent history; however, its doubtful that investors can take this circumstance for granted. It would be prudent for even the most conservative investors to maintain a reasonable level of equities in their portfolios to protect themselves against the erosive effects of inflation. (For related reading, see Curbing The Effects Of Inflation.)
Conclusion
Inflation will always be with us; its an economic fact of life. It is not intrinsically good or bad, but it certainly does impact the investing environment. Investors need to understand the impacts of inflation and structure their portfolios accordingly. One thing is clear: depending on personal circumstances, investors need to maintain a blend of equity and fixed-income investments with adequate real returns to address inflationary issues.
What Is An ETF?: An Infographic
Sometimes reading up on everything that the market has to offer isnt the best way to learn. Its understandable, and perfectly OK, if as a beginner investor, a lot of the unfamiliar words and concepts go straight over your head. The fact is, some people are visual learners, and they do better with pictures than words.
So lets take a look at ETFs. Chances are that if youre new to investing youve heard all about ETFs and that theyre a great investment for people who want to get into the market. However, did you really understand the explanations of why? Heres an easy way to break it down, provided by Mint.com.
Contemplating Collectible Investments
If you have much space for storage, your attic and garage might be stuffed with old furniture, books and other items youve held onto over the years. If this is the case, you may be sitting on a few valuable collectibles just waiting to make you money. That said, you are just as likely to be looking at little more than a pile of junk. In this article well take a look at collectibles as an investment and help you decide whether this emotional market is a good place to park your money.
All Things Old Made New Again
140,000,000 B.C: A young Allosaurus missteps and finds itself mired in a sink hidden beneath the underbrush. Millions of geological ages later, an amateur paleontologist helps him out - or at least what was left of his head. In 2005, the Allosaurus restored skull sells for the high price of $600.
1908: Honus Wagner of the Pittsburgh Pirates hits his tenth home run and ends the year with a .354 batting average, marking one of the best years of his career. The next year, the American Tobacco Company commemorates Wagner by putting a trading card inside its cigarette packages. Less than 60 make it into stores before it is discovered that Honus is vehemently against smoking. In 2000, Wagners cigarette trading card is sold on EBay for $1.1 million.
1962: Stan Lee creates a superhero who has to worry about rent, his ailing aunt and passing his next test - all in addition to saving the world. Peter Parkers misadventure with a radioactive spider hit the stands with a $0.12 cover price. And, in 2006, the first edition of The Amazing Spider-Man is among the most valuable comics with a price around $6,000 or more, according to Wizard: The Guide To Comics pricing guide.
These are all examples of the strange and wonderful world of collectibles. While there is no denying the thrill of owning a juvenile Allosaurus skull, is collecting really a form of investment?
All That Glitters ...
The reason we began by discussing a fossil, a comic and a baseball card is that people have no qualms about calling them collectibles. However, when you speak about diamonds, gold and other precious materials, people tend to call theminvestments . In theory, these materials - and even stocks - could be termed collectibles because their price is based more on what people are willing to pay for them (or market value) than on their actual intrinsic value. But in the practical world, precious metals and stocks have an intrinsic value. For metals, this value is based on rarity and the fact that if you melt it, burn it or bend it, you still have the same atomic substance in the end. For stocks, the value is produced by the underlying brick and mortar company that the share represents - a company that is generating earnings to justify the prices you pay for its stock.
What makes collectibles different is that even a little damage can erase all of a collectibles value. This is because a collectibles value is based on emotional factors like nostalgia. These emotional factors can be as erratic as they are powerful. If you were asked whether people would be willing to pay more for a dinosaur skull or a baseball card, even if you chose one over the other you would give them both a higher value than, say, a torn up baseball card or a box of bone fragments. Those items you would probably call worthless (unless you are an archaeologist or a fan of papier-mâché).
The 20-Year Itch
It is said that nostalgia runs in 20-year cycles. In other words, the things that are popular now will become collectibles in 20 years when people want to reconnect with their past. This doesnt mean that you can buy the top 10 items from consumer polls, incubate them for 20 years and then sell them for a fortune. It means that some items this year will become collectibles if they meet two conditions: rarity and appeal.
Rarity is becoming a harder thing to find as mass production methods allow companies to (over)fill demand without incurring that much extra cost. Beanie Babies have devalued as more and more product lines are introduced. It is profitable for a company to sell as many products as it takes to satiate demand, and that mentality destroys a future collectors profits. (For more on this concept, check out Economics Basics.)
Appeal is also a difficult thing to nail down. To make money at collecting, you have to predict what will become popular in retrospect - perhaps something that is not in high demand now will become popular in the future, either because they are rare or they were not fully appreciated at the time. For example, in the 1950s and 1960s, wing-tipped plastic sun glasses with glass lenses were sold for a few dollars in drugstores, but they can now fetch hundreds of dollars in collectors markets.
Reasons Not To Buy Collectibles
Mark-ups
When you buy a collectible from a dealer, that dealer is usually marking up the price to make a profit. Unlike collectors, dealers do not have the luxury of holding an item for years and years while the value may or may not increase - they have sales to make and a business to run.
Maintenance
Many collectibles require special care to keep them in top condition. These can range in cost from the $1 plastic cover used to keep hockey cards safe to a special room with moisture, heat and light monitors to lengthen a paintings life. On top of the storage costs, there are the added costs of buying insurance for the more valuable types of collectibles as well as paying to have professionals, appraisers, restorers and dealers look at the collectible before you sell it. A collectible doesnt produce income while you hold it, and it may actually eat income while you wait for it to increase in value.
Wear
Most categories of collectibles - from Pokemon cards to antique plumbing fixtures - have a manual classifying how much an item is worth in pristine condition and what sorts of damage degrades it by what percentage of value. For example, a well-read copy of the aforementioned Amazing Spiderman #1 may only be worth 30-60% of the $6,000 list price, depending on what type and what degree of wear it shows.
Counterfeiting
Most museums display dinosaur fossils models - not the real thing. Can you tell the difference between an Allosauras skull made of plaster and cement and one made of fossilized bone? No matter how experienced the appraiser, forgeries do make it to the dealers and then through to the collectors, which could leave you holding a very expensive piece of criminal art.
Low Returns
Collectibles tend to have lower returns than a stock market index fund, a money market account and most bond funds. If you took an average of the returns on all collectibles – which is practically impossible to do given some have little or no market to measure – it would be dismal compared to the S
The Financial Characteristics Of A Successful Company
It is often debated whether a commonly perceived good company, as defined by characteristics, such as competitive advantage, above-average management and market leadership, is also a good company to invest in. While these characteristics of a good company can point toward a good investment, this article will explain how to evaluate the companys financial characteristics to make a final decision. (For further reading on the other characteristics, see 3 Secrets Of Successful Companies.)
Tutorial: Top Stock Picking Strategies
Background
The world of stock picking has evolved. What was once the duty of traditional stock analysts has become an internet phenomenon; stocks are now analyzed by all kinds of people, using all kinds of methods. Furthermore, the speed at which information now travels around the world, has led to increased volatility in stock prices and changes in the way that stocks are evaluated, at least in the short-term. In addition, the advent of self-directed 401(k)s, IRAs and investment accounts, has empowered individual investors to get more involved in the selection of stocks to buy. (Read House Your Retirement With Self-Directed Real Estate IRAs for more on this investment vehicle.)
While the short-term process may have changed, the characteristics of a good company to buy stock in have not. Earnings, return on equity (ROE) and their relative value compared to other companies, are timeless indicators of companies that might be good investments.
Earnings
Earnings are essential for a stock to be considered a good investment. Without earnings, it is difficult to evaluate what a company is worth, except for its book value. While current earnings may have been overlooked during the internet stock boom, investors, whether they knew it or not, were buying stocks in companies that were expected to have earnings in the future. Earnings can be evaluated in any number of ways, but three of the most prominent metrics are growth, stability and quality (Read more about the dotcom boom and other crazes that went wrong in Crashes: What Are Crashes And Bubbles?)
Earnings Growth
Earnings growth is usually described as a percentage, in periods like year-over-year, quarter-over-quarter and month-over-month. The basic premise of earnings growth is that the current reported earnings should exceed the previous reported earnings. While some may say that this is backward-looking and that future earnings are more important, this metric establishes a pattern that can be charted and tells a lot about the companys historic ability to grow earnings. (Read about how earnings can be linked to future growth in PEG Ratio Nails Down Value Stocks.)
While the pattern of growth is important, like all other valuation tools, the relative relationship of the growth rate matters, as well. For example, if a companys long-term earnings growth rate is 5% and the overall market averages 7%, the companys number is not that impressive. On the flip side, an earnings growth rate of 7%, when the market averages 5%, establishes a pattern of growing earnings faster than the market. This measure on its own is only a start, though; the company should then be compared to itsindustry and sector peers. (For related reading, see Five Tricks Companies Use During Earnings Season.)
Earnings Stability
Earnings stability is a measure of how consistently those earnings have been generated. Stable earnings growth typically occurs in industries where growth has a more predictable pattern. Earnings can grow at a rate similar to revenue growth; this is usually referred to as top-line growth and is more obvious to the casual observer. Earnings can also grow, because a company is cutting expenses to add to the bottom line. It is important to verify where the stability is coming from, when comparing one company to another. (For further reading, see Revenue Projections Show Profit Potential.)
Earnings Quality
Quality of earnings factors heavily into the evaluation of a companys status. This process is usually left to a professional analyst, but the casual analyst can take a few steps to determine the quality of a companys earnings. For example, if a company is growing its earnings, but has declining revenues and increasing costs, you can be guaranteed that this growth is an accounting anomaly and will, most likely, not last. (Read more in Earnings: Quality Means Everything.)
Return On Equity
Return on equity (ROE) measures the effectiveness of a companys management to turn a profit on the money that its shareholders have entrusted it with. ROE is calculated as follows:
ROE = Net Income / Shareholders Equity
ROE is the purest form of absolute and relative valuation and can be broken down even further. Like earnings growth, ROE can be compared to the overall market and then to peer groups in sectors and industries. Obviously, in the absence of any earnings, ROE would be negative. To this point, it is also important to examine the companys historical ROE to evaluate its consistency. Just like earnings, consistent ROE can help establish a pattern that a company can consistently deliver to shareholders. (For more on this topic, read Keep Your Eyes On The ROE, Earnings Power Drives Stocks and Profitability Indicator Ratios: Return On Equity.)
While all of these characteristics may lead to a sound investment in a good company, none of the metrics used to value a company should be allowed to stand alone. Dont make the common mistake of overlooking relative comparisons when evaluating whether a company is a good investment. (For further reading, see Peer Comparison Uncovers Undervalued Stocks and Relative Valuation: Dont Get Trapped.)
Where to Find Information
In order to compare information across a broad spectrum, data needs to be gathered. The internet can be a good place to look, but you have to know where to find it. Since the majority of information on the internet is free, the debate is whether to use the free information or subscribe to a service. A rule of thumb is the old adage, You get what you pay for. For example, if you are looking at comparing earnings quality across a market sector, a free website would probably provide just the raw data to compare. While this is a good place to start, it might behoove you to pay for a service that will scrub the data or point out the accounting anomalies, enabling a clearer comparison. (What youre getting isnt easy to determine. Find out how to get your moneys worth in Investment Services Stump Investors.)
The Bottom Line
While there are many ways to determine if a company that is widely regarded as good, is also a good investment, examining earnings and ROE are two of the best ways to draw a conclusion. Earnings growth is important, but its consistency and quality need to be evaluated to establish a pattern. ROE is one of the most basic valuation tools in an analysts arsenal, but should only be considered the first step in evaluating a companys ability to return a profit on shareholders equity. Finally, all of this consideration will be in vain if you dont compare your findings to a relative base. For some companies, a comparison to the overall market is fine, but most should be compared to their own industries and sectors.
How To Invest In Corporate Bonds
When investors buy a bond, they are lending money to the entity that issues the bond. The bond is a promise to repay the face value of the bond (the amount loaned) with an additional specified interest rate within a specified period of time. The bond, therefore, may be called an I.O.U.
Bond Types
The various types of bonds include U.S. government securities, municipals, mortgage and asset-backed, foreign bonds and corporate bonds.
Corporate bonds are issued by companies and are either publicly traded or private. Bond rating services such as Standard
6 Misconceptions About Investing Young
Investing is seen by many as an arduous task - one that is complicated, risky and best left to other people. It is often easier to avoid investing altogether, than confront it head on. A natural human reaction is to create excuses that rationalize why one has chosen to avoid an activity. Investing at a young age is no exception: a variety of misconceptions about investing young perpetuates the idea that investing is best left to older people and experts. This article will examine several of these misconceptions that are often used as an excuse to delay or avoid investment activity.
SEE: Young Investors: What Are You Waiting For?
I dont have enough money.
While it is true that young adults are usually inundated with debt - from student loans, car payments and mortgages - many can find at least a small amount of money to invest on a monthly or yearly basis. Contributing to employer-sponsored plans, such as 401(k)s, can allow a small investment to grow over time, particularly when matched by the employer. The power of compounding creates a golden opportunity for young investors, even those on a tight budget. It is important to keep in mind that investing does not have to involve huge positions; it is possible to invest in a very small number of stock shares.
I dont know anything about investing.
Ignorance is not an excuse to avoid investing. Young investors have many years to study, research and develop proficiency in investing techniques and strategies. A wealth of information is available to tech-savvy young adults, from financial and education websites, to social media pages, webinars and the many advanced trading platforms that are available for free or for a limited monthly fee.
Investing is too risky.
Many young adults are keenly aware of the economic crisis and the resulting chaos that ensued. While investing can be risky, it can be managed in a way that keeps it from being too risky, however that is defined for each individual. Young investors with a low risk tolerance can select more conservative portfolios, like blue-chip stocks and bonds. Investors with a higher tolerance for risk can enter more aggressive positions with higher reward potential.
Investing can wait till Im older.
Young investors have to contribute less to make more money over time than older investors. This is due to the power of compounding. A person who starts at age 20 and invests $100 per month until age 65 (a total contribution of $54,000) will have more than $200,000 when he or she reaches age 65, assuming a 5% return. If the person delays investing until age 40, he or she will have to contribute $334 each month (a total contribution of $100,200) to arrive at the same $200,000 by age 65.
Investing is for old people and Wall Street types.
While the media do portray many investors either as wizened old men or young, power-hungry Wall Street types, most investors are ordinary people, both young and old, wealthy and not. Even though we often hear You are never too old to start investing (or saving for retirement), the opposite is true as well: people are never too young to start investing.
My 401(k) should be all I need.
Depending on social security and 401(k)s can be risky. It is difficult to predict where social security will be in future years, and many investors learned the hard way in the last decade that employee-sponsored retirement plans dont always work out. Starting young and diversifying through a variety of investment vehicles is the best way to secure ones financial future.
The Bottom Line
Young adults often have so many distractions that it is difficult to set aside the time to think about investing. In addition to being busy with friends, work and hobbies, this age group is often burdened by a significant amount of debt, making investing seem like something that will have to wait. Despite these common misconceptions about investing young, those who do start studying, researching and investing young, have many advantages over those who wait, including the power of compounding and the ability to weather a certain degree of risk.
Valuing Firms Using Present Value Of Free Cash Flows
Decisions to invest can be made based on simple analysis such as finding a company you like with a product you think will be in demand in the future. The decision might not be based on scouring the financial statements, but the underlying reason for picking this type of company over another is still sound. Your underlying prediction is that the company will continue to produce and sell high-demand products and thus will have cash flowing back to the business. The second, and very important, part of the equation is that the companys management knows where to spend this cash to continue operations. A third assumption is that all of these potential future cash flows are worth more today than the stocks current price.
To place numbers into this idea, we could look at these potential cash flows from the operations, and find what they are worth based on their present value. In order to determine the value of a firm, an investor must determine the present value of operating free cash flows. Of course, we need to find the cash flows before we can discount them to the present value.
Calculating Operating Free Cash Flow
Operating free cash flow (OFCF) is the cash generated by operations, which is attributed to all providers of capital in the firms capital structure. This includes debt providers as well as equity. Calculating the OFCF is done by taking earnings before interest and taxes and adjusting for the tax rate, then adding depreciation and taking away capital expenditure, minus change in working capital and minus changes in other assets. Here is the actual formula:
OFCF = EBIT(1-T) depreciation - CAPEX - ï„ï€ working capital - ï„ï€ any other assets
Where:
EBIT = earnings before interest and taxes
T= tax rate
CAPEX = capital expenditure
This is also referred to as the free cash flow to the firm, and is calculated in such as way to reflect the overall cash-generating capabilities of the firm before deducting debt related interest expenses and non-cash items. Once we have calculated this number, we can calculate the other metrics needed such as the growth rate. (These five qualitative measures allow investors to draw conclusions about a corporation that are not apparent on the balance sheet. check out Using Porters 5 Forces To Analyze Stocks.)
Calculating the Growth Rate
The growth rate can be difficult to predict and can have a drastic effect on the resulting value of the firm. One way to calculate it is to take the return on the invested capital (ROIC) multiplied by the retention rate. The retention is the percent of earnings that are held within the company and are not paid out as dividends. This is the basic formula:
g = RR x ROIC
Where:
RR= average retention rate, or (1- payout ratio)
ROIC= EBIT(1-tax)/total capital
Present Value of Operating Free Cash Flows
The valuation method is based on the operating cash flows coming in after deducting the capital expenditures, which are the costs of maintaining the asset base. This cash flow is taken before the interest payments to debt holders in order to value the total firm. Only factoring in equity, for example, would provide the growing value to equity holders. Discounting any stream of cash flows requires a discount rate, and in this case it is the cost of financing projects at the firm. The weighted average cost of capital (WACC) is used for this discount rate. The operating free cash flow is then discounted at this cost of capital rate using three potential growth scenarios; no growth, constant growth and changing growth rate.
No Growth
To find the value of the firm, discount the OFCF by the WACC. This discounts the cash flows that are expected to continue for as long as a reasonable forecasting model exists.
Firm Value = ï“ Operating Free Cash Flowst
(1 WACC)t
Where:
Operating Free Cash Flows = the operating free cash flows in period t
WACC = weighted average cost of capital
If you are looking to find an estimate for the value of the firms equity, subtract the market value of the firms debt.
Constant Growth
In a more mature company you might find it more appropriate to include a constant growth rate in the calculation. To calculate the value, take the OFCF of next period and discount it at WACC minus the long-term constant growth rate of the OFCF.
Value of the firm = ï“OFCF1
k-g
Where:
OFCF1 = operating free cash flow
k = discount rate (in this case WACC)
g = expected growth rate in OFCF
Multiple Growth Periods
Assuming the firm is about to see more than one growth stage, the calculation is a combination of each of these stages. Using the supernormal dividend growth model for the calculation, the analyst needs to predict the higher-than-normal growth and the expected duration of such activity. After this high growth, the firm might be expected to go back into a normal steady growth into perpetuity. To see the resulting calculations, assume a firm has operating free cash flows of $200 million, which is expected to grow at 12% for four years. After four years, it will return to a normal growth rate of 5%. We will assume that the weighted average cost of capital is 10%. (Learn about the components of the statement of financial position and how they relate to each other. See Reading The Balance Sheet.)
Multi-Growth Periods of Operating Free Cash Flow (in Millions)
Period OFCF Calculation Amount Present Value
1 OFCF1 $200 x 1.121 $224.00 $203.64
2 OFCF 2 $200 x 1.122 $250.88 $207.34
3 OFCF 3 $200 x 1.123 $280.99 $211.11
4 OFCF 4 $200 x 1.124 $314.70 $214.95
5 OFCF 5 … $314.7 x 1.05 $330.44
$330.44 / (0.10 - 0.05) $6,608.78
$6,608.78 / 1.104 $4,513.89
NPV $5,350.92
Table 1: The two stages of the OFCF goes from a high growth rate (12%) for four years followed by a perpetual constant 5% growth from the fifth year on. It is discounted back to the present value and summed up to $5.35 billion dollars.
Both the two-stage dividend discount model (DDM) and FCFE model allow for two distinct phases of growth: an initial finite period where the growth is abnormal, followed by a stable growth period that is expected to last forever. In order to determine the long-term sustainable growth rate, one would usually assume that the rate of growth will equal the long-term forecasted GDP growth. In each case the cash flow is discounted to the present dollar amount and added together to get a net present value.
Comparing this to the companys current stock price can be a valid way of determining the companys intrinsic value. Recall that we need to subtract the total current value of the firms debt to get the value of the equity. Then, divide the equity value by common shares outstanding to get the value of equity per share. This value can then be compared to how much the stock is selling for in the market to see if it is over- or undervalued.
The Bottom Line
Calculations dealing with the value of a firm will always use unique methods based on the firm being examined. Growth companies might need a two-period method when there is higher growth for a couple years. In a larger, more mature company you can use a more stable growth technique. It always comes down to determining the value of the free cash flows and discounting them to today. (Calculate whether the market is paying too much for a particular stock.
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.
How To Outperform The Market
All investors must reevaluate and refine their investing styles and strategies from time to time. As we gain investing experience and knowledge, our view of the market is likely to change and most likely broaden how we envision the extent of our investing capacity. Those who want to try to outperform the market - that is, realize returns greater than the market average - might consider an active trading strategy, even if only for a portion of their portfolio. Here we explain what active trading is, how active traders view the market, their tools and investment vehicles and finally, the risks associated with their style.
What Is Active Trading?
The best way to understand active trading is to differentiate it from buy-and-hold investing, which is based on the belief that a good investment will be profitable in the long term. This means ignoring day-to-day market fluctuations. Using a buy and hold strategy, this kind of investor is indifferent to the short-term for two reasons: first, because he or she believes any momentary effects of short-term movements really are minor compared to the long-term average, and second, because short-term movements are nearly impossible to exactly predict.
An active trader, on the other hand, isnt keen on exposing his or her investments to the effect of short-term losses or missing the opportunity of short-term gains. Its not surprising then, that active traders see an average long-term return not as an insurmountable standard but as a run-of-the-mill expectation. To exceed the standard, or outperform the market, the trader realizes that he or she must look for the profit potential in the markets temporary trends, which means trying to perceive a trend as it begins and predict where it will go in the near future.
Below is a chart that demonstrates the difference between the long and short-term movements of the market. Note that even though the security moves upward over time, it experiences many smaller trends in both directions along the way.
Performance and the Short Term
Traders are active because for them the importance of the markets short-term activity is magnified - these market movements offer opportunity for accelerated capital gains. A traders style determines the time frame within which he or she looks for trends. Some look for trends within a span of a few months, some within a few weeks, and some within a few hours. Because a shorter period will see more definitive market movements, a trader analyzing a shorter time frame will be more active, executing more trades.
A greater number of trades doesnt necessarily equal greater profits. Outperforming the market doesnt mean maximizing your activity, but maximizing your opportunities with a strategy. An active trader will strive to buy and sell (or vice versa in the case of shorting) at the two extremes of a trend within a given time frame. When buying a stock, a trader may try to buy it at the lowest point possible (or an upwards turning point, otherwise known as a bottom) and then sell it when there are signs that it has hit a high point. These signs are generally discerned by means of technical analysis tools, which we discuss below. The more the trader strives to buy and sell at the extremes, the more aggressive - and risky - is his or her strategy.
Maximizing returns or outperforming the market isnt just about reaping profits, its also about avoiding losses. In other words, the trader will keep an eye out for any signs that the security is about to take a surprising turn in an undesirable direction. When these signs occur, the trader knows that it is time to exit the investment and seek profits elsewhere. A long-term trader, on the other hand, stays invested in the security if he or she has confidence in its value, even though it may be experiencing a downward shift - the buy and hold investor must tolerate some losses that the trader believes are possible to avoid.
Technical Analysis
You need particular analytical techniques and tools to discern when a trend starts and when it will come to an end. Technical analysis specializes in interpreting price trends, identifying the best time to buy and sell a security with the use of charts. Unlike fundamental analysis, technical analysis sees price as an all-important factor that tells the direction a security will take in the short term. Here are three principles of technical analysis:
• For the most part, the current price of a stock already reflects the forces influencing it - such as political, economic and social changes - as well as peoples perception of these events.
• Prices tend to move in trends.
• History repeats itself.
From these three principles emerges a complicated discipline that designs special indicators to help the trader determine what will happen in the future. Indicators are ways in which price data is processed (usually by means of a calculation) in order to clarify price patterns, which become apparent when the results of the indicators calculation are plotted on a chart. Displayed together with plotted historical prices, these indicators can help the trader discern trend lines and analyze them, reading signals emitted by the indicator in order to choose entry into or exit from the trade. Some examples of the many different types of indicators are moving averages, relative strength and oscillators.
Fundamental analysis can be used to trade, but most traders are well trained and experienced in the techniques of charting and technical analysis. It is a blend of science and art that requires patience and dedication. Because timing is of the utmost importance in active trading, efficiency in technical analysis is a great determiner of success.
Leverage
The short term approach of investing offers opportunities to realize capital gains not only by means of trend analysis, but also through short-term investing devices that amplify potential gains given the amount invested. One of these techniques is leveraging, which is often implemented by something called margin.
Margin is simply the use of borrowed money to make a trade. Say you had $5,000 to invest: you could, instead of simply investing this amount, open a margin account and receive an additional, say, $5,000 to invest. This would give you a total of $10,000 with which to make a trade. So, if you invested in a stock that returned 25%, your $10,000 investment turns into $12,500. Now, when you pay back the original $5,000, youd be left with $7,500 (well assume interest charges are zero), giving you a $2,500 profit or a return of 50%. Had you invested only $5,000, your profit wouldve been only $1,250. In other words, margin doubled your return.
However, as the upside potential is exacerbated, so is the downside risk. If the above investment instead experienced a 25% decline, you would have suffered a loss of 50%, and if the investment experienced a 50% decline, you wouldve lost 100%. You may have already guessed that, with leverage, a trader can lose more than his or her initial investment! As such it is a trading tool that should be used only by experienced traders who are skilled at the art of timing entry into and exit from investments. Also, since margin is borrowed money, the less time you take to pay it back, the less interest you pay on it. If you take a long time to try to reap profits from a trade, the cost of margin can eat into your overall return.
The Risks
Active trading offers the enticing potential of above-average returns, but like almost anything else thats enticing, it cannot be achieved successfully without costs and risks.
The shorter time frame to which traders devote themselves offers a vast potential but, because the market can move fast, the trader must know how to read it and then react. Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses - especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time consuming and expensive. Any person thinking of becoming an active trader should take this into account.
Also the higher frequency of transactions of active trading doesnt come for free: brokerage commissions are placed on every trade and, since these commissions are an expense, they eat into the traders return. Because every trade costs money, a trader must be confident in his or her decision: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what he or she is doing and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.
Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year. This could differ from a more passive investor who holds investments for numerous years and does not pay capital gains tax on a yearly basis. Capital gains tax expense must also be factored in when an active trader is calculating overall return.
Conclusion
As you gain more education and experience as an investor, you may become curious about the different ways to reach returns. It is important to be willing to learn about different strategies and approaches, but it is equally important to know what suits your personality, skills and risk tolerance. You may have guessed that active trading is best suited to those who are committed to taking control over their portfolio and pursuing their goals quickly and aggressively. All of this requires a willingness to not only take risks, but also keep up skills and efficiency. If this sounds like you, it may be time to start learning more!
A Guide To Risk Warnings And Disclaimers
Risk is fundamental to the investment process, but remains a concept that is not particularly well understood by most regular investors. For this reason, risk warnings - those vaguely worded, fine print disclaimers at the bottom of any investment documents and websites - are extremely important for both buyers and sellers.
Unfortunately, although there are many warnings out there, they often remain unread or are not sufficiently explicit. An investor needs a substantial level of experience and sophistication to know what is really meant, or an advisor needs to take the time to explain it to the investor carefully in person. Yet, all too often, these conditions do not prevail. Sometimes, sellers obviously prefer to keep people in the dark in order to make a sale. In this article, we will look at the nature of risk warnings in order to figure out what gets the message across properly, and what still leaves investors not truly knowing what they could be getting into.
Where Do These Warnings Appear and Why?
Mainly for legal reasons, firms generally publish some kind of warning in their brochures and on Internet sites. The objective is not only to explain to the investor the nature of the risks involved in the particular kind of investment being offered, but also to ensure that there can be no legal comeback. The warnings are either in a separate Internet link, or in a brochure. In the latter case, it may vary from a rather small footnote to a pretty explicit and large-print explanation of what can go wrong. The length tends to vary from one sentence to a couple of pages.
Examples of Written Warnings
Lets look at some actual written examples of how investors are warned of what might happen to their money. We will see what the firms say and just how useful it is.
Example - Too vague
An investor may get back less than the amount invested. Information on past performance, where given, is not necessarily a guide to future performance.
Or
The capital value of units in the fund can fluctuate and the price of units can go down as well as up and is not guaranteed.
Warnings like these are very common, regrettably. The problem with these is that there is no quantification and the warning does not really hit home. Can you lose 5% or 25%? There is a big difference between the two. It is unlikely that this warning alone will ensure that the unwary investor knows what could potentially happen to his or her money.
Example - Not easily understood by non-experts
The investments and services offered by us may not be suitable for all investors. If you have any doubts as to the merits of an investment, you should seek advice from an independent financial advisor.
This certainly warns people to be careful, but how many investors really understand what is meant by suitability or would bother to double-check? In addition, if the investor trusts the seller, he will think he is being careful. The odds of an investor actually going to an advisor are low.
Well show you how to turn $1k to $10k for free!
Example - Relativity and context given
You should be aware that certain types of funds might carry greater investment risk than other investment funds. These include our Smaller Companies, Pacific Growth and Japan funds.
Now we are moving in the right direction. You can see from this that the same company has other, safer investments , which you may prefer. This is no longer a token warning, and points clearly to lower-risk alternatives.
Example - The losses can be BIG
Investment in the securities of smaller companies can involve greater risk than is generally associated with investment in larger, more established companies that can result in significant capital losses that may have a detrimental effect on the value of the fund.
What is good about this one is that the investor is warned that the losses can be substantial. This is still not quantified, but the point that the investment is not for the faint at heart is clear enough.
Example - Now thats a warning!
You should not buy a warrant unless you are prepared to sustain a total loss of the money you have invested plus any commission or other transaction charges.
No need for vast experience or a vivid imagination. It is quite clear that you can lose the lot.
Criteria for a Good Risk Warning
There are several criteria that a warning should fulfill if it is to get the right message across:
• Quantification: Although this is not always possible, investors should have some idea as to the proportion of their money that they could lose.
• Warnings should be easy to follow: Any risk warning should be easy to understand. If you dont understand what the risk warning is telling you, dont assume that the investment is right for you just because you trust the seller. An inexperienced investor could easily be advised to buy anything, ranging from a basic stock fund to a highly complex packaged product.
• Signing is important for both parties: If an investor has to sign the warning, this demonstrates its importance to him or her, and provides good protection to the firm. However, never sign anything you dont understand.
• Internet warnings: On the Internet, it is all too easy to click away a warning and carry on with the deal. In a perfect world, the link and entry would be very clear and the investor prompted to take the warning seriously. This is not a perfect world, however, and its up to investors to make sure they read the disclaimer before continuing.
• Personal explanations: This are the only way many investors will really understand the risks of a given investment. If the print warning does not meet your criteria, seek out personal advice. The explanation should be clear and give sufficient detail so you know what you could lose, and how, and what other products might be more or less suitable and appealing. The seller should also make a note of how the warning was presented and, if possible, get the investor to sign this too.
Ask Until You Are Sure
As a private investor, you need to request verbal and/or written information and explanations until you are sure you understand the warnings. Dont stop until you are fully aware, in quantitative terms, of what you stand to gain and lose, and what other potential investments there are with different risk/reward ratios.
The Bottom Line
It is essential that investment risk warnings be clear and sufficient not only to provide legal protection, but also to ensure that the message truly gets home. Firms and advisors should only sell products with a warning that conveys the real level of risk clearly. Unfortunately, what should be done and what is common practice are two different things. As an investor, its crucial to know how much of your money you could lose and what circumstances could cause this to occur. If you are uncomfortable with the risks of the investment, remember there are always lower-risk alternatives.
Demo Accounts A Good (But Imperfect) Indicator Of Investing Skills
Demo accounts are advertised all over the internet, and people who surf financial sites are often exposed to many ads inducing them to open a demo account. Demo account trading is the new form of paper trading. The old-fashioned paper trade involved writing down entries and exits to see how a methodology played out in the market. Demo accounts allow the trader to do this on a computerized simulator. The simulated trading environment does provide a trader with the opportunity to get used to the software they will be using with their broker to trade the markets, but when a person moves to live trading after the demo account, there are several shocks they need to prepare for.
Why the Shock?
Many traders trade profitably in a demo account, but when they move to live trading with their own money, a succession of losses may occur one after the other. Why does this happen?
1. Demo accounts provide better execution than live trading .
Demo accounts will normally fill a market order at the price showing on the screen. When an order is placed in the live market, it is subject to slippage, and therefore it is quite common for market orders to not be filled at the price expected, or in the case of large orders, for at least a portion of the position to be acquired at a different price than is expected.
Demo accounts will also generally give early fills when bidding or offering. Bids and offers in the live market are also subject to a queue. Bidding at the current bid price does not guarantee a fill, as only a few shares or contracts may be filled at that price. In a demo account, it is hard to know which orders would actually have been executed in the live market. This is true of entries and exits, and thus results attained from a demo account are highly subjective at best, and completely inaccurate at worst.
2. Demo accounts often provide more capital than what the trader will actually be using for live trading.
Demo software generally allows the trader to choose the amount of capital he or she would like to simulate trading with. The amounts vary, but are often very large and beyond the actual capital the trader has for trading his own account.
Simulated trading with more capital than will actually be traded provides an unrealistic safety net. More capital allows for small losses to be more easily recouped, while a loss on a smaller account is harder to recoup.
It is also important to note that even share lots (100 shares) in more expensive instruments, which were easy to afford in the high-capital demo account, may be beyond the capacity of the trader in a live account. The instruments and volume traded in the simulator may not be able to be replicated with real capital. A trader may be able to trade several lots of Google at $500/share, but unless he or she has similar capital for live trading, he or she may be unable to trade those higher priced instruments at all.
3.
A demo account cannot simulate the emotions of fear and hope (also called greed) that the trader will experience with real money.
This is one of the most jarring differences between simulated and live trading. A fear of losing ones own capital can wreak havoc on a proven trading system and prevent the trader from implementing it properly. Greed (or hoping a losing position will come back to profitability) can have the same effect, keeping the trader in a trade long after it should have been exited.
When real money is on the line, money that can have a potential material impact (or is perceived to have a potential impact), it is far different from trading a demo account where success or failure has no material impact on the persons life.
Can Demo Trading Be Made More Realistic?
Demo trading does have some benefits, as it gives new traders a general idea of how the market and a companys software works. So, can you trade a demo account in a certain way to make it more realistic? While a demo account can never offer the same results that would be realized in live trading, there are several things you can do when testing out systems on a demo platform to make the results as realistic as possible.
1. Make Realistic Assumptions
If a bid or offer is placed, and you can see that the bid or offer was within one tick or one cent of the low or high of that move, assume that your order was not filled. The demo may show this order was filled, but in the actual market, this may not happen. Remove the profits or losses from these trades from the net profit/loss shown on the simulator – as if the trade never existed. Only assume bids or offers are filled if price trades through the bid or offer by at least a cent more. For thinly traded stocks or low-volume stocks this buffer should be expanded.
2. Account for Slippage
On market orders assume at least a one-cent slippage on high volume stocks, and assume larger slippage in lower volume or more volatile stocks.
3. Trade With Modest Capital
If possible, trade the same amount of capital in the demo account as will be traded in the live market. If the demo does not allow this, trade only a fraction of the demo account capital. Dont access any funds from the demo capital which would be in excess of live trading funds.
4. Get Personal
Pretend the money is real as much as possible. Monitor emotions and how trades are affecting you psychologically while those emotions are felt. Since demo capital provides no real loss or profits, the sense of loss or profit needs to be added in by the trader. One method of doing this is to withhold something you enjoy if you fail to follow your trading plan, or give yourself a small reward when the trading plan is followed (regardless of profit or loss).
Summary
Demo accounts can provide some benefit to new traders, as they allow the trader to become familiar with trading software and get a sense of how the market works. The problem is that simulated results rarely correlate to actual trading results. Therefore, the trader must be aware that execution, capital and emotions can be different when trading real money as opposed to fake money. Traders can, however, make demos more realistic by excluding profits/losses on orders that are unlikely to have been filled in the real market, factoring in slippage, keeping the demo account capital in line with what will actually be traded and making demo losses and profits (and thus emotions) real by incorporating external stimulus.
Five Things To Know About Asset Allocation
With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold - this is referred to as your asset allocation.
What is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors its the best protection against major loss should things ever go amiss in one investment class or sub-class.
The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the sidelines.
We must emphasize that there is no simple formula that can find the right asset allocation for every individual - if there were, we certainly wouldnt be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation:
Risk vs. Return
The risk-return tradeoff is at the core of what asset allocation is all about. Its easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest potential (stocks and derivatives) isnt the answer. The crashes of 1929, 1981, 1987, and the more recent declines of 2000-2002 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. Its time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return. Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you cant keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities. (To learn more about bond investing , see Bond Basics Tutorial.
Dont Rely Solely on Financial Software or Planner Sheets
Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one rule of thumb that many advisors use to determine the proportion a person should allocate to stocks is to subtract the persons age from 100. In other words, if youre 35, you should put 65% of your money into stock and the remaining 35% into bonds, real estate and cash.
But standard worksheets sometimes dont take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that dont capture your financial goals. Remember, financial institutions love to peg you into a standard plan not because its best for you, but because its easy for them. Rules of thumb and planner sheets can give people a rough guideline, but dont get boxed into what they tell you.
Determine your Long and Short-Term Goals
We all have our goals. Whether you aspire to own a yacht or vacation home, to pay for your childs education, or simply to save up for a new car , you should consider it in your asset allocation plan. All of these goals need to be considered when determining the right mix.
For example, if youre planning to own a retirement condo on the beach in 20 years, you need not worry about short-term fluctuations in the stock market . But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments.
Time is your Best Friend
The U.S. Department of Labor has said that for every 10 years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Having time not only allows you to take advantage of compounding and the time value of money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A bad couple of years in the stock market will likely show up as nothing more than an insignificant blip 30 years from now.
Just Do It!
Once youve determined the right mix of stocks, bonds and other investments, its time to implement it. The first step is to find out how your current portfolio breaks down. Its fairly straightforward to see the percentage of assets in stocks vs. bonds, but dont forget to categorize what type of stocks you own (small, mid, or large cap). You should also categorize your bonds according to their maturity (short, mid, long-term). Mutual funds can be more problematic. Fund names dont always tell the entire story. You have to dig deeper in the prospectus to figure out where fund assets are invested.
There is no one standardized solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you dont have, dont worry. Its never too late to get started. Its also never too late to give your existing portfolio a face-lift: asset allocation is not a one-time event, its a life-long process of progression and fine-tuning.
Asset Allocation: The First Step Towards Profit
Financial advisors and brokers, either full or limited service, rarely provide investors with an adequate and concise overview of the investment market. At least, not such that decisions on asset allocation can be made. Investors are faced with a plethora of options on where to put new money; a situation which is often overwhelming.
A primary investment decision is to choose asset classes, particularly equities or fixed income. This decision needs to be considered because each investor has unique objectives. Choosing between equities or fixed income , as well as making investment choices, affects the ability to achieve investment objectives. Individuals need to consider market conditions that are expected to persist over the coming months or years and the influence of economic policy, as well as individual circumstances.
Investment Decision Making
Asset allocation is a term tossed around by investment professionals to describe how to distribute investment dollars in order to achieve an expected rate of return based on certain factors. Individual investors should consider these factors, including current income and expected future income, investment time horizon and tax implications, to name a few. Over any 20-year period, investment returns from various asset classes have been mixed, thus resulting in high returns for one or a couple of consecutive years followed by low returns.
This means that if an investor puts all of his eggs in the same basket year after year, he will receive lower and more volatile returns than if he spread his investment dollars among various asset classes. There are decisions to be made regarding which asset classes to spread or to allocate investment dollars because certain combinations of investments are based upon the degree of aggressiveness (or risk tolerance) needed to meet objectives. Degree of aggressiveness is determined based on a persons age and time horizon as well as tax status. (See Matching Investing Risk Tolerance To Personality to find out more about this crucial step.)
In addition to the long-term perspective inherent in asset allocation decisions based on specific investment objectives, short-term effects on investments need also be taken into account. Short-term and long-term considerations can include, but are not limited to, interest rates and the policies of the Fed, economic outlook and currency.
For example, there are certain investments that do better in a low interest rate environment (equities over fixed income) and some that do well in a rising inflation environment, like treasury inflation protected securities (TIPS) and commodities, that protect the value of the asset (hard assets over soft assets). Currency fluctuations also affect investments. For example, if the dollar is weak vs. foreign currency from country X, then a company domiciled in the U.S. and has its expenses in U.S. dollars, but makes a majority of its revenue from country X, will likely benefit from the weak U.S. dollar. Therefore, the choice of asset class is an important decision for both a short- and long-term investment horizon.
Overview of the Asset Classes
Asset classes include equities and fixed income. Investing in equities means that the shareholder is a part owner in the company - he/she has an equity interest in the company but in the case of bankruptcy, has very little to no claim, resulting in a risky investment. Fixed income means that the investor receives a predetermined stream of income from the investment, usually in the form of a coupon, and in the event of bankruptcy, has senior claim to liquidated assets compared to shareholders. The fixed income traded in the public market is typically in the form of bonds.
Asset classes can be broken up into sub-classes. Sub-classes for equities include domestic, international (developed and developing or emerging countries) and global (both domestic and international). Within these divisions, equities can further be grouped by sectors such as energy, financials, commodities, health care, industrials etc. And within the sectors, equities can be grouped again by size or market capitalization, from small cap (under $2 billion) to mid cap ($2 billion-10 billion) to large caps (over $10 billion) stocks .
Sub-classes for fixed income include investment-grade corporate bonds, government bonds (treasuries) and high yield or junk bonds. The importance of breaking investments down into sub-classes is to manage the degree of risk generally associated with the investment. Investing in companies with small capitalizations and in developing countries has historically been more risky, but has had greater potential for higher returns than investments in large capitalizations, domestic companies. Similarly, due to its junior status to bonds, equity is generally considered more risky than fixed income.
Strategy
Proper asset allocation is the key to providing the best returns over the long term, but there are some general rules of thumb when investing that can help guide through the short term, normal fluctuations of the market. In the short term (one- to three-year time frame), the economy and economic policies of the government have significant influence on investment returns.
• Rule 1 - The stock market is a leading indicator, so its movement often precedes change in the economy that impacts labor, consumer sentiment and company earnings.
• Rule 2 - Policy and the impact of decision making by the government due to various economic data are mid to lagging indicators as to what the market is doing.
• Rule 3 - If you watch money flows (movement of money into and out of a particular stock, sector or asset class), when the chart shows a peak or bottom in money flow, you should do the opposite. Basically, a contrarian view may be best in this circumstance.
• Rule 4 - Options are most profitable in volatile markets. A good indicator of market volatility is the VIX (Chicago Board Options Exchange Volatility Index). At times when the VIX is expected to move higher, investing in options rather than owning the equity may sometimes be more profitable and less risky.
• Rule 5 - If there is a worry about rising inflation, buying protection via TIPS or hard assets like commodities usually insulates a portfolio.
• Rule 6 - In a market that is continually moving up, stock selection is often less important than buying the market, thus buying a market ETF or index fund may lead to high returns with lower risk. But in a market that is moving sideways, stock selection is key and investors need to understand the growth drivers of a companys stock.
Conclusion
Designing a portfolio that performs well in both the long and short term is obviously not easy to accomplish. However, weeding out a lot of the noise and concentrating on some simple rules in the short term, while focusing on proper and re-balanced asset allocation in the long term, can steer investors to a model portfolio that should produce less risky, more stable returns.
Alternative Assets For Average Investors
Alternative assets can bring significant benefits to investment portfolios through diversifying exposure away from traditional fixed income and equity assets. Moreover, alternative assets are no longer the exclusive province of the super-wealthy; if fact, the average retail investor can avail him- or herself of a wide range of alternative asset strategies through traditional vehicles, including mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs). This article will serve as a guide to understanding the different types of alternative assets, and how they can be effectively used to enhance portfolio diversification. (For more on the basics of asset allocation, read Asset Allocation Strategies.)
Defining Alternative Assets
Whats an alternative asset? We can, perhaps, start by explaining what an alternative asset is not: it is not a direct fixed-income or equity claim on the assets of an issuing entity. For example, a holder of a senior secured bond owns a claim on certain specified assets of the issuer, like residential property or farm equipment. In the event of liquidation, an issuers secured and unsecured bondholders are paid off according to the seniority of their claims. Equity investors, by definition, own a claim on the residual net worth of the company after all its liabilities have been paid off, whether this amount is a lot or nothing at all.
Single-Asset Alternatives
Alternative assets are none of the above, which is why they are called alternative. An example of an alternative asset is a commodity futures contract. The contract gives its owner the obligation to take delivery of some object of value, like gold or pork bellies or Japanese yen, at some specified point in the future. An option on this futures contract would confer the right (not the obligation) to exercise the contract at one or more defined times during its life, or to let the option expire as worthless. Options and futures are derivatives: they derive their value from an underlying source, such as gold or pork bellies. (To learn the basics of derivatives, read The Barnyard Basics Of Derivatives and Are Derivatives Safe For Retail Investors?)
Pooled Vehicles
In addition to single-asset instruments, the term alternative assets also refers to pooled investment vehicles (multiple investors money is pooled by one manager) constructed to possess a different risk and reward matrix from traditional debt or equity investments. Pooled alternative vehicles can come in the same forms as their traditional counterparts - such as SEC-registered mutual funds or separately managed accounts (SMAs). They can also be unregistered vehicles like hedge funds, venture capitals or private-equity funds. These funds typically employ a combination of securities, some standard and some alternative. (For more on SMAs, read Separately Managed Accounts: A Mutual Fund Alternative.)
Low Correlation and Absolute Return
Alternative assets come in many varieties, but a common thread is their low correlation coefficients with both equities and fixed income. Consider the following chart:
Figure 1
Source: Zephyr
Interest Rates And Your Bond Investments
Most investors care about future interest rates , but none more than bondholders. If you are considering a bond or bond fund investment, you must ask yourself whether you think interest rates will rise in the future. If the answer is yes then you probably want to avoid long-term maturity bonds or at least shorten the average duration of your bond holdings; or plan to weather the ensuing price decline by holding your bonds and collecting the par value at maturity. (For a review of the relationships between prevailing interest rates and yield, duration, and other bond aspects, please see the tutorial Advanced Bonds Concepts.)
The Treasury Yield Curve
In the United States, the Treasury yield curve (or term structure) is the first mover of all domestic interest rates and an influential factor in setting global rates. Interest rates on all other domestic bond categories rise and fall with Treasuries, which are the debt securities issued by the U.S. government. To attract investors, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher yield. For example, the 30-year mortgage rate historically runs 1% to 2% above the yield on 30-year Treasury bonds.
Below is a graph of the actual Treasury yield curve as of December 5, 2003. It is considered normal because it slopes upward with a concave shape:
Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve therefore combines anticipated inflation and real interest rates. Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but its biggest hammer is the federal funds rate, which is only a one-day, overnight rate. Third, the rest of the curve is determined bysupply and demand in an auction process.
Sophisticated institutional buyers have their yield requirements which, along with their appetite for government bonds, determine how these institutional buyers bid for government bonds. Because these buyers have informed opinions on inflation and interest rates, many consider the yield curve to be a crystal ball that already offers the best available prediction of future interest rates. If you believe that, you also assume that only unanticipated events (for example, an unanticipated increase in inflation) will shift the yield curve up or down.
Long Rates Tend to Follow Short Rates
Technically, the Treasury yield curve can change in various ways: it can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).
The following chart compares the 10-year Treasury yield (red line) to the one-year Treasury yield (green line) from June 1976 to December 2003. The spread between the two rates (blue line) is a simple measure of steepness:
Consider two observations. First, the two rates move up and down somewhat together (the correlation for the period above is about 88%). Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in magnitude. Specifically, when short rates rise, the spread between 10-year and one-year yields tends to narrow (curve of the spread flattens) and when short rates fall, the spread widens (curve becomes steeper). In particular, the increase in rates from 1977 to 1981 was accompanied by a flattening and inversion of the curve (negative spread); the drop in rates from 1990 to 1993 created a steeper curve in the spread, and the marked drop in rates from March 2000 to the end of 2003 produced a very steep curve by historical standards.
Supply-Demand Phenomenon
So what moves the yield curve up or down? Well, lets admit we cant do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon. (For a refresher on how increases and decreases in the supply and demand of credit affect interest rates, see the article Forces Behind Interest Rates.)
Supply-Related Factors
Monetary Policy
If the Fed wants to increase the fed funds rate, it supplies more short-term securities in open market operations. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation (credit) available for borrowers. By increasing the supply of short-term securities, the Fed is yanking up the very left end of the curve, and the nearby short-term yields will snap quickly in lockstep.
Can we predict future short-term rates? Well, the expectations theory says that long-term rates embed a prediction of future short-term rates. But consider the actual December yield curve illustrated above, which is normal but very steep. The one-year yield is 1.38% and the two-year yield is 2.06%. If you were going to invest with a two-year time horizon and if interest rates were going to hold steady, you would, of course, do much better to go straight into buying the two-year bond (which has a much higher yield) instead of buying the one-year bond and rolling it over into another one-year bond. Expectations theory, however, says the market is predicting an increase in the short rate. Therefore, at the end of the year you will be able to roll over into a more favorable one-year rate and be kept whole relative to the two-year bond, more or less. In other words, expectations theory says that a steep yield curve predicts higher future short-term rates.
Unfortunately, the pure form of the theory has not performed well: interest rates often remain flat during a normal (upward sloping) yield curve. Probably the best explanation for this is that, because a longer bond requires you to endure greater interest rate uncertainty, there is extra yield contained in the two-year bond. If we look at the yield curve from this point of view, the two-year yield contains two elements: a prediction of the future short-term rate plus extra yield (i.e., a risk premium) for the uncertainty. So we could say that, while a steeply sloping yield curve portends an increase in the short-term rate, a gently upward sloping curve, on the other hand, portends no change in the short-term rate - the upward slope is due only to the extra yield awarded for the uncertainty associated with longer term bonds.
Because Fed watching is a professional sport, it is not enough to wait for an actual change in the fed funds rate, as only surprises count. It is important for you, as a bond investor , to try to stay one step ahead of the rate, anticipating rather than observing its changes. Market participants around the globe carefully scrutinize the wording of each Fed announcement (and the Fed governors speeches) in a vigorous attempt to discern future intentions.
Fiscal Policy
When the U.S. government runs a deficit, it borrows money by issuing longer term Treasury bonds to institutional lenders. The more the government borrows, the more supply of debt it issues. At some point, as the borrowing increases, the U.S. government must increase the interest rate to induce further lending. However, foreign lenders will always be happy to hold bonds in the U.S. government: Treasuries are highly liquid and the U.S. has never defaulted (it actually came close to a default in late 1995, but Robert Rubin, the Treasury secretary at the time, staved off the threat and has called a Treasury default unthinkable - something akin to nuclear war). Still, foreign lenders can easily look to alternatives like eurobonds and, therefore, they are able to demand a higher interest rate if the U.S. tries to supply too much of its debt.
Demand-Related Factors
Inflation
If we assume that borrowers of U.S. debt expect a given real return, then an increase in expected inflation will increase the nominal interest rate (the nominal yield = real yield inflation). Inflation also explains why short-term rates move more rapidly than long-term rates: when the Fed raises short-term rates, long-term rates increase to reflect the expectation of higher future short-term rates; however, this increase is mitigated by lower inflation expectations as higher short-term rates also suggest lower inflation (as the Fed sells/supplies more short-term Treasuries, it collects money and tightens the money supply):
An increase in feds funds (short-term) tends to flatten the curve because the yield curve reflects nominal interest rates: higher nominal = higher real interest rate lower inflation.
Fundamental Economics
The factors that create demand for Treasuries include economic growth, competitive currencies and hedging opportunities. Just remember: anything that increases the demand for long-term Treasury bonds puts downward pressure on interest rates (higher demand = higher price = lower yield or interest rates) and less demand for bonds tends to put upward pressure on interest rates. A stronger U.S. economy tends to make corporate (private) debt more attractive than government debt, decreasing demand for U.S. debt and raising rates. A weaker economy, on the other hand, promotes a flight to quality, increasing the demand for Treasuries, which creates lower yields. It is sometimes assumed that a strong economy will automatically prompt the Fed to raise short-term rates, but not necessarily. Only when growth translates or overheats into higher prices is the Fed likely to raise rates.
In the global economy, Treasury bonds compete with other nationss debt. On the global stage, Treasuries represent an investment in both the U.S. real interest rates and the dollar. The euro is a particularly important alternative: for most of 2003, the European Central Bank pegged its short-term rate at 2%, a more attractive rate than the fed funds rate of 1%.
Finally, Treasuries play a huge role in the hedging activities of market participants. In environments of falling interest rates, many holders of mortgage-backed securities, for instance, have been hedging their prepayment risk by purchasing long-term Treasuries. These hedging purchases can play a big role in demand, helping to keep rates low, but the concern is that they may contribute to instability.
Conclusion
We have covered some of the key traditional factors associated with interest rate movements. On the supply side, monetary policy determines how much government debt and money are supplied into the economy. On the demand side, inflation expectations are the key factor. However, we have also discussed other important influences on interest rates, including: fiscal policy (that is, how much does the government need to borrow?) and other demand-related factors such as economic growth and competitive currencies.
Here is a summary chart of the different factors influencing interest rates:
Portfolio Management Tips For Young Investors
Too many young people rarely, or never, invest for their retirement years. Some distant date, 40 or so years in the future, is hard to imagine. However, without investments to supplement retirement income, if any, retirees will have a difficult time paying for lifes necessities. TUTORIAL:Stocks Basics
Smart, disciplined, regular investment in a portfolio of diverse holdings, can yield good long-term returns for retirement and provide additional income throughout an investors working life.
An often stated reason for not investing is a lack of knowledge and understanding of the stock market. This objection can be overcome through self-education and step-by-step through the years, as an investor learns by investing. Classes in investing are also offered by a variety of sources, including city and state colleges, civic and not-for-profit organizations, and there are numerous books targeted to the beginning investor.
However, youve got to start investing now; the earlier you begin, the more time your investments will have to grow in value. Heres a good way to start building a portfolio, and how to manage it for the best results. (For related reading, see Top 5 Books For Young Investors.)
Start Early
Start saving as soon as you go to work by participating in a 401(k) retirement plan, if its offered by your employer. If a 401(k) plan is not available, establish an Individual Retirement Account (IRA) and earmark a percentage of your compensation for a monthly contribution to the account. An easy, convenient way to save in an IRA or 401(k) is to create an automatic monthly cash contribution. Keep in mind, the savings accumulate and the interest compounds without taxes, as long as the money is not withdrawn, so its wise to establish one of these retirement investment vehicles early in your working life.
Another reason to start saving early is that usually the younger you are, the less likely you are to have burdensome financial obligations: a spouse, children and mortgage, for example. That means you can allocate a small portion of your investment portfolio to higher risk investments, which may return higher yields.
When you start investing while young, before your financial commitments start piling up, youll probably also have more cash available for investing and a longer time horizon before retirement. With more money to invest for many years to come, youll have a bigger retirement nest egg.
To illustrate the advantage of value investing as soon as possible, assume you invest $200 every month starting at age 25. If you earn a 7% annual return on that money, when youre 65 your retirement nest egg will be approximately $525,000. However, if you start saving that $200 monthly at age 35 and get the same 7% return, youll only have about $244,000 at age 65. (For additional reading, see Accelerating Returns With Continuous Compounding.)
Diversify
Select stocks across a broad spectrum of market categories. This is best achieved in an index fund. Invest in conservative stocks with regular dividends, stocks with long-term growth potential, and a small percentage of stocks with better returns, along with higher risk potential. If youre investing in individual stocks, dont put more than 4% of your total portfolio into one stock. That way, if a stock or two suffers a downturn, your portfolio wont be too adversely effected. Certain AAA rated bonds are also good investments for the long term, either corporate or government. Long-term U.S. Treasury bonds, for example, are safe and pay a higher rate of return than short- and mid-term bonds. (To learn more on investing in bonds, read Bond Basics: Different Types Of Bonds.)
Keep Costs to a Minimum
Invest with a discount brokerage firm. Another reason to consider index funds when beginning to invest is that they have low fees. Because youll be investing for the long-term, dont buy and sell regularly in response to market ups and downs. This saves you commission expenses and management fees, and may prevent cash losses when the price of your stock declines.
Discipline and Regular Investing
Make sure that you put money into your investments on a regular, disciplined basis. This may not be possible if you lose your job, but once you find new employment, continue to put money into your portfolio.
Asset Allocation and Re-Balance
Assign a certain percentage of your portfolio to growth stocks, dividend paying stocks, index funds and stocks with a higher risk, but better returns.
When your asset allocation changes (i.e., market fluctuations change the percentage of your portfolio allocated to each category), re-balance your portfolio by adjusting your monetary stake in each category to reflect your original percentage. (For more information, read Five Things To Know About Asset Allocation.),
Tax Considerations
A portfolio of holdings in a tax-deferred account, a 401(k), for example, builds wealth faster than a portfolio with tax liability. You pay taxes on the amount of money withdrawn from a tax deferred retirement account. A Roth IRA also accumulates tax free savings, but the account owner doesnt have to pay taxes on the amount withdrawn. To qualify for a Roth IRA, your modified adjusted gross income must meet IRS limits and other regulations. Earnings are federally tax free if youve owned your Roth IRA for at least five years and youre older than 59.5, or if youre younger than 59.5, have owned your Roth IRA for at least five years and the withdrawal is due to your death or disability, or for a first time home purchase.
The Bottom Line
Disciplined, regular, diversified investment in a tax deferred 401(k), IRA or a potentially tax-free Roth IRA, and smart portfolio management can build a significant nest egg for retirement. A portfolio with tax liability, dividends and the sale of profitable stock can provide cash to supplement employment or business income. Managing your assets by re-allocation and keeping costs, such as commissions and management fees, low, can produce maximum returns. If you start investing as early as possible, your stocks will have more time to build value. Finally, keep learning about investments throughout your life, both before and after retirement. The more you know, the more your potential portfolio return, with proper management, of course.
Test Your Money Personality
Like almost everything else in life, your response to money is largely dictated by your personality. But have you given much thought to how you behave in regard to your finances and how that behavior affects your bottom line? Understanding your money personality is the first step and will help you shape your approach to spending, saving and investing. So whats your money personality? Read on to find out.
Whats Your Type?
Money personalities have been analyzed in a variety of ways and many people can identify with aspects of several profiles. They key is to find the profile that most closely matches your behavior. The major profiles are: big spenders, savers, shoppers, debtors and investors.
• Big Spenders
Big spenders love nice cars, new gadgets and brand-name clothing. Big spenders arent bargain shoppers; they are fashionable and they are looking to make a statement. This often means a desire to have the smallest cell phone, the biggest plasma TV and a beautiful home. When it comes to keeping up the Joneses, big spenders are the Joneses. They are comfortable spending money, dont fear debt and often take big risks when investing.
• Savers
Savers are the exact opposite of big spenders. They turn off the lights when leaving the room, close the refrigerator door quickly to keep in the cold, shop only when necessary, and rarely make purchases with credit cards. They generally have no debts and are often viewed as cheapskates. Savers are not concerned about following the latest trends, and they derive more satisfaction from reading the interest on a bank statement than from acquiring something new. Savers are conservative by nature and dont take big risks with their investments .
• Shoppers
Shoppers derive great emotional satisfaction from spending money. They often cant resist spending money, even if its to purchase items they dont need. Shoppers are usually aware of their addiction to spending and are even concerned about the debt that it creates. They look for bargains and are pleased when they get a good deal. Shoppers will often shop to entertain themselves, even if the items they buy go unused.
Shoppers are an eclectic bunch when it comes to investing. Some invest on a regular basis through 401(k) plans and other automatic investments and may even invest a portion of any sudden windfalls such as bonuses or inheritance money, while others view investing as something they will get to later on. (To learn more, read Seven Common Financial Mistakes.)
• Debtors
Debtors arent trying to make a statement with their expenditures, and they dont shop to entertain or cheer themselves up. They simply dont spend much time thinking about their money and therefore dont keep tabs on what they spend and where they spend it. Debtors generally spend more than they earn and are deeply in debt and they dont put much thought into investing. Similarly, they often fail to even take advantage of the company match in their 401(k) plans . (For more, check out Digging Out Of Personal Debt.)
• Investors
Investors are consciously aware of money. They understand their financial situations and try to put their money to work. Regardless of their current financial standing, investors tend to seek a day when passive investments will provide sufficient income to cover all of their bills. Their actions are driven by careful decision making, and their investments reflect the need to take a certain amount of risk in pursuit of their goals. (To learn more about how investors think, read The Successful Investment Journey.)
Advice for Your Personality
Once you recognize yourself in one of these profiles and have put some thought into how you approach money, its time to see what you can do to make the most of what you have. Sometimes making just small changes can yield big results.
• Spenders: Shop a Little Less, Save a Little More
If you love to spend, you are going to keep doing it, but you should seek long-term value, not just short-term satisfaction. Before you splurge on something expensive or trendy, ask yourself how much that purchase is going to mean to you in a year. If the answer is not much, skip the purchase. In this way, you can try to limit your spending to things youll actually use.
When you channel your energy into saving, you have another opportunity to think long term. Look for slow and steady gains as opposed to high-risk, quick-win scenarios. If you really want to challenge yourself, consider the merits of scaling back. (Downsize Your Home To Downsize Expenses and The Disposable Society: An Expensive Place To Live.)
• Savers: Use Moderation
Ben Franklin once recommended moderation in all things. For a saver, this is particularly good advice. Dont let all of the fun parts of life pass you by just to save a few pennies.
Tune up your savings efforts too. Pinching pennies is not enough. While minimizing risk is any investors prime goal, minimizing risk while maximizing return is the key to investing success. (For more on how to do this in your portfolio, read Asset Allocation Strategies and Achieving Optimal Asset Allocation.)
• Shoppers: Dont Spend Money You Dont Have
A critical step for shoppers is to take control of their credit cards. Unchecked credit card interest can wreak havoc on your finances , so think before you spend - particularly if you need a credit card to make the purchase. (To learn more, read Take Control Of Your Credit Cards and Understanding Credit Card Interest.)
Try to focus your efforts on saving your money. Learn the philosophy behind successful savings plans and try to incorporate some of those philosophies into your own. If spending is something you use to compensate for other areas of your life that you feel are lacking, think about what these might be and work on changing them.
• Debtors: Start Investing
If you are a debtor, you need to get your finances in order and set up a plan to start investing. You may not be able to do it alone, so getting some help is probably a good idea. Deciding on who will guide your investments is an important choice, so choose any investment professional carefully. (To find out more, see Invest In Spite Of Debt.)
• Investors: Keep Up the Good Work
Congratulations! Financially speaking, you are doing great! Keep doing what you are doing, and continue to educate yourself. (To see if you are on track to achieve post-work bliss, read A Pre-Retirement Checkup.)
Knowledge is Power
While you may not be able to change your personality, you can acknowledge it and address the challenges that it presents. Managing your money involves self awareness; knowing where you stand will allow you to modify your behavior to achieve your desired outcome.
Portfolio Mismanagement: 7 Common Stock Errors
Ignorance may be bliss, but not knowing why your stocks are failing and money is disappearing from your pockets is a long way from paradise. In this article, well uncover some of the more common investing faux pas, as well as provide you with suggestions on how to avoid them.
1. Ignoring Catalysts
The financial pundits, trade journals and business schools teach that proper valuation is the key to stock selection. This is only half of the picture because calculating P/E ratios and running cash flow spreadsheets can only show where a company is at a given point in time - it cannot tell us where it is heading.
Therefore, in addition to a quantitative evaluation of a company, you must also do a qualitative study so that you can determine which catalysts will drive earnings going forward.
Some good questions to ask yourself include:
• Is the company about to acquire a very profitable enterprise?
• Is a potential blockbuster product about to be launched?
• Are economies of scale being realized at the companys new plant and are margins about to rise dramatically?
• What will drive earnings and the stock price going forward?
2. Catching the Falling Knife
Investors love to buy companies on the cheap, but far too often, investors buy in before all of the bad news is out in the public domain, and/or before the stock stops its free fall. Remember, new lows in a companys share price often beget further new lows as investors see the shares dropping, become disheartened and then sell their shares. Waiting until the selling pressure has subsided is almost always your best bet to avoid getting cut on a falling knife stock. (To learn more, read How Investors Often Cause The Markets Problems.)
3. Failing to Consider Macroeconomic Variables
You have found a company you want to invest in. Its valuation is superior to that of its peers. It has several new products that are about to be launched, and sales could skyrocket. Even the insiders are buying the stock, which bolsters your confidence all the more.
But if you havent considered the current macroeconomic conditions, such as unemployment and inflation, and how they might impact the sector you are invested in, youve made a fatal mistake!
Keep in mind that a retailer or electronics manufacturer is subject to a number of factors beyond its control that could adversely impact the share price. Things to consider are oil prices, labor costs, scarcity of raw materials, strikes, interest rate fluctuations and consumer spending. (For more on these factors, see Macroeconomic Analysis and Where Top Down Meets Bottom Up.)
4. Forgetting About Dilution
Be on the lookout for companies that are continuously issuing millions of shares and causing dilution, or those that have issued convertible debt. Convertible debt may be converted by the holder into common shares at a set price. Conversion will result in a lower value of holdings for existing shareholders.
A better idea is to seek companies that are repurchasing stock and therefore reducing the number of shares outstanding. This process increases earnings per share (EPS) and it tells investors that the company feels that there is no better investment than their own company at the moment. (You can read more about buybacks in A Breakdown Of Stock Buybacks.)
5. Not Recognizing Seasonal Fluctuations
You cant fight the Fed. By that same token, you cant expect that your shares will appreciate even if the companys shares are widely traded in high volumes. The fact is that many companies (such as retailers) go through boom and bust cycles year in and year out. Luckily, these cycles are fairly predictable, so do yourself a favor and look at a five-year chart before buying shares in a company. Does the stock typically wane during a particular part of the year and then pick up during others? If so, consider timing your purchase or sale accordingly. (To learn more, see Capitalizing On Seasonal Effects.)
6. Missing Sector Trends
Some stocks do buck the larger trend; however, this behavior usually occurs because there is some huge catalyst that propels the stock either higher or lower. For the most part, companies trade in relative parity to their peers. This keeps their stock price movements within a trading band or range. Keep this in mind as you consider your entry/exit points in a stock.
Also, if you own stock in a semiconductor company (for example), understand that if other semiconductor companies are experiencing certain problems, your company will too. The same is true if the situation was reversed, and positive news hit the industry.
7. Avoiding Technical Trends
Many people shy away from technical analysis, but you dont have to be a chartist to be able to identify certain technical trends. A simple graph depicting 50-day and 200-day moving averages as well as daily closing prices can give investors a good picture of where a stock is headed. (To learn about this method, read the Basics Of Technical Analysis.)
Be wary of companies that trade and/or close below those averages. It usually means the shares will go lower. The same can be said to the upside. Also remember that as volume trails off, the stock price typically follows suit.
Lastly, look for general trends. Has the stock been under accumulation or distribution over the past year? In other words, is the price gradually moving up, or down? This is simple information that can be gleaned from a chart. It is truly surprising that most investors dont take advantage of these simple and accessible tools.
The Bottom line
There are a myriad of mistakes that investors can and do make. These are simply some of the more common ones. In any case, it pays to think about factors beyond what will propel the stock you own higher. A stocks past and expected performance in comparison to its peers, as well as its performance when subjected to economic conditions that may impact the company, are some other factors to consider.
How To Dispute A Credit Card Charge
What happens when the brand-new digital camera you brought home turns out to be a bust? Or the DVD player you got for your spouses birthday gets stuck permanently on rewind? Or, when youve been double-charged for something youre sure you only came home with one of?
SEE: Check out our credit card comparison tool and find out which credit card is right for you.
If youve made these purchases on a credit card - and these days, thats a near certainty - youre in luck. Thanks to the Fair Credit Billing Act, consumers have a good deal of protection for their credit card purchases. This law allows consumers to withhold payment on poor-quality, damaged merchandise or incorrectly billed items they bought with a credit card until the matter is resolved. Read on as we show you how to dispute a credit card charge and actually come out on the winning side.
Retrace Your Steps
Your first move is always to go back and attempt to resolve the problem with the merchant. If you give them a chance to address your complaint, they very often will; especially if you approach them with politeness and courtesy. Most large retailers have customer service policies in place that err strongly on the side of being generous, at least within a certain period of time, and under ordinary circumstances.
Bottom line is, if you act promptly and reasonably, youre likely to get the full benefit of the doubt. If you dont have luck with the first representative you speak with, ask to talk with the manager or supervisor on duty. Be sure to keep records of each interaction, the person you spoke with as well as the date and time, so you can refer back to them if needed.
Put It In Writing
If the merchant wont budge, its time to put your complaint in writing. Draft a short, detailed letter outlining your particular dispute, and address it to the merchant via certified mail. Before you send it, make a few copies, so you can save one for your records and send another copy to your credit card company, as proof of your efforts to resolve this dispute.
Next youll draft a letter to your credit card company, to officially alert it of the disputed purchase amount. The Fair Credit Billing Act mandates that you do this in writing, within 60 days after the bill with the disputed charge was sent to you. In your letter, youll need to include your account number, the closing date of the bill on which the disputed charge appears, a description of the disputed item and the reason youre withholding payment. You should also enclose a copy of your complaint letter to the merchant, along with any other documentation that supports your position. This letter should also be sent via certified mail, return receipt requested; be sure you send it to the billing inquiries address at your credit card company, and not the regular address for payments (since these are often two separate departments).
Keep on Paying
Even though youre disputing an item on your current bill, its important to maintain your other payments. If youve charged anything else on your card during this cycle, youll need to send that payment and all financing charges to the regular address, otherwise youll incur interest and late-payment charges.
At this point, youre just waiting to hear the result of your challenge. Some card companies - especially the bigger firms, such as Capital One - will often give the benefit of the doubt to their consumers, and issue a temporary credit until the dispute is resolved. This isnt required by law, however, so dont assume you will get this consideration. Meanwhile, the card issuer will get in touch with the merchant to find out their side of the story. Basically, if they end up siding with you, you will enjoy a full refund. If not, youll have to pay for the disputed item, as well as any additional finance charges that may have accrued.
There are a few catches to the Fair Credit Billing Act. Technically, the sale must be for more than $50 and must have taken place in your home state or within 100 miles of your billing address, which means phone or internet orders may be immune. However, few issuers enforce these rules on purchases, because most credit card companies are eager to hold onto your business, given the highly competitive nature of the industry these days. But, theres still always a chance that your claim could be denied on these grounds.
You Have a Better Chance Than You Might Think
If you find yourself in the position of having to dispute a credit card charge, you may have more rights and advantages than you realize. The key is to act quickly and responsibly. Address the matter in a prompt and courteous fashion with the merchant in question, and if necessary, follow up with your credit card issuer. In most cases the whole matter can be resolved within a matter of weeks to your satisfaction.
Pros And Cons Of Offshore Investing
Offshore investing is often demonized in the media, which paints a picture of investors stashing their money with some illegal company located on an obscure Caribbean island where the tax rate is next to nothing. While its true that there will always be instances of shady offshore deals, the vast majority of offshore investing is perfectly legal. In fact, depending on your situation, offshore investing may offer you many advantages.
Tutorial: Personal Income Tax Guide
What Is Offshore Investing?
Offshore investing refers to a wide range of investment strategies that capitalize on advantages offered outside of an investors home country. We will briefly touch on the advantages and disadvantages of offshore investing. The particulars are far beyond the scope of this introductory article.
There is no shortage of money-market, bond and equity assets offered by reputable offshore companies that are fiscally sound, time-tested and, most importantly, legal.
Advantages
There are several reasons why people invest offshore:
Tax Reduction - Many countries (known as tax havens) offer tax incentives to foreign investors. The favorable tax rates in an offshore country are designed to promote a healthy investment environment that attracts outside wealth. For a tiny country with very few resources and a small population, attracting investors can dramatically increase economic activity. Simply put, offshore investment occurs when offshore investors form a corporation in a foreign country. The corporation acts as a shell for the investors accounts, shielding them from the higher tax burden that would be incurred in their home country. Because the corporation does not engage in local operations, little or no tax is imposed on the offshore corporation. Many foreign companies also enjoy tax-exempt status when they invest in U.S. markets. As such, making investments through foreign corporations can hold a distinct advantage over making investments as an individual. (For additional information, read What is an Emerging Market Economy?)
In recent years, however, the U.S. government has become increasingly aware of the tax revenue lost to offshore investing, and has created more defined and restrictive laws that close tax loopholes. Investment revenue earned through offshore investment is now a focus of regulators and the tax man alike. According to the U.S. Internal Revenue Service (IRS), U.S. citizens and residents are now taxed on their worldwide income. As a result, investors who use offshore entities to evade U.S. federal income tax on capital gains can be prosecuted for tax evasion. Therefore, although the lower corporate expenses of offshore companies can translate into better gains for investors, the IRS maintains that U.S. taxpayers are not to be allowed to evade taxes by shifting their individual tax liability to some foreign entity. (To learn more, see How International Tax Rates Impact Your Investments.)
Asset Protection - Offshore centers are popular locations for restructuring ownership of assets. Through trusts, foundations or through an existing corporation individual wealth ownership can be transferred from people to other legal entities. Many individuals who are concerned about lawsuits, or lenders foreclosing on outstanding debts elect to transfer a portion of their assets from their personal estates to an entity that holds it outside of their home country. By making these on-paper ownership transfers, individuals are no longer susceptible to seizure or other domestic troubles. If the trustor is a U.S. resident, their trustor status allows them to make contributions to their offshore trust free of income tax. However, the trustor of an offshore asset-protection fund will still be taxed on the trusts income (the revenue made from investments under the trust entity), even if that income has not been distributed.
Confidentiality - Many offshore jurisdictions offer the complimentary benefit of secrecy legislation. These countries have enacted laws establishing strict corporate and banking confidentiality. If this confidentiality is breached, there are serious consequences for the offending party. An example of a breach of banking confidentiality is divulging customer identities; disclosing shareholders is a breach of corporate confidentiality in some jurisdictions. However, this secrecy doesnt mean that offshore investors are criminals with something to hide. Its also important to note that offshore laws will allow identity disclosure in clear instances of drug trafficking, money laundering or other illegal activities. From the point of view of a high-profile investor, however, keeping information, such as the investors identity, secret while accumulating shares of a public company can offer that investor a significant financial (and legal) advantage. High-profile investors dont like the public at large knowing what stocks theyre investing in. Multi-millionaire investors dont want a bunch of little fish buying the same stocks that they have targeted for large volume share purchases - the little guys run up the prices.
Because nations are not required to accept the laws of a foreign government, offshore jurisdictions are, in most cases, immune to the laws that may apply where the investor resides. U.S. courts can assert jurisdiction over any assets that are located within U.S. borders. Therefore, it is prudent to be sure that the assets an investor is attempting to protect not be held physically in the United States.
Diversification of Investment - In some countries, regulations restrict the international investment opportunities of citizens. Many investors feel that such restriction hinders the establishment of a truly diversified investment portfolio. Offshore accounts are much more flexible, giving investors unlimited access to international markets and to all major exchanges. On top of that, there are many opportunities in developing nations, especially in those that are beginning to privatize sectors that were formerly under government control. Chinas willingness to privatize some industries has investors drooling over the worlds largest consumer market. (To read more, see Investing Beyond Your Borders.)
Disadvantages
Tax Laws are Tightening - Tax agencies like the IRS arent ignorant of offshore strategies. Theyve clamped down on some traditional ways of tax avoidance. There are still loopholes, but most are shrinking more and more every year. In 2004, the IRS amended the Internal Revenue Code (IRC) and began to collect taxes from both American corporations that operate out of another country and American citizens and residents who earn money through offshore investments. (For more information on tax laws that affect offshore investors, see the IRS International Taxpayer - Expatriation Tax.)
Cost - Offshore Accounts are not cheap to set up. Depending on the individuals investment goals and the jurisdiction he or she chooses, an offshore corporation may need to be started. Setting up an offshore corporation may mean steep legal fees, corporate or account registration fees and in some cases investors are even required to own property (a residence) in the country in which they have an offshore account or operate a holding company. Furthermore many offshore accounts require minimum investments of between $100,000 and $1 million. Businesses that make money facilitating offshore investment know that their offerings are in high demand by the very wealthy and they charge accordingly.
How Safe Is Offshore Investing?
Popular offshore countries such as the Bahamas, Bermuda, Cayman Islands and Isle of Man are known to offer fairly secure investment opportunities. More than half of the worlds assets and investments are held in offshore jurisdictions and many well-recognized companies have investment opportunities in offshore locales. Still, like every investment you make, use common sense and choose a reputable investment firm. It is also a good idea to consult with an experienced and reputable investment advisor, accountant, and lawyer who specializes in international investment. If you are looking to protect your assets, or are concerned with estate planning or business succession, it would be prudent to find an attorney (or a team of attorneys) specializing in asset protection, wills or business succession. Of course, these professionals come at a cost. In most cases the benefits of offshore investing are outweighed by the tremendous costs of professional fees, commissions, travel expenses and downside risk. (For more information, see Investment Scams: Prime Banks.)
Conclusion
We are not lawyers, tax accountants or offshore investment experts in any country. Every individuals situation is different. Offshore investment is beyond the means of most investors, and above the risk tolerance of others.
Despite the many pitfalls of offshore investing, it can still pay off to shift some investment assets from one jurisdiction to another. As with even the most insignificant investment, do your research before parting with your money - unless youre prepared to lose it.
Get Organized With An Investment Analysis Form
When youre thumbing through annual reports, proxy statements and analyst ratings of multiple companies, the numbers can start to blur together. On top of that, once youve taken a look at all the financials a company has to offer, you can find yourself wondering what the significance is of the figures youve been looking at. Its information overload and its to be expected in any situation where fairly abstract ideas, like solvency ratios and assets per share, are thrown about in large quantities. In this article, well show you how to organize all the company information youve gathered into a readable and useful format.
Just sitting down with a bunch of financial statements isnt a very efficient or effective way of determining whether or not a company is a good investment decision. Youve got to organize your thoughts - otherwise youre just going to be spinning your wheels. Thats why creating your own investment analysis form can be one of the most valuable investment tools in your arsenal. An investment analysis form is a tool that you can use to help gather numbers and essential information needed to make an investment decision in one easy-to-use format.
Simplify Your Research
An investment analysis form is the perfect place to record key figures and pieces of information about your company as you find them in your research. This can be done on a customized form on a sheet of paper or on the computer through a spreadsheet program.
An investment analysis form allows you to better interpret your data systematically, as all of the information is collected into a standardized format. Because information is plugged in uniformly, youre guaranteed not to miss anything that you have deemed important.
An investment analysis form also allows an investor to simplify his or her research by only looking at information that is relevant to the investment decision , while throwing out any superfluous data. There are a lot of reasons why you might run into extraneous information in your research, but unless you make sure that its kept out of your investment criteria, its difficult to say whether or not unimportant information is influencing an important decision.
You can bet that investment professionals dont just go at a 10-K without a plan, and neither should you.
Collect Key Figures
Information Within the Form
The first step in developing your own investment analysis form is determining what you want to include in it. There are some figures that are essential and some that will be specific to your individual investing style.
Things like recent stock price, earnings per share (EPS), price/earnings ratio and total debt are pretty universal. Dont have an investment form that is missing an essential piece of financial information - anything that you would expect to see on the stock quote page of your favorite financial website should probably be included.
Numbers arent the only thing that belongs on the form. Youll definitely want places to write in things like products, addressed and unaddressed risk, legal troubles and the like. Your personal instincts and impressions after doing your research will be invaluable when you go back to looking at the stock a day or a year down the road, so make sure that you have a place to write them down. If you do a lot of investment research , its even easier to forget your impressions about a certain stock. Thats when having all those comments right at your fingertips is such a benefit. (Learn why it is helpful to keep a log of your instincts and actions, read Lessons From A Traders Diary.)
Now that youve got the essentials and the write-ins taken care of, dont forget the simple stuff. Have a place for the company name, the symbol and the date you did your research. Include things like state of incorporation, investor relations contact and a phone number for the main circuit board. While it may seem like a lot, it sure comes in handy when you need to reach someone to voice your concerns or just to get the latest financials from the company.
The process of creating an investment form is not a one-time deal, as you will likely make many changes over time as you hone your analysis skills.
Creating the Form
There are a couple of ways to set up your form. You can take a pen and paper and set up your spaces to write in information or, for the technically inclined, you can put it together on your computer using anything as simple as a word processor or as complex as professional page layout software.
If youd prefer to go paperless, using a spreadsheet program like Microsoft Excel can offer you quite a bit of flexibility. If you prefer to use the old-school paper method, take your form template to your closest copy center and go copy crazy. Make enough copies so that you wont have to worry about running out in the near future. That way, when they are finally ready for some analyzing, youll have all the blank copy forms youll need.
Analyze Your Investments
Once youre all set up with a form of your own, youll probably find that collecting your thoughts is a lot easier than it used to be. If you can interpret a stock quote online, you should have no problem interpreting the data youd want to include on your form. It just simplifies the process of investment analysis.
Where the idea of an investment analysis form really shines is when youre trying to scale across investments . Having information available to you in an organized way for multiple companies makes a comparison of two companies a much less impractical task and can help cement your understanding of what attributes make for an attractive investment. Just dont forget that an investment analysis form is just an aide. It wont tell you whether a particular stock is a smart investment, but it can help you organize your thoughts and data so that you can make that determination for yourself.
Conclusion
Scouring through piles of 10-Ks can be an unpleasant and confusing task, especially for a less experienced investor, but with the right tools for the job, making use of the information you collect can be all the easier. Creating your own investment analysis form can enable you to interpret the information you deem important in selecting an investment without losing your head in a sea of numbers.
Benchmark Your Returns With Indexes
Investors look to broad indexes as benchmarks to help them gauge not only how well the markets are performing, but also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S
Benchmark Your Returns With Indexes
Investors look to broad indexes as benchmarks to help them gauge not only how well the markets are performing, but also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S
The Wall Street Animal Farm: Getting To Know The Lingo
Many people are intimidated by the business news because they dont understand the vernacular. Bull? Bear? Ostrich?!! What does this have to do with money? But theres good news: Wall Street language isnt only for business elites with advanced degrees from Ivy League schools. In fact, you may be surprised to find out that most Wall Street lingo is neither sophisticated nor esoteric. Yes, the truth is that investment bankers and brokers typically use words you probably mastered in kindergarten. Lets take a look at these barnyard words from a financiers perspective - youll be fluent in no time.
A Dog With Fleas
Depending on your movie knowledge, you may remember this classic line in the 1987 movie Wall Street : Its a dog with fleas, kid. That was how Gordon Gekko described a stock tip from a young, ambitious stockbroker named Bud Foxx. A dog is an underperforming stock or asset. Most Wall Street investors think of dog as a four-letter word, but a few are attracted to the dogs of the market. An investment philosophy called the dogs of the Dow theory advocates purchasing the most beaten-down stocks in the Dow Jones Industrial Average (DJIA) each year. According to this theory, by purchasing the stocks with the highest dividend yields in the Dow 30, investors can expect returns in the 13% range over a 15-year period.
Bear
The term bear refers to the given market conditions. Bull and bear are probably the most familiar terms on Main Street. Bear markets are rife with pessimism and negative sentiment. Typically, a bear market is one that has experienced declines of at least 15-20% and lasts more than two months. Probably the most famous bear markets occurred in 1929, which some believe caused the Great Depression. Unfortunately, economic indicators in 2008 have drawn comparisons to the Great Depression of 1929. The severe housing and credit bubbles originating in the first decade of the new millennium in the United States burst abruptly in 2007, and this credit unwinding, or deleveraging had a negative ripple effect on economies and markets worldwide. Venerable institutions, such as Bear Sterns and Lehman Brothers were wiped out by this bear market . Stock markets across the globe also experienced severe downturns. Governments engineered financial rescue packages for many large banks and insurance giants to avoid global financial markets meltdowns.
While there is no clear-cut strategy for investors in terms of surviving a bear market, many financial advisors suggest that bear markets occur as part of the normal economic and business cycle. For longer-term investors, these bear markets could be viewed as buying opportunities. Other advisors may recommend selling stocks and raising cash until a clear direction or bottom of the market begins to appear. (To learn more, read Adapt To A Bear Market.)
Bull
The term bull refers to a very positive stock market environment in which stock prices are increasing and money is flowing into stocks. Investor confidence is high in bull markets. During the 1990s and through early 2000, the U.S. stock market experienced a sustained bull market in stocks. Perhaps the poster child for the technology bull market of the 1990s was Cisco Systems (Nasdaq:CSCO). Cisco was experiencing tremendous growth due to the internet boom, and the stock returned nearly 75,000% from 1990 to 2000. Similarly, America Online (AOL) returned 480% in just six months. Bull markets can be very powerful creators of wealth for the average investor as well as Wall Street gurus. (For related reading about stock returns during bull markets, see The All Equities Portfolio Fallacy.)
Ostrich
An ostrich is an investor who fails to react to critical situations or events that are likely to impact his or her investment. For example, if the Securities and Exchange Commission (SEC) is launching an investigation into a company, an action that could be detrimental to the companys stock price, the ostrich will simply ignore this news. The ostrich effect is one in which investors bury their heads in the sand, hoping for better days ahead. Ostriches appear (or disappear) most frequently during bear markets, when people tend to experience the most financial stress.
Pig
A pig is any investor who puts greed ahead of his or her investment principles or sound strategies. Anyone who watches investment guru Jim Cramer knows one of his most famous expressions: Bulls make money, bears make money and pigs get slaughtered. A pig tends to think that a 100% return over a 12-month period is not good enough. As a result, the pig may then go and borrow money on margin or mortgage his or her home to buy more of a stock at a higher price with the hope of making more money on the investment. The pig can get slaughtered if the stock drops and all the original gains are lost.
Smart investors are disciplined investors. Professional investors know when to take profits as well as when to cut their losses. Their primary concern is the preservation of capital and not necessarily hitting a home run every time they step up to the plate.
Sheep
A sheep is an investor who has no strategy or focus in mind. This type of person simply listens to others for financial advice, and often misses out on the most meaningful moves in the market as a result. For example, sheep investors who had a philosophy of only buying value stocks in the 1990s missed one of the greatest bull markets of our time. In other words, a sheep can be eaten by a bull or bear if he or she isnt in the right place in the market.
Conclusion
Dont assume that you cant learn trader-talk or Wall-Street-speak just because you dont work there. In fact, picking up the lingo may be more of an exercise of your animal knowledge instead of your investment savvy. Learning these terms can help you gain some insight into the world of words on Wall Street. Surprisingly, youll find that they arent different much from the words heard on Main Street - or in kindergarten classrooms across America.
An Introduction To Stock Market Indexes
June 04 2011| Filed Under » Index Fund, Investing Basics, Stocks
Its not unusual for people to talk about the market as if there were a common meaning for the word. But in reality, the many indexes of the differing segments of the market dont always move in tandem. If they did, there would be no reason to have multiple indexes. By gaining a clear understanding of how indexes are created and how they differ, you will be on your way to making sense of the daily movements in the marketplace. Here well compare and contrast the main market indexes so that the next time you hear someone refer to the market, youll have a better idea of just what they mean.
Tutorial: Stock Basics
The Dow
If you ask an investor how the market is doing, you might get an answer that is based on the Dow. The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known and most frequently used indexes in the world. It includes the stocks of 30 of the worlds largest and most influential companies. The DJIA is whats known as a price weighted index. It was originally computed by adding up the per-share price of the stocks of each company in the index and dividing this sum by the number of companies - thats why its called an average. Unfortunately, it is no longer this simple to calculate. Over the years, stock splits, spin-offs and other events have resulted in changes in the divisor, making it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dows price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have the same effect on the DJIA as a $1 change in the price of a $20 stock, even though one stock may have changed by 0.8% and the other by 5%.
A change in the Dow represents changes in investors expectations of the earnings and risks of the large companies included in the average. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. On the other hand, because the Dow is made up of some of the most well-known companies in the U.S., large swings in this index generally correspond to the movement of the entire market, although not necessarily on the same scale. (For more information on this index, see Calculating The Dow Jones Industrial Average.)
The S
A Brief History Of Exchange-Traded Funds
In less than 20 years, exchange-traded funds (ETFs) have become one of the most popular investment vehicles for both institutional and individual investors. Often promoted as cheaper, and better, than mutual funds, ETFs offer low-cost diversification, trading and arbitrage options for investors. Now with over $1 trillion assets under management, new ETF launches number from several dozen to hundreds, in any particular year. ETFs are so popular that many brokerages offer free trading in a limited number of ETFs to their customers. (For related reading, see Introduction To Exchange-Traded Funds.)
Beginning at the Beginning
The idea of index investing goes back quite a while; trusts or closed-end funds were occasionally created with the idea of giving investors the opportunity to invest in a particular type of asset. None of these really resembled what we now call ETFs, though.
The first real attempt at something like an ETF was the launch of Index Participation Shares for the S
Real Estate Vs. Stocks: Which Ones Right For You?
Over the years, we have heard the comparisons as to which is the better investment : real estate or stocks. Both have their advantages and disadvantages, and there are several aspects of each that make them unique investments in their own way. To make money with either investment requires that you understand the positives and negatives of both.
Real Estate
Real estate is something that you can physically touch and feel – its a tangible good and, therefore, for many investors, feels more real. Maybe this partially accounts for the high return on the investment, as from 1978-2004, real estate has had an average return of 8.6%. For many decades this investment has generated consistent wealth and long term appreciation for millions of people.
How it Works
Generally, there are two main types of real estate: commercial and residential. While other types exist (mobile home parks, strip malls, apartment buildings, office buildings, store fronts and single family homes), they generally fall into those two categories. Making money in real estate isnt as cut-and-dry. Some people take the home flipping route – searching for distressed properties, refurbishing them and selling them for a profit at a higher market value . Others look for properties that can be rented in order to generate a consistent income.
Generally, a down payment of up to 20% of the purchase price can be made, and the rest can be financed. This gives you leverage, meaning that you can invest in different types of properties with less money down, helping to build your net worth or income that you could make off the properties. While this can be a positive, if this leverage is used incorrectly, you may owe more on the properties than they are actually worth.
Positives
There are many positive benefits to investing in real estate, including depreciation (writing off wear and tear of a commercial property), tax deductions and finally, you can sell the property through what is know as a 1031 exchange, and will not have to pay capital gains taxes, as long as you invest the money into a similar kind of property type.
Negatives
Like all investments , real estate also has its drawbacks. Most importantly, the investment is illiquid. When you invest in a property, you usually cannot sell it right away. In many cases, you may have to hold the property for several years to realize its true profit potential. Also, the closing cost can add up to thousands of dollars, and include taxes, commissions, and fees. Also, real estate prices have a tendency to fluctuate. While long-term prices generally increase, there are times when prices could go down or stay flat. If you have borrowed too much against the property, you may have trouble making the payment with a property that is worth less money than the amount borrowed on it.
Finally, its often hard to get diversified if investing in real estate. However, diversification is possible in real estate, provided that you do not concentrate on the same community and have a variety of different types of property. That being said, there is an additional way that you can be able to diversify in real estate through real estate investment trusts (REITs), under which you can purchase a trust that is invested in a large portfolio of real estate, and will offer you a dividend as a shareholder. However, in general, stocks offer more diversification because you can own many different industries and areas across the entire economy. (Learn more about REITs in our article Investing In Real Estate.)
Stocks
From 1978-2006, stocks have delivered an average return of 13.4%. They can be more volatile than real estate but over the long run they have provided a much better return than real estates 8.6% average.
How They Work
With a stock , you receive ownership in a company. When times are good, you will profit. During times of economic challenges, you may see diminishing funds as the earnings of the company drop. Taking a long-term approach and being balanced in many areas can help build your net worth at a much greater rate, compared with real estate.
As with real estate, financing in stocks allows you to use margin as leverage to increase the overall amount of shares that you own. The downside is that, if the stock position falls, you could have what is known as margin call. This is where the equity, in relation to amount borrowed, has fallen below a certain level and money must be added to your account to bring that amount back up. If you fail to do this, the brokerage firm can sell the stock to recover the amount loaned to you.
Positives
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account – tax-free - until you start to withdraw the money. As well, many stocks can do considerably better than real estate in one year. Due to the volatility of some stocks, it is not unusual to see companies that are averaging 20% or even 50% growth in one year.
Negatives
Stocks can be very volatile, especially when the economy or the company is facing challenges. Also, stocks are often emotional investments, and your decisions within the market can often be irrational. Finally, bankruptcy is always in the back of the active stock investors mind – as it should be, as your investment will be dissolved in this instance.
Conclusion
In general, stocks may have the advantage in more categories than real estate. However, real estate seems to be better when it comes to stability and tax advantages. A good compromise may be to own a REIT , which combines some of the benefits of stocks with some of the benefits of real estate. While each area has its own benefits and drawbacks, to decide which one would work well for you depends on your overall financial situation and level of comfort.
The ABCs Of Mutual Fund Classes
In mutual fund investing, the old adage that high costs indicate quality couldnt be further from the truth. There is no proof that if you pay a higher fee youll get a higher return. If anything, the mutual fund manager of a high-cost fund might take more risks in the attempt to produce a higher return - and, of course, this higher return is not a sure thing. So, if the managers risky moves dont pan out, youve not only forked out more money in costs, but youve also seen your portfolio value shrink from capital losses.
To avoid paying high fees only to suffer losses, and to maximize your investment return, it is important to consider which class of mutual fund shares is suitable for you and to know what kind of fees you will be paying when you invest in a mutual fund. Here we give an overview of these different classes.
What Are Mutual Fund Classes?
While stock classes indicate the number of voting rights per share, mutual fund classes indicate the type and number of fees charged for the shares in a fund.
Although mutual fund companies can have as many as seven or more classes of shares for a particular fund , there are three main types of mutual fund classes that are most popular: A, B and C (also known as A-shares, B-shares and C-shares). Each of these classes has various benefits and consequences. Lets examine each in turn.
Class-A Shares
Class-A shares charge a front-end load that is taken off your initial investment.
Pros
• Lower 12b-1 fees - Class A shares tend to have lower 12b-1 fees, so if you plan on holding these shares for several years, a front-end load might be beneficial in the long run.
• Breakpoints - These provide a discount off regular front-end load rates each time your investment reaches a certain amount in a series. If the first breakpoint is $25,000, you could invest that amount initially to receive the first discount. (To learn more, read Break Free Of Fees With Mutual Fund Breakpoints.)
• Right of Accumulation - This gives you the opportunity to receive a discount on the front-end load if you reach the first breakpoint with the second installment. So, again, say that the first breakpoint is $25,000 and your initial investment is $10,000. If you invest $15,000 to reach the breakpoint on the second installment, youd receive a discounted front-load fee.
• Letter of Intent - Some companies also offer front-end load discounts up front to individuals who initially express their intent to invest an amount over a certain breakpoint by a certain point in time.
Cons
• High Initial Investment Required - Investors who do not have the funds to reach a breakpoint before the deadline indicated by a letter of intent will have to pay regular front-end fees.
• Long Time Horizon Required - These funds are not optimal for investors with a short time horizon. For example, say your initial investment is $4,750 after $250 in front-load fees, and your investment increases 3% during the course of a year. If you liquidate at the end of the year, you would have actually lost $107.50 [(4750*1.03)-5000], or 2.15%.
Class B Shares
These shares are classified by their back-end or contingent deferred sales charge. These shares are typically good for investors with little investment cash and a long investment horizon.
Pros
• No Front-End Fees - Your entire initial investment contribution earns interest income.
• Deferred Sales Charges - The longer you hold the shares, the lower your deferred sales charge.
• Conversion to Class A - Class B shares automatically convert to Class A shares after a certain period of time. This is beneficial because Class A shares have a lower yearly expense ratio than Class B shares (see below).
Cons
• Long Time Horizon Required - If you withdraw funds within a certain period of time (typically five to eight years) you are a charged a back-end or deferred sales charge.
• No Breakpoints - Class B shares do not provide breakpoints on the deferred sales charge, so regardless of how much you invest, there is no discount on these charges.
• Higher Expense Ratios - Class B shares charge higher expense ratios than both Class A and C shares, until shares are eligible to be converted to Class A.
Class C Shares
Class C shares are a type of level-load fund. This class works well for individuals who will be redeeming shares in the short term.
Pros
• No Front-End Fees - Your entire initial investment contribution earns interest income.
• Small Back-End Load - The back-end load is typically only 1%.
• Opportunity to Avoid back-End Load - The back-end load is normally removed after the shares have been held for one year.
Cons
• Back-End Load - A back-end load - although small - is typically charged if funds are withdrawn within the first year.
• Higher Expense Raios - Although the expense ratios of Class C shares are lower than those of Class B shares, they are higher than those for Class A shares.
• No Conversion - Unlike Class B shares, Class C shares cannot be converted into Class A shares, removing the opportunity for lower expense ratios. As such, if you have a long time horizon, Class C shares are not optimal for you as the high management fees are continuous. That is, your investment returns will be reduced the longer you stay invested because the fees will add up considerably over time.
• No Discounts - Class C shares do not offer discounts on expenses when the account reaches certain levels.
Applying the Pros and Cons
Lets look at how the characteristics and pros and cons described above work in the following share classes of the Index Plus Mid-Cap mutual fund shares offered by ING.
ING Index Plus Mid-Cap Funds, A,B,C Comparison
Class Symbol Front End Back End 12b-1 Fees Details
A AIMAX 3% n/a 0.25% • 2004 total yearly return = 16.09%
• expense ratio = 1%
• $1,000 min investment
B APMBX n/a 5% (6-yr declining balance) 1% (converted to Class A after 8 eight yrs) • 2004 total yearly return = 15.23%
• expense ratio = 1.75%
• $1,000 min investment
C APMCX n/a 1% (expires after one year) 0.75% • 2004 total yearly return = 15.5%
• expense ratio = 1.5%
• $1,000 min investment
Source: Morningstar.com, June 30, 2005, and ING Funds, July 22, 2005
In this example, you can see how each of these different share classes are better for different types of investors and situations. If you plan on investing in this fund for retirement and your retirement is 20 years away, Class A or B shares would work best because they both offer declining costs the longer you stay invested. Also, if you plan to invest just one lump-sum amount and it is enough to qualify for a breakpoint discount, Class A would be the best over time: you would get a discount on the initial load, and your yearly expenses (the expense ratio and 12b-1 fees) are very low, allowing your investment to grow. With Class B shares, you are not charged an initial fee; however, you are charged a 1.75% expense ratio per year rather than 1%, and you would need to keep invested for at least eight years before the Class B shares convert to Class A. At the same time, if you are planning to invest in the fund continuously, Class B may be better as each deposit is not charged.
Class C shares would work best if you are planning to invest for a limited period, optimally no less than one year. In this way, you avoid both front- and back-end loads. Although your expense ratio will normally be higher than Class A shares, your full investment will gain interest while it is invested.
To show you how Class C shares work best for a shorter-term investment, lets compare the returns of a one-year investment of $10,000 in Class A and the same kind of investment in Class C shares:
• Class A - Because $300 will be deducted for front-end fees, the value of the initial investment is $9,700. After one year with a 10% return and 0.25% 12b-1 fees, the investment would then be worth $10,645.75 ($9,700*1.0975).
• Class C - There are no deductions for front-end loads, and the back-end load requirement expires after the year is up. The value of a $10,000 investment with a 10% return and 0.75% 12b-1 fees would be $10,925 ($10,000*1.0925).
Note the difference - youve made $279.25 more with Class C shares. Over a long period, however, Class A shares would be more optimal: the Class Cs higher 12b-1 fee paid over the course of more than 10 years would eat into your returns to a point where Class A shares would provide you with a higher return.
Conclusion
When deciding which class of mutual fund shares to choose, remember to read the prospectus. In addition, you must take into account your investment horizon, the amount you have to invest initially, the frequency of your investments and the probability you will need to withdraw funds before you initially intend to do so. For an overview of mutual funds
Play The Market Like Tiger Plays Golf
Very few people on this planet have earned the title of greatest ever. In investing , many would argue that this distinction goes to Warren Buffett; in golf, its Tiger Woods. But in this world you do not need to be the best to achieve success. However, we are fortunate that those who are considered the best have laid out lessons for us that can help us become more successful. (Read about Buffett in our articles on The Greatest Investors.)
Both Warren Buffett and Tiger Woods do a few simple things spectacularly well to achieve their goals. While odds are quite high that you will never become Woods or Buffett, you dont have to in order to succeed. There are a lot of subtle yet critical similarities between golf and investing. If you pay attention to how they go about perfecting their craft, you can gain a lot of wisdom that will set you ahead of the pack.
Practice Makes Perfect
How Tiger Woods practices may be one of the most intriguing activities in all of sports. People are often advised that practice makes perfect. In other words, continue to practice, practice, practice, and you will get better. While theres no doubt that practice very often leads to improvement, its not practice that sets Woods apart; its perfect practice.
When Woods is on the driving range hitting balls, he is not just hitting balls for the sake of it. Instead, he hits every single ball with a specific target in mind. Woods will hit 500 balls a day with a specific target for each one.
The parallel for investors is constant discipline. Many investors incorrectly invest just for the sake of investing - without any discipline or specific target in mind. As a result, new investors have no idea how to navigate the course or manage risk. Investors often buy most of their stocks with the same expectations - that the stock price will go up - without giving any consideration to the existing competition, the quality of management and the level of difficulty of the current market layout.
What It Takes to Win
When the course is easy - in a bull market - every shot you take looks like a good one. It doesnt seem to matter what price you pay, the favorable landscape makes you look like an expert. However, the real danger lies in the fact that the longer this persist the greater the likelihood that you begin confusing your investment acumen with what is really going on: favorable conditions. This happened during the internet boom in the 1990s and the majority of people never had a chance to cash in on their spectacular gains. In fact, many actually lost lots of money when things came crashing down.
When the investing layout is hard, as it is during bear markets and recessions, its crucial to understand shooting par could likely be the long-term winner. As stock prices begin to rapidly rise, they often become riskier propositions, but most investors naively do not see it that way and continue to buy. Then when the course gets hard, the wrong lessons they learned on the easy course cost them dearly.
Invest with Purpose
Like Woods, investors should always invest with a specific target in mind. When stock prices rise dramatically without any regard for valuation, ignore the fact that some people may make superior returns over the next several months or year. Very often, the majority of those folks wont have the faintest idea when the goods times will end and all those profits will vanish.
Always invest with a specific target in mind. Be cautious when everyone is excited about buying stocks because that usually means paying a very rich price. Consider bonds, or high quality dividend paying stocks that usually dont attract as much excitement as the Amazons or Googles of the world. Sometimes shooting even par often produces the winning score.
Manage Your Expectations
Theres a saying that goes in order to finish first, you must first finish. There is tremendous wisdom in those words for investors. Success in investing is very often highly correlated to longevity. If you can navigate the market storms and not suffer catastrophic losses, then you are able to capitalize on the opportunities available when stocks prices are discounted. As is so often the case, many investments funds go out of businesses when the markets collapse, which is the absolute worst time to exit the game.
Tiger Woods does a brilliant job of managing his expectations. He doesnt go out on Thursday focusing on the leader board and trying to come out on top that day. Instead he plays his game against the course, fully aware that it is the person who remains consistent during the tournament who usually comes into Sundays round with the best chance to take home the trophy. Of course, during the course of play, Woods, like many investors, will often weigh the risk rewards of a difficult or low probability shot and make his decision based on the benefit gained.
Learn from the Best
Long-term success is not a result of luck. However, discipline and hard work often leads to opportunities that might not otherwise appear, and to outsiders this is often viewed as simple luck. Examine the approach of guys like Tiger Woods and Warren Buffett, learn from their successes and failures and youve already got a head start.
5 Dumb Things Investors Do With Their Money
The beginning of a new year is usually a good time to reflect on the past in order to make certain resolutions about the coming one. In investing, future success can have little to do with what has worked well in the past. Trying to predict short-term market movements is also generally an investment strategy that can lead you to financial ruin. Keeping these perspectives in mind, below are five of the dumbest things you can do with your money in 2012.
Trade Volatility
Lately, it has been en vogue to consider volatility its own asset class. Trading volatility has become possible through vehicles based off the Chicago Board Options Exchange Market Volatility Index, or VIX for short. A range of exchange-traded funds (ETFs) have been created so that investors can make bets on the extent to which the market bounces up and down. There are even ETFs that let investors gain twice the exposure to market volatility, which can be used to make bets on both advances and declines in the market.
The problem, as with most short-term strategies, is developing a compelling trading strategy capable of predicting market volatility. Trading VIX-related indexes may make sense for hedging near-term market fluctuations, but there is simply not going to be any way to predict market moves with any certainty. Major inflection points in the market are missed by the best investors and include the credit crisis, flash crash and latest concerns over sovereign debt levels in Europe. Without a crystal ball, speculating on future market volatility has to be one of the dumbest things investors can do with their money. (To learn more on volatility, read A Simplified Approach To Calculating Volatility.)
Buy Bond Funds
U.S. interest rates have been on a steady decline since around 1980 when they reached the double digits. These days, shorter-term rates are hovering around zero, while the 30-Year Treasury Bond rate is extremely low at roughly 3%. These low rates qualify as all-time lows in many instances, such as for bank Certificate of Deposits (CDs), mortgages and U.S. Treasury rates.
Savvy investors, including Pimcos Bill Gross, have lamented at the low interest rate environment. Sadly enough, Grosss near-term call on the appeal of U.S. Treasuries has left his flagship Pimco Total Return Fund badly lagging its index and an estimated 84% of its peer group. Given the low historical rates, many see it as only a matter of time before rates start to rise. As bond prices move in the opposite direction of yields, there is the potential for sizable losses for many investors in bond funds. At the very least, investors should consider investing in individual bonds to at least ensure the return of their principal at maturity. (For related reading, see Bond Basics.)
Speculate in Currencies
As with trading volatility, speculating in short-term currency movements is another dubious investment strategy. As with most investing, a long-term perspective can be much more meaningful. The Economist magazine issues a Big Mac Index, the origin of which has been described as a light-hearted way to make exchange-rate theory more digestible. Namely, it looks at the price of a Big Mac across the world as a proxy for the extent that currencies are either undervalued or overvalued, relative to each other. Specifically, it states that in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country.
Looking for penny stocks that skyrocket?
Betting on short-term movements in currencies is a certifiably dumb strategy, as shorter-term fears and emotions can push currency relationships far off from what is reasonable over the long haul. The carry trade, or borrowing in a currency with a low interest rate to invest in one with a higher interest rate, is a case in point. A popular carry trade in recent years involved borrowing in the Japanese yen, and it has unraveled at various times, including during the credit crisis in 2007 and natural disasters earlier this year. As with many short-term market movements, many speculators were caught by surprise. (For more information, read The Big Mac Index: Food For Thought.)
Load Up on Gold
A market strategist at Fifth Third Bank recently suggested that investors in gold implement a gambling strategy that also works in Las Vegas. After a big win or run up in any investment, put your initial capital back in your pocket and continue to play with house money. This minimizes the potential that an investment, such as gold, which has had an amazing price run, stops for a breather or gives up most of its original gains. Investors in residential real estate back in 2005 and 2006 would have been well served with this strategy, and while gold may continue to have a strong run (gold is up more than 150% over the past five years, while the stock market is flat), buying it aggressively at these levels is likely a very foolish trading strategy.
Invest in Social Media
The fact that many social media firms continue to push through initial public offerings (IPOs) in the face of a difficult stock market should serve as a solid indicator that these companies have unknown underlying business appeal over the long haul. Firms including Groupon, LinkedIn, Facebook, Zynga and Twitter may be growing sales rapidly, but they are spending just as much to advertise and boost sales.
Collectively, they have unproven business models, barriers to entry are very low as competing sites are rather easy to develop, and hundreds of millions of dollars of investment capital are pursuing only a handful of good ideas in the space. It all spells a recipe for disaster, for investors looking to invest these days. (For related reading, see How An IPO Is Valued.)
The Bottom Line
Smarter investment choices include buying into blue-chip stocks and even residential real estate in many markets in the U.S. With a long-term perspective, many wise investment choices can be made. The dumber ones generally consist of trying to predict short-term market movements and piling into investments that have had very strong price runs or are extremely popular.
ADRs: Invest Offshore Without Leaving Home
It was April 1927. Calvin Coolidge was president, and noteworthy events that die-hard historians or baseball fans may recall include the Italian anarchists Saccho and Vanzetti receiving their death sentences and Babe Ruth hitting the first of his 60 home runs, - a single-season record at the time. For investors, a third event in April 1927 has proved equally important and far more profitable: the debut of American depositary receipts (ADRs). (Read What Are Depositary Receipts? for background reading on this common type of security.)
An ADR represents ownership of shares in a foreign company, but it can be bought and sold just like any U.S. stock, allowing investors to diversify their portfolios with foreign assets, but skip the hassle of a foreign brokerage account. Sound intriguing? Find out how these securities work and what they can add to your portfolio.
History of the ADR and Current Stats
John Piermont Morgan (yes, that J.P. Morgan), launched the first ADR for the U.K.s Selfridges Provincial Stores Limited, the famous retailer now known as Selfridges Plc. Even the audacious J.P. Morgan probably had no idea of the trend he was touching off. As of mid-2008, there were more than 2,250 depositary programs representing more than 1,800 companies from over 70 countries listed on global stock exchanges. According to the Bank of New York Mellon, in the first half of 2008, 52 billion shares of ADRs changed hands, representing a value of $2.07 trillion.
Benefits of ADR Investing
Some benefits of ADR investing are clear. First, many international markets, especially emerging markets, have higher GDP growth rates than the United States or Europe. While the American stocks in your portfolio may be stagnating, holding a few ADRs has the potential to provide you with solid returns during downturns in domestic markets. Your broker and the financial media are always advocating diversification; ADRs represent a great avenue to diversify yourportfolio. (Read Going International to learn about this and other ways to diversify your portfolio with foreign stocks.)
Another benefit investors can realize through ADR investing is favorable currency conversions for dividends and other cash distributions. For example, if you own shares of a European ADR and the euro is strong against the dollar, a dividend increase will be that much more rewarding because the dividend payment has to be converted to dollars. (Read more in The Impact Of Currency Conversions.)
The most obvious benefit of ADRs is that they make international companies that investors would normally have to pay a premium for (or perhaps be unable to buy at all) more accessible. If you want to buy 100 shares of Petrobras, the Brazilian oil giant, all you need to do is call your broker or log onto your online brokerage account. Theres no need to find a distant relative living in Brazil to execute the trade for you.
Perils and Pitfalls
As buyers of ADRs, we treat them as we would any other securities purchase: we want to profit. However, there are issues that can arise with ADRs that arent always germane to domestic stocks. Lets use a 2008 geopolitical conflict to highlight a potential peril. Say you own some shares of a Russian oil ADR, and neighboring country Georgias military is able to knock out a couple hundred miles of pipeline. As far-flung as it seems, this scenario could come to bear, especially in a developing nation. The same goes for political unrest. Its probably best to identify dictators and not invest in companies based in nations that are ruled by these leaders, as these countries are more prone to political strife. (Due diligence is key to not getting burned by an unfamiliar investment. Read Due Diligence In 10 Easy Steps to learn what to look for.)
Of course your ADR investments are subject to some of the same risks as your domestic investments, including credit, currency and inflation risk. These should be taken into account, regardless of the state of the market. There are some markets, such as Australia and Canada, where the local currencies are tied directly to commodity prices. If gold or oil is going up, this contributes to a rise in those currencies. Of course, when those commodities fall, the currencies fall in tandem. This is just one more factor an investor needs to take into account. (Read Investing Beyond Your Borders for more risks associated with investing overseas.)
There are levels of ADRs on U.S. markets. For example, a Level I ADR trades over the counter and as such, is highly speculative. Those shares probably arent liquid and, whats worse, information on the company is scant. Keep in mind that many countries dont require their public companies to report results quarterly like the U.S. does. For better or worse, Level I issues are the fastest-growing segment of the ADR market, according to the Bank of New York Mellon.
Thinking of buying that Chinese solar company that trades 20,000 shares a day at $1.50? Its probably best to wait for it to graduate to the Nasdaq or NYSE. Level II and III ADRs are where investors want to be. These are the ADRs that trade on major U.S. exchanges and must uphold the same general reporting rules and SEC regulations as American-based corporations. (IFRS are poised to change some aspects of international reporting. Read International Reporting Standards Gain Global Recognition to learn more.)
Tax Treatment of ADRs
Tax treatment of ADRs by the IRS is generally the same as for domestic investments. Investors are subject to the same capital gains and dividend taxes at the same rates. There is a little twist, however: many countries will withhold taxes on dividends paid. While the American investor must still pay U.S. income tax on the net dividend, the amount of the foreign tax may be claimed by the investor as a deduction against income or claimed against U.S. income tax. Investors are encouraged to consult a professional tax or investment advisor to make sure they are recording (and paying taxes on) their ADR investments properly. (Read more about capital gains and dividend taxation in Dividend Facts You May Not Know.)
Conclusion
Investors should look beyond the confines of the U.S. borders in an effort to diversify and maximize returns. Many investors ignore the foreign-equity asset class entirely, and this is not beneficial to their portfolios. ADRs are one way to diversify your portfolio and help you achieve better returns when the U.S. market is in a slump.
Information Overload: How It Hurts Investors
Our information-based society is often plagued with excess. There are many areas of everyday life in which information overload prevails, but the investment sector may well be where the consequences are the most serious. And the less financial knowledge and understanding people have, the worse they cope.
Information Overload Leads to Bad Decisions and Passivity
An important investigation on this very issue by Julie Agnew and Lisa Szykman (both professors at the Mason School of Business, Williamsburg, VA), published in the Journal of Behavioral Finance (2004), reveals that people with a low level of financial knowledge suffer particularly from overload, which leads them to take the path of least resistance, the default option in defined contribution retirement plans. Many are simply overwhelmed and cannot cope at all. (For a related reading, see Taking A Chance On Behavioral Finance.)
TUTORIAL: Behavioral Finance Use Investment Information Effectively
For a lot of people, financial security and peace of mind depend on making the right financial decisions now and in the future. Yet, there is growing evidence that far too many individuals make very poor decisions, and many cannot be described as making decisions at all.
While some investors inevitably have too little information, others have too much, which leads to panic and either bad decisions or trusting the wrong people. When people are exposed to too much information, they tend to withdraw from the decision-making process and reduce their efforts. (A lack of information, which one could call underload can have the same result, by the way, and is certainly just as dangerous).
In other words, simply providing people with information about investment options, may not be enough to produce rational and sound decisions. Investment information needs not only to be sufficient without being overwhelming, it also needs to be easy to use, and actually be used. This is a very real problem with potentially dreadful consequences. (To learn more, see Financial Media 4-1-1 For Investors.)
The Specific Causes of Overload
Agnew and Szykman tell us that there are three main causes of information overload. One is pure quantity. The second is having too many options (although too few is also bad), and the third factor is option similarity. If everything seems the same, differentiating one alternative from another is confusing and difficult. Well use their findings to extend to general investors rather than simply DC plan contributors.
Also important in the use of information is the investors level of financial knowledge. That is, knowledge which is directly relevant to the investment process. Theoretical economic or general business knowledge may be no help at all, being too removed from the nuts and bolts of money management. We are talking here about an awareness of how investment should be done in practice, what works and what does not.
The research indicates that many investors dont even have a basic understanding of financial concepts. This applies more to those who earn less. Not surprisingly, people who have never had much money, have had little practice in investing it. For this reason, someone who suddenly wins the lottery or inherits is often at a loss, initially metaphorically and then, not uncommonly, literally. (For a related reading, see Do Financial Decisions Get Better With Age?)
Consequences of Overload: Asset Misallocation
Floundering in a maze of information opens people up to misselling. Namely, getting really lousy, unsuitable investments foisted on them. These may be too risky, too conservative or insufficiently undiversified, to name just three of the classic horrors. In short, investors land up with investments that are lucrative only for the seller, or which are simply easy to sell and no trouble to manage.
In their experiment, Agnew and Szykman found that people who were not coping with the investment information just went for the default option, which was easiest to do. They did not bother to find out what is really best for them. In the real world of investment, this is truly dangerous. An investment that is totally devoid of risk, just cash, for instance, really does not pay off in the long run. This option may lead to an inadequate retirement fund, and almost everyone should have some equities.
By contrast, having too many stocks or weird, exotic funds, assets and certificates, is extremely volatile and can win or lose you a fortune. Most investors do not want such risks, and are often unaware that they are taking them – until disaster strikes. This kind of portfolio can lead to wealth, if you are lucky, and poverty if you are not. For most people, it is not worth the gamble, neither psychologically nor financially. (To learn more, see Achieving Optimal Asset Allocation.)
Coping with Information Overload
This can be done from both sides of the market. Brokers, banks and so on, need to ensure that they only provide investors with what they really need to know, and it must be simple to understand. The point is that the average investor needs to be informed sufficiently (but no more) on what will help them make the right decisions. There is a clear optimum, beyond which dysfunctional overload occurs, and of course, too little is just as bad. It is also absolutely essential for the sell side to ensure that the information is understood and converted into the appropriate investment decisions.
If investors themselves find they are being swamped with information, and truly do not have the skills or time to figure it out and use it, they need to go back to the seller and ask for concise information that they can use. If this fails to be provided, it is probably best to take ones money and business elsewhere.
Investors themselves do need to make an effort to find out what is appropriate for them. As indicated above, this can be daunting, but for this reason, sellers and regulators need to get the message across that the more they learn and the more they know, the safer the investment process.
There are inevitably some people who just cannot or will not understand the information and use it. This may be due to a lack of education or a phobia about money, and some people are just not prepared to bother with their money. Such individuals do then need some sort of independent advisor whom they can trust. (For more, see Advice For Finding The Best Advisor.)
Conclusion
An important research project from the Mason School of Business in Virginia informs us of the very serious problem of information overload (or the converse of underload) in the financial services industry. Ensuring that investors have an optimal amount of information that they can (and do) understand, and really use as a basis for decision making, is easier said than done. But it must be done; both the industry and investors themselves need to be proactive in solving the problem. The variety of potential investments, and the evolving nature of the relevant markets means that an ongoing, reciprocal and productive process of information provision and utilization is absolutely fundamental to peoples financial future and peace of mind.
Portfolio Management Pays Off In A Tough Market
When you think about investing, you have a very long decision tree - the question of passive or active, long or short, stocks or funds, China or Brazil and on and on. These topics seem to occupy the majority of the media as well as individuals minds. However, these decisions are far down the investing process relative to portfolio management. Portfolio management is basically looking at the big picture. This is the classic forest and trees analogy; many investors spend too much time looking at each tree (stock, fund, bond, etc) and not enough - if any - time looking at the forest (portfolio management).
Prudent portfolio management begins after the client and his or her advisor have reviewed the total picture and completed an investment policy statement (IPS). Embedded in the IPS is the asset allocation strategy of which there are four: integrated, strategic, tactical and insured. Most people recognize how critical asset allocation is, but most investors are unfamiliar with asset allocation rebalancing strategies, of which there are also four: buy-hold, constant-mix, constant proportion and option based. A lack of familiarity with rebalancing strategies helps explain why many confuse the constant-mix rebalancing strategy with buy-hold. Here is a side-by-side comparison of these two most common asset allocation rebalancing strategies.
Buy-Hold Rebalancing
The objective of buy-hold is to buy the initial allocation mix and then hold it indefinitely, without rebalancing regardless of performance. The asset allocation is allowed to vary significantly from the starting allocation as risky assets, such as stocks, increase or decrease. Buy-hold essentially is a do not rebalance strategy and a truly passive strategy. The portfolio becomes more aggressive as stocks rise and you let the profits ride, no matter how high the stock value gets. The portfolio becomes more defensive as stocks fall and you let the bond position become a greater percentage of the account. At some point, the value of the stocks could reach zero, leaving only bonds in the account.
Constant-Mix Investing
The objective of constant-mix is to maintain a ratio of, for example, 60% stocks and 40% bonds , within a specified range by rebalancing. You are forced to buy securities when their prices are falling and sell securities when they are rising relative to each other. Constant-mix strategy takes a contrarian view to maintaining a desired mix of assets, regardless of the amount of wealth you have. You essentially are buying low and selling high as you sell the best performers to buy the worst performers. Constant-mix becomes more aggressive as stocks fall and more defensive as stocks rise.
Returns in Trending Markets
The buy-hold rebalancing strategy outperforms the constant-mix strategy during periods when the stock market is in a long, trending market such as the 1990s. Buy-hold maintains more upside because the equity ratio increases as thestock markets increase. Alternately, constant-mix has less upside because it continues to sell risky assets in an increasing market and less downside protection because it buys stocks as they fall.
Figure 1 shows the return profiles between the two strategies during a long bull and a long bear market. Each portfolio began at a market value of 1,000 and an initial allocation of 60% equities and 40% bonds. From this figure, you can see that buy-hold provided superior upside opportunity as well as downside protection.
Figure 1: Buy-hold vs. constant-mix rebalancing
Copyright  2009 Investopedia.com
Returns in Oscillating Markets
However, there are very few periods that can be described as long-trending. More often than not, the markets are described as oscillating. The constant-mix rebalancing strategy outperforms buy-hold during these up and down moves. Constant-mix rebalances during market volatility, buying on the dips as well as selling on the rallies.
Figure 2 shows the return characteristics of a constant-mix and buy-hold rebalancing strategy, each starting with 60% equity and 40% bonds at Point 1. When the stock market drops, we see both portfolios move to Point 2, at which point our constant-mix portfolio sells bonds and buys stocks to maintain the correct ratio. Our buy-hold portfolio does nothing. Now, if the stock market rallies back to initial value, we see that our buy-hold portfolio goes to Point 3, its initial value, but our constant-mix portfolio now moves higher to Point 4, outperforming buy-hold and surpassing its initial value. Alternatively, if the stock market falls again, we see that buy-hold moves to Point 5 and outperforms constant-mix at Point 6.
Figure 2
Copyright  2009 Investopedia.com
Conclusion
Most professionals working with retirement clients follow the constant-mix rebalancing strategy. Most of the general investing public has no rebalancing strategy or follows buy-hold out of default rather than a conscious portfolio management strategy. Regardless of the strategy you use, in difficult economic times, you will often hear the mantra stick to the plan, which is preceded by be sure you have good plan. A clearly defined rebalancing strategy is a critical component of portfolio management.
Choosing A Compatible Broker
Did you hear about Chanko Wireless?
Yeah, I got in at $25.10.
Well I got in at $25.05!
How did you get a better price than I did?
For those of you who dont remember this dialog, it is a snippet from an old Ameritrade (a brokerage) commercial. In the ad, two men bicker because one got into a wireless company for a nickel less than the other. Do you care about a nickel? If you are like the majority of investors, you probably dont. Still, this commercial raises a good point: one of the most important investment decisions you have to make has nothing to do with choosing stocks , bonds or mutual funds. Its about choosing the right broker for your individual needs. Here we look at what to consider.
How Does Choosing a Broker Relate to the Nickel?
First off, we should make it clear that we are not making any comment about Ameritrade. The nickel is important to many investors (primarily traders), but it amounts to only a few dollars if you are buying less than 100 shares. If you arent an active trader, a nickel wont even show up on the chart over the long term. So, worrying about the nickel when choosing a broker matters only for particular types of investors.
Its easy to see, then, that although there may be many good brokerages out there, not all of them are geared to the way you invest. Different investor personalities affect broker selection. The task of making your selection may seem overwhelming at first, but with a little study and some basic guidelines, youll be able to make an informed decision suited to your investing personality and end up with a broker that is right for you.
The Importance of Your Investing Personality
Your investing style is one of the biggest factors to consider when selecting an online broker. To determine your style, you must define your needs. Here are some questions to help you do this:
• Do you need personal advice, or can you do your own homework with research reports?
• How long do you typically hold an investment?
• What is the size of trades you typically make?
• How important is it to have direct access to a real person?
• Is fast and efficient order execution absolutely necessary?
There are four main types of investor personalities. Try to determine what personality you resemble most and ask yourself if your broker is providing the services that match your personality.
Individual Investors
Those classified under this category are also known as retail investors. They dont require any special assistance or advisory services. Individual investors empower themselves by doing their own research, selecting their own stocks and knowing how to place online orders efficiently. The main priorities for the independent investor are fast, consistent trade executions and low commission levels.
The fruit of such priorities and labor is the opportunity to take advantage of the lowest commission rates around. Several brokers like E*Trade and Ameritrade - known as discount brokers - have chosen to target independent investors because this clientele makes up such a large and diverse market.
Reliant Investors
These investors need some hand holding and assistance when selecting a prospective investment. Typically, they require a broker capable of offering individualized advice and assistance. This is especially true for new investors, who may need all the help they can get when starting out.
As you can imagine, extra services equal higher commissions, and as more and more investors become self-sufficient, brokers serving this market segment become fewer and fewer. The ones that do stay around are generally larger companies, such as Charles Schwab and Fidelity. Known as full-service brokers, they provide many of the services necessary for successful investing: that is, not only picking stock, but also tax planning, asset allocation and long-term planning . Additionally, if you are a new investor with a fairly large amount of money, but you arent comfortable investing on your own, you may consider a wrap account. This type of account charges one flat fee, usually quarterly, which covers all administrative, commission and management expenses. The drawback is that wrap accounts usually require minimum investments of between $50,000 and $100,000. (For more on the wrap, see Wrap It Up: The Vocabulary and Benefits of Managed Money.)
Short-Term Investors (Traders)
Short-term traders are not the same as day traders. Depending on the type of security, a short-term position can range from an hour to a few months. For the most part, short-term trading is a practice used primarily by the top financial players. These are the professionals who have devoted time to understanding all aspects of trading and investment and are often trading what are called momentum stocks or momo plays. Traders require access to superior research information, excellent execution skills and most likely the ability to trade in other types of securities, such as derivatives.
With such experience and knowledge, short-term traders require next to no assistance from a broker. Because these investors are attempting to profit from the relatively short-term movements in a securitys price, they are more concerned about getting the best possible fill price than a longer-term investor, but not as concerned as a day trader, as we explain below. Discount online brokers supply the fast order execution, the low commissions and the trading tools that are the biggest concerns of the short-term investor.
Day Traders
These are experienced stock traders who hold positions for a very short time (from minutes to hours) and make numerous trades each day - most trades are entered and closed out intraday.
As a result, day traders value order fulfillment speed and trade execution. So, for them, selecting the right broker is crucial. Day traders are probably the only investors who should worry about whether their broker will help them secure the nickel. Because day traders are self-sufficient and place many trades daily, they can demand exceptionally low commissions - usually no more than a couple of bucks a trade - and top-notch order fulfillment. Because the day trader needs to monitor stock prices constantly, live price quotations are essential to his or her success. The fancy tools for this come at a price, however, as commissions at brokerages with loads of tools will be higher than those at brokerages offering fewer tools. Like short-term investors/traders, day traders basically use online discount brokers to facilitate their trading. Again, speed of order execution, low cost and good tools are important to these types of investors not requiring advice from their broker.
Every successful investor needs to have the right tools for the trade. This begins with choosing the right broker. No broker is perfect for everybody, and a firm that doesnt meet your style isnt necessarily a low-quality company; it may just offer services that dont fit your investment personality. Whether youre concerned about that nickel or your retirement plan, there is a broker out there that is right for you.
Taking A Look Behind Hedge Funds
Once dismissed as secretive, risky and only for the well-heeled, hedge funds represent a growth industry. They can promise higher-than-average market returns in a downtrodden market, but despite the allure of these alternative investment vehicles, investors should think twice before taking the hedge fund plunge.
What Are Hedge Funds?
Hedge funds are privately offered investments that use a variety of non-traditional strategies to try to offset risk, an approach called - you guessed it - hedging.
One such technique is short selling. Hedge fund managers identify a stock in which price is likely to decline, borrow shares from someone else who owns them, sell the shares and then make money by later replacing the borrowed shares with others bought at a much lower price; buying at this lower price is possible only if the share price actually falls.
Hedge fund managers also invest in derivatives, options, futures and other exotic or sophisticated securities. Generally, hedge funds operate as limited partnerships or limited liability companies and they rarely have more than 500 investors each. (For more read Getting To Know Hedge-Like Mutual Funds.)
Arguments for Hedge Funds
Some hedge fund managers say these funds are the key to consistent returns, even in downtrodden markets. Traditional mutual funds generally rely on the stock market to go up; managers buy a stock because they believe its price will increase. For hedge funds, at least in principle, it makes no difference whether the market goes up or down.
While mutual fund managers typically try to outperform a particular benchmark, such as the S
How To Evaluate A Companys Balance Sheet
For stock investors, the balance sheet is an important consideration for investing in a company because it is a reflection of what the company owns and owes. The strength of a companys balance sheet can be evaluated by three broad categories of investment-quality measurements:working capital adequacy, asset performance and capitalization structure.
Tutorial: Financial Statement AnalysisIn this article, well look at four evaluative perspectives on a companys asset performance: (1) the cash conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets ratio and (4) the impact of intangible assets.
The Cash Conversion Cycle (CCC)
The cash conversion cycle is a key indicator of the adequacy of a companys working capital position. In addition, the CCC is equally important as the measurement of a companys ability to efficiently manage two of its most important assets - accounts receivable and inventory.
Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets.
CCC = DIO DSO – DPO
DIO - Days Inventory Outstanding
DSO - Days Sales Outstanding
DPO - Days Payable Outstanding
There is no single optimal metric for the CCC, which is also referred to as a companys operating cycle. As a rule, a companys cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics.
Investors looking for investment quality in this area of a companys balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators. (To read more on CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.)
The Fixed Asset Turnover Ratio
Property, plant and equipment (PP
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.