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The Hidden Differences Between Index Funds
June 30 2012| Filed Under » Index Fund, Investing Basics, Investment, Mutual Funds
Think of your trips to the candy store as a child. Youd pick out your favorite candy ... lets say it was jelly beans. Orange tasted like oranges and yellow tasted like lemons; but sometime later, the yellow jelly beans you purchased might taste like pineapples, or popcorn! What was up with that? The lesson here, that appearances cant be trusted, can be applied to index funds too. Although a S
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.
What Investment Is Best For You?
Investors that have neither the time nor the patience to actively manage their money have options. They can hire a money manager, a hedge fund manger, or invest in a mutual fund or an exchange-traded fund (ETF). But how is an investor to know which route is the best option? There are several things to consider when deciding how to have your money managed - if it is managed at all. Read on for some food for thought.
Starting Costs
An important consideration for many investors is how much it will cost to get into a particular investment. ETFs can theoretically be purchased one share at a time, so the minimum investment is generally negligible. However, many mutual funds have minimums to open an account. To many people, particularly younger investors, the typical $500-$1,000 or more initial deposit a lofty initial investment. (For more insight, see Start Investing With Only $1,000.)
Hedge funds generally have an even higher threshold. Many hedge funds require that their investors own up to $5 million in investments and have a minimum net worth and/or a sizable income stream, typically in the $300,000 range. Some funds have an even higher threshold. (If you dont have the large capital needed to invest in a hedge fund, read Can You Invest Like A Hedge Fund?)
Costs
ETFs carry transaction costs that vary depending on the broker the investor uses. However, in many cases, the total costs are quite small - usually less than 2% of the total amount invested. Meanwhile, investment advisory services and money management firms typically charge 1- 2% of the clients total assets per year in management and advisory fees. On top of that, brokerage fees are typically charged; therefore, the annual returns an investor must obtain to break even can easily top 5% or more per year. (For more, see Dont Let Brokerage Fees Undermine Your Returns.)
Mutual funds can also levy pretty large fees. And while they may vary depending on how the fee structure is laid out, funds by law can charge a front-end load of up to 8.5%, which can be an enormous drag on profits for years. (To learn more, read Stop Paying High Mutual Fund Fees.)
Hedge funds typically charge annual management fees of 1-2% and then retain 20% of the profits an investor earns. According to Barclay Group, a firm that tracks hedge fund costs, the average management fee in 2005 was 1.56%. In that same year, the average performance fee was 19.6%. Some hedge fund managers charge even more for their services.
In any case, the trick is to figure out whether these fees are truly worth it. In some cases, a firm that charges high fees might also generate very high returns for its investors. However, this is not always so, and in most cases, high fees just erode investors returns. (For related reading, see Benchmark Your Returns With Indexes.)
Investment Horizon
Because ETFs are traded on the major stock exchanges and the transaction fees are generally inexpensive, an investor can trade in and out of them with relative ease. However, mutual funds, because they often contain redemption fees, and/or large front-end loads, are usually considered longer-term investments. (For related reading, see When To Sell A Mutual Fund.)
Hedge funds are also considered to be longer term investments because redemptions are typically only allowed in certain quarters - and sometimes only with advanced written notice. In fact, some hedge funds have extended multi-year lock up periods.
When looking for the right investment, investors must realize the advantages and limitations of each investment vehicle prior to becoming involved.
Risk Tolerance/Hand Holding
In many cases ETFs track or mimic major indexes, such as the S
How To Be A Stock Trader In 2012
If one of your New Years resolutions is to take control of your finances and put some of your savings to work, you might be considering using the stock market to do that. 2011 proved to be a tough year for even the bestinstitutional investor and individual traders had an equally tough time navigating markets that saw a large amount of violent swings, both to the upside and the downside.
If youre planning to enter the markets as a new trader this year, here are a few tips to consider as you put your money to work. (For related reading, see 4 Common Active Trading Strategies.)
Dont Trade for Real … Yet
Before you put your hard-earned money to work, spend some time trading fake money. Many brokerages and sites like Yahoo! Finance offer virtual or paper trading accounts that allow you to get a hands-on feel for how the markets work. Just like any new skill, you probably wont do very well with your first attempts. Use virtual funds to see if your investing decisions could potentially earn you money. Once you see that youre having success, put a small amount of real money to work. Continue to use your virtual account to test new strategies. Even the pros use virtual accounts to test the waters. (Use the Investopedia Stock Simulator to trade a virtual account, risk free!)
Learn How to Research
Its easy to make the mistake of relying on somebody elses research for investing decisions. There are two problems with this. First, somebody elses risk tolerance, investment objective and account size arent the same as yours. The trade may be right for them, but not for you. Second, they may tell you when to get into the trade but they likely wont tell you when to get out.
There are plenty of good resources that teach you how to research before you buy. Read books, talk to other traders and read company balance sheets, listen to conference calls and work to gain a real understanding of the markets. You can learn to excel at any endeavor through experience and study. Becoming a great money manager requires the same commitment. (To learn more, see Investing Books It Pays To Read.)
Say No to the Seminars
Every big city has an endless supply of weekend-long thousand dollar or more seminars that guarantee to make you the next great trader. Dont be fooled. They may have some good information, but if becoming a high-performing, profitable trader could happen over a weekend, everybody would do it. There are better ways to spend your money.
Dont Try to Win
Weve learned that in order to get ahead in this world, we have to be better than our competition. That isnt true in investing. If youre new to the markets, you arent going to beat the professionals. Even the professionals dont always beat other professionals. There are an exceedingly small amount of professional investors who have a consistent track record of beating others in the market. Aim to invest your money in products that tend to perform in line or slightly better than the market. Later, as you gain more investing experience, you can try your hand at some of the riskier trades.(For more information, read Measuring And Managing Investment Risk.)
Dont Make Money, Manage Risk
The professionals know that if you manage risk correctly, making money will naturally follow. Having a portfolio that includes a good supply of companies with a track record of success and that pay a healthy dividend, is good risk management. Only investing in products you truly understand, without looking to get rich quick, is the mark of a mature investor. You arent going to strike it rich by capturing short-term gains, so dont take the unnecessary risk of trying.
The Bottom Line
2012 promises to be another year of tough-to-navigate markets for even the best traders. Dont try to score the big win. Instead, use 2012 to be conservative with your money as you learn the complicated art of trading stocks.
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.
The Pitfalls Of Diversification
Diversification is a prominent investment tenet known by average and sophisticated investors alike. Diversification means putting your proverbial eggs into more than one basket. Proponents of this method recommend diversification within a portfolio or across various types of investments. The assumption is that diversification helps mitigate the risk of multiple investments decreasing all at once, or that relatively better performing assets will at least offset the losses. There is some truth to this approach, but there is another side to this coin. Investors should also be asking how diversification affects their portfolios performance. In other words, is diversification all that its cracked up to be? This article will examine some of the pitfalls of over-diversifying your portfolio and possibly debunk some misconceptions along the way.
SEE: Top 4 Signs Of Over-Diversification
Expenses
Having and maintaining a truly diversified portfolio can be more expensive than a more concentrated one. Regardless of whether an investor is diversified across various assets, such as real estate, stocks , bonds or alternative investments (such as art), expenses will likely rise simply based on the actual number of investments. Every asset class will probably require some expense that will be incurred on a transactional basis. Real estate brokers, art dealers and stockbrokers all will take a portion of your diversified portfolio. An average investor may have a mix of 20 or so stock and bond funds. It is likely that your financial advisor is recommending certain fund families across investable sectors.
In many cases, these funds are expensive and may carry a sales and/or redemption charge. These expenses cut into your returns and you will not get a refund based on relative underperformance. If diversification is a must-have strategy for your investable assets, then consider minimizing maintenance and transaction costs. Doing this is critical to preserving your return performance. For example, pick mutual funds or exchange traded funds (ETFs) with expense ratios less than 1% and pay a load for investing your hard-earned dollars. Also, negotiate commissions on large purchases, such as real estate.
Balancing
Many investors may incorrectly assume that having a diversified portfolio means they can be less active with their investments. The idea here is that having a basket of funds or assets enables a more laissez-faire approach, since risk is being managed through diversification. This can be true, but isnt always the case. Having a diversified portfolio may mean that you have to be more involved in and/or knowledgeable about, your investment choices. Most portfolios across or within an asset class will likely require rebalancing. In laymans terms, you have to decide how to reallocate your already invested dollars. Rebalancing may be required due to many reasons, including, but not limited to, changing economic conditions (recession), relative outperformance of one investment versus another or because of your financial advisors recommendation.
Many investors with over 20 funds or multiple asset classes now will likely face a choice of picking a sector or asset class and funds that they are simply unfamiliar with. Investors may be advised to delve into commodities or real estate without real knowledge of either. Investors now face decisions on how to rebalance and what investments are most appropriate. This can quickly become quite a daunting task unless you are armed with the right information to make an intelligent decision. One of the assumed benefits of being diversified may actually become one of its biggest hassles.
Underperformance
Perhaps the greatest risk of having a truly diversified portfolio is the underperformance that may occur. Great investment returns require choosing the right investments at the correct time and having the courage to put a large portion of your investable funds toward them. If you think about it, how many people do you know have talked about their annual return on their 20 stock and bond mutual funds ? However, many people can recall what they bought and sold Cisco Systems for in the late 1990s. Some people can also remember how they invested heavily in bonds during the real estate collapse and ensuing Great Recession in the mid to late 2000s.
There have been several investing themes over the last few decades that have returned tremendous profits: real estate, bonds, technology stocks, oil and gold are just some examples. Investors with a diverse mix of these assets did reap some of the rewards, but those returns were limited by diversification. The point is that a concentrated portfolio can generate outsized investing returns. Some of these returns can be life changing. Of course, you have to be willing to work diligently to find the best assets and the best investments within those assets. Investors can leverage Investopedia.com and other financial sites to help in their research to find the best of the best.
SEE: 4 Steps To Building A Profitable Portfolio
The Bottom Line
At the end of the day, having a diversified portfolio, perhaps one managed by a professional, may make sense for many people. However, investor beware, this approach is not without specific risks, such as higher overall costs, more accounting for and tracking of investments, and most importantly, potential risk of significant underperformance. Having a concentrated portfolio may mean more risk, but it also means having the greatest return potential. This may mean owning all stocks when pundits and professionals say owning bonds is preferred (or vice versa). It could mean you stay 100% in cash when everyone else is buying the market hand over fist. Of course, common sense cannot be ignored: no one should blindly go all-in on any investment without understanding its potential risks. Hopefully, one can recognize that having a diversified portfolio is not without risks of its own.
What Investment Is Best For You?
Investors that have neither the time nor the patience to actively manage their money have options. They can hire a money manager, a hedge fund manger, or invest in a mutual fund or an exchange-traded fund (ETF). But how is an investor to know which route is the best option? There are several things to consider when deciding how to have your money managed - if it is managed at all. Read on for some food for thought.
Starting Costs
An important consideration for many investors is how much it will cost to get into a particular investment. ETFs can theoretically be purchased one share at a time, so the minimum investment is generally negligible. However, many mutual funds have minimums to open an account. To many people, particularly younger investors, the typical $500-$1,000 or more initial deposit a lofty initial investment. (For more insight, see Start Investing With Only $1,000.)
Hedge funds generally have an even higher threshold. Many hedge funds require that their investors own up to $5 million in investments and have a minimum net worth and/or a sizable income stream, typically in the $300,000 range. Some funds have an even higher threshold. (If you dont have the large capital needed to invest in a hedge fund, read Can You Invest Like A Hedge Fund?)
Costs
ETFs carry transaction costs that vary depending on the broker the investor uses. However, in many cases, the total costs are quite small - usually less than 2% of the total amount invested. Meanwhile, investment advisory services and money management firms typically charge 1- 2% of the clients total assets per year in management and advisory fees. On top of that, brokerage fees are typically charged; therefore, the annual returns an investor must obtain to break even can easily top 5% or more per year. (For more, see Dont Let Brokerage Fees Undermine Your Returns.)
Mutual funds can also levy pretty large fees. And while they may vary depending on how the fee structure is laid out, funds by law can charge a front-end load of up to 8.5%, which can be an enormous drag on profits for years. (To learn more, read Stop Paying High Mutual Fund Fees.)
Hedge funds typically charge annual management fees of 1-2% and then retain 20% of the profits an investor earns. According to Barclay Group, a firm that tracks hedge fund costs, the average management fee in 2005 was 1.56%. In that same year, the average performance fee was 19.6%. Some hedge fund managers charge even more for their services.
In any case, the trick is to figure out whether these fees are truly worth it. In some cases, a firm that charges high fees might also generate very high returns for its investors. However, this is not always so, and in most cases, high fees just erode investors returns. (For related reading, see Benchmark Your Returns With Indexes.)
Investment Horizon
Because ETFs are traded on the major stock exchanges and the transaction fees are generally inexpensive, an investor can trade in and out of them with relative ease. However, mutual funds, because they often contain redemption fees, and/or large front-end loads, are usually considered longer-term investments. (For related reading, see When To Sell A Mutual Fund.)
Hedge funds are also considered to be longer term investments because redemptions are typically only allowed in certain quarters - and sometimes only with advanced written notice. In fact, some hedge funds have extended multi-year lock up periods.
When looking for the right investment, investors must realize the advantages and limitations of each investment vehicle prior to becoming involved.
Risk Tolerance/Hand Holding
In many cases ETFs track or mimic major indexes, such as the S
How To Efficiently Read An Annual Report
A companys annual report is the single most important way for it to convey itself to potential investors. As such, it should come as no surprise that an annual report serves to present the company in best light possible without violating any Securities and Exchange Commission (SEC) regulations. Unfortunately, many investors read annual reports but fail to read them effectively. In other words, while annual reports are clearly prepared without any intent to deceive or reflect dishonesty about the business, investors should always read them with a sense of skepticism. In other words, learn how to read between the lines and decipher the actual condition of the company. Annual Report Vs. 10-K Filing
Typically, a company will file both an annual report and 10-K report to the SEC. An annual report is the shorter version that often comes with pictures, nice glossy color pages, a letter from the Chairman/CEO and an overview of the financials.
The 10-K is the black and white, no color pictures document that is submitted to the SEC. Very often, a business will simply file the 10-K as its annual report since that document is mandatory for every public company. So guess which one carries more significance to the investor - the longer and more boring 10-K filing. Think of the glossy annual report as informative marketing material. If a company does file both reports, use the annual report as a great first look at a business before tackling the 10-K filing. Very often, the annual report and 10-K are merged into one document, with the annual report at the beginning to provide an overview of the years results.
The Components of an Annual Filing
If you are interested in investing in a public company you can not avoid examining and reading the 10-K filing, which I will now refer to as the annual report.
The 10-Ks begin with a detailed description of the business, followed by risk factors, a rundown of any legal issues, and, finally, the numbers and financial notes in the back. Oftentimes, the most essential components of the annual filing are the following items:
• Item 1: Business - a description of the companys operation
• Item 1A: Risk Factors
• Item 3: Legal Proceedings
• Item 6: Selected Financial Data
• Item 7: Managements Discussion and Analysis of Financial Condition
How to Tackle
People read annual reports in different ways. Some investors even prefer to start at the back and work their way to the beginning. It makes no difference how you read them, as long you absorb the essential points of the business and its financial condition. However, there is a good way to tackle these reports that is both most efficient and most effective.
Without question, you should first read Item 1, which is the business description. You cant possibly go any further in your research without knowing what the company does! Also, by getting to know the business first, you can then determine if you need to go any further. That determination is simple. Just ask yourself if you understand what the company does, who its customers are, and the industry it operates in. If you answer no, youre done. Move on to the next business.
Next, you should jump to Items 6 and 7 and examine and analyze the financial data . How has the company performed over a period of years? Has the balance sheet gotten stronger or weaker over time? Look over the cash flow statement and see if the business has been a generator of cash or a user of cash. Its possible for businesses to report net income while at the same time remaining cash flow negative. Compare the income statement with the cash flow statement for any red flags. If you like what you see, move on and if not, move on to the next company.
Afterwards its time to determine if any hidden surprises may lurk beneath the surface. So you must now go back and read the risk factors section and the legal proceedings section, if any legal matters exist. Because this is a filing to the SEC, the risk factors will be very detailed and include risks like our industry is highly fragmented with lots of competitors or our stock price may experience periods of volatility. While these are important risks to consider, they should not significantly reduce the desirability of the business.
Instead, focus on any unusual risk factors, such as if the company generates a substantial portion of its revenues for one or two customers. In addition, the Legal Proceedings section will alert you if any significant lawsuits are in the works. Again, dont ignore any legal liabilities, but if youre looking at a billion dollar company and it has a pending lawsuit against it for damages of $10 million, thats not uncommon. Pfizer, one of the largest drug companies in the world, will also have patent lawsuits and drug liability claims that may exceed hundreds of millions of dollars. But thats part of the normal course of business for any major pharmaceutical company, and a drop in the bucket for Pfizer when you see that the company has over $50 billion in cash and short-term investments on the balance sheet.
Focus on What You Know
We all have different ways of deciphering and storing information. Feel free to read the annual report in a way that works for you. But learn to concentrate on the most important aspects of a companys 10-K filing. By doing so, you will avoid wasting unnecessary time on companies that do not meet your investment suitability. But always remember that just because you arent investing in that particular business that you have wasted your time. Investing is a discipline that rewards those who are continuously learning.
The Benefits Of An Investment Club
Most mutual fund investors would be hard pressed to name more than one or two of the top holdings within their favorite funds. This is because fund investors tend to compare mutual funds on the basis of their performance, without giving much thought to the specific stocks, bonds and other financial instruments held within the fund. By their nature, mutual funds are a passive form of investment: we trust that the mutual fund manager has the expertise to choose the right investments that will provide the best returns in our portfolios.
As individual investors, we rarely have a large enough portfolio to make individual equity or bond selections on our own. As a result, the average retail portfolio is usually insufficiently diversified with individual stock picks, and we mutual fund holders are subjected to undue risk from one or two bad choices forming a large percentage of our total holdings. For these reasons, retail investors who are dissatisfied with the passive approach of mutual funds and want to take a more active role in choosing equities would do well to join an investment club. (Find out more in Benefit From A Winning Investment Club.)
The Benefits of an Investment Club
You can think of an investment club as a small-scale mutual fund where decisions are made by a committee of non-professionals. In fact, an investment club can be established as a legal entity, either as a legal partnership or as a limited liability corporation, making its framework similar in principle to that of a mutual fund. Best of all, an investment club avoids the often burdensome management fees that all mutual funds levy on their unit holders - fees that can have a significant impact on the overall return provided by mutual funds.
But the benefits of an investment club come with a major caveat: the returns (or losses) that the club realizes entirely depend on club members and their abilities to choose the right investments for their pooled funds. When we purchase mutual funds from the major fund companies, we are effectively purchasing the education, experience, skills and discipline of the mutual fund managers entrusted with our money. When we join an investment club, we are attempting to replicate (and improve upon) some of those management attributes, but in a non-professional setting.
A typical investment club will meet on a regular basis (usually every month) to review its existing portfolio and to take suggestions from club members regarding new investment opportunities. The monthly meeting is an open floor, where each club member is able to voice his or her opinion about the suitability of new investments and other concerns regarding the performance of the pooled funds. Unlike any mutual fund, the investment club is a true democracy: here, the collective wisdom of the club members, combined with information theyve gathered through intensive research, serves (in theory) to produce the best investment decisions.
Principles of a Successful Investment Club
The National Association of Investors Corporation (NAIC) is the pre-eminent advocate of collaborative investing. It maintains extensive archives of information for starting and maintaining investment clubs. The NAIC advocates four simple principles which apply as much to making excellent individual investment decisions as they do to making democratic decisions in a club setting:
• Invest regularly.
• Reinvest dividends and capital gains.
• Discover and own leadership growth companies.
• Prudently diversify by company size and industry.
These principles are very much in keeping with a buy-and-hold strategy, characterized by low portfolio turnover rates. The average holding period for equities within NAIC-advocated portfolios is more than six years. The NAICs principles and strategies have enabled it to claim that on average, the long-term performance of NAIC members has generally outperformed market benchmarks. The NAIC boasts a large membership consisting of both individual investors and investment clubs, and it offers services for introducing individuals to clubs in their area. (Learn more about investment clubs in Investment Clubs Pool Assets, Expertise and 4 Tips For Joining An Investment Club.)
Conclusion
You dont need to belong to the National Association of Investors Corporation to see the value in its overarching principles of discipline, diversification, reinvestment and careful selection of top companies. Indeed, you dont even need to belong to an investment club to adopt these principles as part of your individual investment strategy.
But there are clear benefits to the discipline and decision-making typical of investment clubs. By maintaining a strict regimen of regular meetings, investment clubs force individual investors to adopt an active investment style, in which portfolio review is ongoing and investment decisions - whether to buy, sell or hold - are constantly made.
Furthermore, the decision-making power of the investment club resides in its democracy. Each member brings his or her own education, experience and skills to the group, all of which are used to their fullest when evaluating and debating a decision. The power of the mutual fund comes from professional management that may be able to beat average market returns. The power of the investment club comes from the collective talents of numerous individual members.
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.
Rational Ignorance And Your Money
Ignorance is regarded as rational when the cost of information and finding out exceeds the benefits. This is especially true in situations where it would be a waste of time to learn about the particular issue. A classic example of this would be in general elections, where one vote really does not count much. Clearly, however, if everyone thinks this way, there is a problem, but the fact remains that rather than poring over election promises and campaigns for hours, you would do better to invest the time learning more about and managing your portfolio of assets.
The Two Faces of Investor Ignorance
In the world of money, with its countless traps, endless alternatives, conflicts of interest and shady dealers, ignorance is probably less rational than in any other context. However, investors have to contend with two associated problems, which I would term inevitable ignorance and induced ignorance.
Inevitable Ignorance
Inevitable ignorance arises because it is just not possible to know everything about your investments. Clearly, the amount known varies very substantially between investors, due to huge disparities in experience, education, the amount of time people are able and willing to devote to their money, and so on.
However, everyone is ignorant about some aspects of their own investments and of the industry. For instance, nobody knows all there is to know about every company on the New York Stock Exchange, let alone those in France, China, Brazil and the rest of the world, developed, developing and in between. Not to mention, who could possibly know about the management and future prospects of all those thousands of funds out there, ranging from equities, to bonds, to futures and options, to alternative investments and CDs? (Consider yourself a beginner? Need to brush up on the basics? Start with Why You Should Understand The Stock Market.)
Induced Ignorance
Sadly, the wheeler and dealers of the industry are fully aware of this and therefore create ignorance quite deliberately in order to sell things that people would not buy if they were fully informed. It is well documented in the marketing literature that people take advantage of rational ignorance by increasing the complexity of a decision.
The rogues in the investment industry exploit both rational and irrational ignorance by ensuring that products are either so numerous and/or available in so many combinations and permutations that buyers are overwhelmed and find it too much trouble to make an informed decision; they just take their chances and, at worst, way too much risk.
To be fair, some of this complexity is inherent to the products and markets themselves; there are a lot of people selling a lot of things that are not particularly easy to understand. People often dont like having to think and worry about money, so they leave it to others who do not always behave ethically, and who themselves may be ignorant. In the case below, we have a combination of the above factors leading to continued ignorance. (For an additional on dishonesty in the market, check out The Rise Of The Rogue Trader.)
An Information Brochure for Certificates
Precisely because of widespread financial ignorance, advisors and brokers in Germany are obliged to provide a certain type of brochure with certificates and other investments. These are along the lines of what you get with medicine, and the documents are termed just that, Beipakzettel (package brochure). Similar to what you get with pills, information is to be provided on the risks and opportunities, as well as cost and taxation implications.
A study performed in Sept. 2011, however, revealed that this measure does not help much. For starters, there are no guidelines as to who is to provide the brochures, so it usually ends up being the seller.
For the study, a tabloid newspaper article, which is generally considered very understandable, was compared to the financial product brochures for bonus or caped-bonus certificates; they were found to be barely comprehensible. The long, unfamiliar words, complex sentences and clumsy grammar left readers totally perplexed. The literature for the major banks tested varied, but overall the results were extremely poor.
Part of the problem, explained one consultant, was that the providers found themselves in a quandary. On the one hand, they had to provide sufficient information in three pages to convey the relevant issues. On the other hand, they wanted to ensure they were covered legally. This resulted in legalese formulations designed to be legally watertight, but which severely reduced the readability and comprehensibility.
The moral of the story is that even well-intentioned efforts to reduce rational investment ignorance,¬ by making it easy and rational to be informed, can easily fail. So what does this say about bad-faith attempts to sell lousy investments through a smoke screen?
The Bottom Line
In this context, the regulators really do have an important role to play, but it needs to be done better than in the above case. Banks have to resolve the legally watertight vs. readability trade-off. Somehow, they need to get the message across clearly, but without opening themselves up to legal problems.
As always, investors must find out as much as they can, including who to trust, but they also need to understand and accept the limits of what they and others can and do know, and act accordingly. It is certainly advisable to buy only what you understand or trust, but as implied above, eliminating everything you dont understand fully, may mean burying your cash in the garden, which is not a great investment either.
Whisper Numbers: Should You Listen?
During earnings season - the time when companies publicly report their results from the last quarter - many whisper numbers can be heard floating around Wall Street and on the Internet. It can be a period of extreme stock market volatility; the companies that dont meet earnings estimates are usually hammered hard, and experience a decline in share price. However, even companies that meet earnings estimates can suffer if they dont match the seemingly mysterious whisper number. What are whisper numbers? Where do they come from? Well attempt to demystify the whisper number, and evaluate its importance to you as an individual investor. (To learn more, see 5 Tricks Companies Use During Earnings Season.)
Earnings Estimates
When a company releases its earnings, any increase or decrease in its profitability is secondary to how well the company fared compared to investor expectations. This is because a stocks price almost always takes into account all future information. In other words, how well (or poorly) a company is expected to do is already built into a stocks price. For example, the market will punish a company that is expected to grow earnings by 20% if actual earnings only increase by 15%. Conversely, a company thats expected to grow 10% but expands 12% will be rewarded. This phenomenon occurs because future earnings are the driving force behind share price valuations. An unexpected earnings surprise for a companys current quarter will very likely have far-reaching effects on earnings forecasts for many years to come, and can significantly change how investors calculate the present value of the companys shares. (For further reading, see Getting The Real Earnings and How To Evaluate The Quality Of EPS.)
It is not surprising, then, that most analysts spend the majority of their time trying to make an exact prediction of a companys future earnings, called forward earnings. Surprising or disappointing Wall Street estimates by even a few cents can have a dramatic effect on a stock. If a large brokerage firm can make a prediction that is even one cent more accurate than that of its competitors, it stands to earn a lot of extra money.
Taking things one step farther, there are companies out there that do nothing but sell earnings estimates to institutional investors. Their job is to contact as many brokerage firms as possible and get quarterly earnings predictions from each firms analysts. The estimates that you see in the newspaper, online or on TV are usually compiled by these firms, and are often reported as an average, or what is called a consensus estimate. Often, when you read the consensus estimate you will see that the highest and lowest estimate values are also reported - this can give you a sense of the variance of analysts estimations. Large proportional differences between the high and low estimates generally indicate greater uncertainty about a given earnings report. (To read more about earnings estimates, see Earnings Guidance: The Good, The Bad And Good Riddance?)
The Whisper Number
Even after plenty of research, however, consensus earnings estimates often still arent that accurate. An explanation might be that there just arent that many analysts covering the entire market. Large caps often have dozens of analysts, but there are plenty of mid-caps and small-caps who dont have any analyst coverage! On top of that, as news of the earnings estimate spreads, the game then turns to trying to predict what the discrepancy will be between the actual earnings and the estimates. (To learn more, see What Mutual Fund Market Cap Suits Your Style?)
This is where the whisper number comes into play. While the consensus estimate tends to be widely available, whispers are the unofficial and unpublished earnings per share (EPS) forecasts. In the past, these came from professionals on Wall Street and were meant for the wealthy clients of top brokerages. However, post Sarbanes-Oxley, the definition of whisper numbers has changed. You see, with all the regulations on Wall Street, you wont find analysts providing favorite clients with insider earnings data - the risk of getting in trouble with the SEC is just too great. (To learn more about the SEC, read Policing The Securities Market: An Overview Of The SEC.)
While over the past few years it has become more difficult (if not impossible) to get whispers from insiders on the street, a new type of whisper has emerged in which the expectations of investors as a whole (based on shared information, fundamental research and past earnings performance) create a sense of what to expect from a company, which spreads much like insider information.
In other words, the whisper now is the expectation from individual investors. The whisper is still unofficial, if you consider the consensus estimate to be the official number, but the difference is that it comes from individuals, not from professionals. The source has also changed from your broker, to websites that put the whisper together.
The most obvious concerns here are manipulation of this consensus by investors who have a vested interest in promoting (or trashing) a stock.
Should You Follow the Whisper?
While the quality of the source of a whisper number is certainly important, whether or not you should take heed of a whisper mostly depends on what type of investor you are. For a long-term (buy-and-hold) investor, the price action around earnings season will, over time, be merely a small blip, making the whisper number a relatively trivial statistic.
However if you are a more active investor who is looking to profit from share price changes during earnings season, a whisper can be a much more valuable tool. Differences between actual earnings results and consensus estimates can have a significant effect on a stocks price. Whisper numbers can be useful when they differ (and of course, are more accurate) than the consensus forecast. For example, a lower whisper can provide a signal to get out of a stock you own before earnings come out. Also, whisper numbers certainly have a use when it comes to the large number of stocks that arent covered by any analysts. If you are analyzing a stock with little coverage, a whisper number at least provides some insight into the upcoming financials.
There certainly is an ethical issue with what we referred to as the older type of whisper number. Lets assume that there are analysts breaking federal laws and providing you (or a website) with non-public information. Do you really want to take the chance with illegal data? While all investors are continually looking for a leg-up on the competition, insider trading laws are serious business - just ask Martha Stewart. (To learn more, see Should Insider Trading Be Legal?)
Conclusion
Whisper numbers used to be the unpublished EPS forecasts circulating around Wall Street, now they are more likely to represent the collective expectations of individual investors. For more active investors, an accurate whisper number can be extremely valuable over the short term. The extent to which this is important to you depends on your investing style. While whisper numbers arent a guaranteed way to make money (nothing is), they are another tool that serious investors should consider.
The Essentials Of Corporate Cash Flow
If a company reports earnings of $1 billion, does this mean it has this amount of cash in the bank? Not necessarily. Financial statements are based on accrual accounting, which takes into account non-cash items. It does this in an effort to best reflect the financial health of a company. However, accrual accounting may create accounting noise, which sometimes needs to be tuned out so that its clear how much actual cash a company is generating. The statement of cash flow provides this information, and here we look at what cash flow is and how to read the cash flow statement.
What Is Cash Flow?
Business is all about trade, the exchange of value between two or more parties, and cash is the asset needed for participation in the economic system. For this reason - while some industries are more cash intensive than others - no business can survive in the long run without generating positive cash flow per share for its shareholders. To have a positive cash flow, the companys long-term cash inflows need to exceed its long-term cash outflows. (For more, see What Is Money?)
An outflow of cash occurs when a company transfers funds to another party (either physically or electronically). Such a transfer could be made to pay for employees, suppliers and creditors, or to purchase long-term assets and investments, or even pay for legal expenses and lawsuit settlements. It is important to note that legal transfers of value through debt - a purchase made on credit - is not recorded as a cash outflow until the money actually leaves the companys hands.
A cash inflow is of course the exact opposite; it is any transfer of money that comes into the companys possession. Typically, the majority of a companys cash inflows are from customers, lenders (such as banks or bondholders) and investors who purchase company equity from the company. Occasionally cash flows come from sources like legal settlements or the sale of company real estate or equipment.
Cash Flow vs Income
It is important to note the distinction between being profitable and having positive cash flow transactions: just because a company is bringing in cash does not mean it is making a profit (and vice versa).
For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other.
What Is the Cash Flow Statement?
There are three important parts of a companys financial statements: the balance sheet, the income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a companys assets and liabilities (see Reading the Balance Sheet). And the income statement indicates the businesss profitability during a certain period (see Understanding The Income Statement).
The cash flow statement differs from these other financial statements because it acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the companys cash transactions (the inflows and outflows) during the given period. It shows whether all those lovely revenues booked on the income statement have actually been collected. At the same time, however, remember that the cash flow does not necessarily show all the companys expenses: not all expenses the company accrues have to be paid right away. So even though the company may have incurred liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are paid (see the section What Cash Flow Doesnt Tell Us below).
The following is a list of the various areas of the cash flow statement and what they mean:
• Cash flow from operating activities - This section measures the cash used or provided by a companys normal operations. It shows the companys ability to generate consistently positive cash flow from operations. Think of normal operations as the core business of the company. For example, Microsofts normal operating activity is selling software.
• Cash flows from investing activities - This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement.
• Cash flows from financing activities - This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see.
When you look at a cash flow statement, the first thing you should look at is the bottom line item that says something like net increase/decrease in cash and cash equivalents, since this line reports the overall change in the companys cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC
How To Manage Your Company Stock
If you work for a larger corporation theres a good chance that you have access to company stock as part of your compensation package. Your company may issue stock options or you may have access to company stock in your 401(k) retirement plan or an employee stock purchase plan. Heres what you need to know about managing company stock.
Its Not Different
When you think about your company stock, do you see it as a different kind of investment than you would make in the stock market? Does it feel more stable and secure to you since you know so much about the company? Holding company stock as part of your overall investment portfolio is no different than buying the stock of another company through your brokerage account.
The truth is that you likely have very little knowledge of news and events that would directly affect the price of the stock. Its illegal for company management to give you advance knowledge of coming events and if youre one of the decision makers that has access to the knowledge, youre aware of the tight restrictions you have when trading your stock.
Dont adopt a false sense of security because you work there. History is filled with past employees of now bankrupt companies that were left holding worthless company stock, (Enron, Lehman Brothers, etc.)
Dont Own More Than 10%.
If your main investment dollars are in a 401(k), no more than 10% of your 401(k) should be in company stock and some experts advise much less. If you have investments outside of your 401(k), your company stock should make up no more than 10% of your entire portfolio. How would you feel if you lost 10% of your portfolio? If that scares you, trim your company stock down to 5% or even less.
How About Company Stock Options?
Many employees make the mistake of letting their stock options gain too much value, because they dont understand how they work. They also dont understand that the value of stock options degrade over time. If youre awarded stock options, typically you receive a certain amount of options that have to go through a vesting period - this means that you cant exercise these options right away. Once youre able to exercise the options, you want the options to be above the strike price before you exercise.
Employee stock options not only have a minimum amount of time that goes by before you exercise the option, theres also a maximum. Count these options as part of your overall portfolio and although you shouldnt let this part of your portfolio become too large, when to exercise the options is complicated and best done with the help of a trusted financial adviser. Make sure they discuss the tax implications with you.
Should You Sell?
According to Reuters, purchasing company stock is on the decline and for good reason. For investors without the time or experience to manage individual stocks, mutual funds, some exchange traded funds and index funds are better, more diversified alternatives to owning single company stocks, even if the company happens to be your employer. If you dont have a high level of stock market knowledge, owning company stock outside of stock options is a bad idea.
The Bottom Line
The company stock you own in one of the many forms should not violate the rules of good diversification. No more than 10% of your portfolio should be in any one stock even if the company supplies your paycheck. Also remember that like any investment, company stock comes with the same risk as any other single stock. Dont hold a false sense of security since the company happens to employ you.
The 3 Moral Types Managing Your Money
In the late 1970s, business academic Archie Carroll published some now classic work on corporate ethics and social responsibility. His work includes the well-known CSR Pyramid (Corporate Social Responsibility), which deals with stakeholders, economic responsibilities, philanthropy and many other related issues.
Of particular relevance to private investors, however, are the three moral types commonly encountered in the industry. Your financial fate is influenced very substantially by whether your broker and/or his/her firm is immoral, amoral or moral. Each type is clearly differentiated from one another and you only want to give your money to the moral ones; the immoral and the amoral are to be avoided like the plague. We will now take a look at the differences between the three methods and what this could mean for your savings.
The Immoral, the Amoral and the Moral
Immoral brokers , fund managers and firms do not care about you at all. They want to make money out of you and not for you. They are motivated only by self-interest and regard clients as factors of production to be exploited, manipulated and bled. There can be no doubt that even though such people are only fit to be shunned, they abound in the industry, which has led to many mis-selling and mismanagement scandals, not to mention major crises in recent and less recent years. Some are in jail, and many others should be.
Amoral sellers are arguably not as bad, but they are bad enough. While not blatantly dishonest, they look after themselves and just do not bother about ethics. They keep to the letter of the law, but the spirit of the law is ignored. Therefore, they fulfill their regulatory obligations, but they do not look after your interests. They are unlikely to fleece you outright, but they can lose you a lot of money through indifferent management and bad advice.
Moral people are the only ones who deserve your money. They will treat your fairly, do their best for you and sell you only what they truly believe is what you want and what is suitable for you. Fortunately, there are such people out there, but the two groups of baddies and mega-baddies are there as well, and they all want your money. Only the moral ones have a conscience, and can be trusted and relied upon.
Why Is it Like This?
Human nature has produced all three types of morality for at least 2000 years, particularly in the context of money and wealth, and that is not going to change. All professions have their black sheep, but because the financial services industry deals only with money, it has more of these than elsewhere. Furthermore, due to the nature of the industry, there is a lot of money to be made from selling excessively risky and other forms of lousy products to the unwary; and the unwary have been around since the year dot.
This precarious scenario is exacerbated by the complexity of the industry; there are a plethora of local and international products. Furthermore, it is horrendously easy to present products so that they sound far better than they really are. People are also genuinely tempted by greed and offers that are too good to be true. This is an environment in which amorality and immorality thrive.
In fact, in this day and age, dishonest people with some financial or selling skills can make a fortune with minimal risk. Why pick locks, blow up safes or ride your horse into town with guns blazing, when you can put on a snazzy suit and pretend to be a gentleman, selling the investment of a lifetime?
SEE: 8 Ethics Guidelines For Brokers
How Do You Find the Moral Ones?
As is always the case, you need to be as educated as you can on investment issues, shop around and double check. I would also emphasize that there are other ways to spot what type of seller you are dealing with.
My experience is that you can tell a lot by observing how the brokers you deal with personally handle you and your money. If they seem to really want you to understand what you are getting, that is good. If they offer you a wide range of products and do not push just one or two, that is better. If the range includes various alternative risk-return combinations, some of which really do not earn so much for the seller, such as trackers, and funds with low or no up-front fees, then you could be dealing with a moral person.
Body language is also important. Keep an eye open for some telltale and quite reliable signs of lying. These include blinking, speech errors and hesitation, self-touching and doing weird things with ones hands. Jittery feet are supposed to be a reliable sign that you are dealing with the wrong moral type. Given the importance of body language, it is often safer to ensure that you deal with sellers personally, rather than just by email or on the phone.
In general, be perceptive and have a healthy level of cynicism. In this industry, cynicism is a good investment.
SEE: Choosing A Compatible Broker
The Bottom Line
What we have here are the good, the bad and the ugly aspects of the investment industry. These types are here to stay, but you can avoid the immoral and the amoral by being careful and watching for warning signs. Watch out for pushy selling, products or policies that you do not understand, and for patterns of behavior that just dont seem right. Make sure your money stays your own and grows over time. It can also help to understand some of the ethical issues your broker faces.
The Hidden Differences Between Index Funds
June 30 2012| Filed Under » Index Fund, Investing Basics, Investment, Mutual Funds
Think of your trips to the candy store as a child. Youd pick out your favorite candy ... lets say it was jelly beans. Orange tasted like oranges and yellow tasted like lemons; but sometime later, the yellow jelly beans you purchased might taste like pineapples, or popcorn! What was up with that? The lesson here, that appearances cant be trusted, can be applied to index funds too. Although a S
Investing In A Unit Investment Trust
A unit investment trust (UIT) is a U.S. investment company that buys and holds a portfolio of stocks, bonds or other securities. UITs share some similarities with two other types of investment companies : open-ended mutual funds and closed-end funds. All three are collective investments in which a large pool of investors combine their assets and entrust them to a professional portfolio manager. Units in the trust are sold to investors, or unit holders.
Basic Characteristics
Like open-ended mutual funds , UITs offer professional portfolio selection and a definitive investment objective. They are bought and sold directly from the issuing investment company, just as open-ended funds can be bought and sold directly through fund companies. In some instances, UITs can also be sold in the secondary market. Like open-ended mutual funds, UITs often have low minimum investment requirements and can often be purchased with an initial investment of as little as $1,000. (Learn about the basics - and the pitfalls - of investing in mutual funds, read the Mutual Fund Basics Tutorial.
Like closed-end funds, UITs are issued via an initial public offering (IPO). If purchased at the IPO, there are no embedded gains to be found in open-end mutual funds. Each investor receives a costs basis that reflects the net asset value (NAV) on the date of purchase, and tax considerations are based on the NAV. Open-ended funds, on the other hand, pay out dividends and capital gains each year to all shareholders regardless of the date on which the shareholder bought into the fund. This can result, for example, in an investor buying into a fund in November, but owing capital gains tax on gains that were realized in March. Even though the investor didnt own the fund in March, tax liability is shared among all investors on a yearly basis. (For more articles on taxes, check out the Tax Article Archive.)
Termination Date
Unlike either mutual funds or closed-end funds, a UIT has a stated date for termination. This date is often based on the investments held in its portfolio. For example, a portfolio that holds bonds may have a bond ladder consisting of five-, 10-, and 20-year bonds. The portfolio would be set to terminate when the 20-year bonds reach maturity. At termination, investors receive their proportionate share of the UITs net assets.
While the portfolio is constructed by professional investment managers, it is not actively traded. So after it is created, it remains intact until it is dissolved and assets are returned to investors. Securities are sold or purchased only in response to a change in the underlying investments, such as a corporate merger or bankruptcy. (Learn more about these corporate actions in the Mergers and Acquisitions Tutorial and An Overview Of Corporate Bankruptcy.)
Types
There are two types of UITs: stock trusts and bond trusts. Stock trusts conduct IPOs by making shares available during a specific amount of time known as the offering period. Investors money is collected during this period and then shares are issued. Stock trusts generally seek to provide capital appreciation, dividend income or both. Trusts that seek income may provide monthly, quarterly or semiannual payments. Some UITs invest in domestic stocks, some invest in international stocks and some invest in both.
Bond UITs have historically been more popular than stock UITs. Investors seeking steady, predictable sources of income often purchase bond UITs. Payments continue until the bonds begin to mature. As each bond matures, assets are paid out to investors. Bond UITs come in a wide range of offerings, including those that specialize in domestic corporate bonds, international corporate bonds, domestic government bonds (national and state), foreign government bonds or a combination of issues. (Find out if you need exposure to debt instruments in the Bond Tutorial.)
Early Redemption/Exchange
While UITs are designed to be bought and held until they reach termination, investors can sell their holdings back to the issuing investment company at any time. These early redemptions will be paid based on the current underlying value of the holdings. Investors in bond UITs should make particular note of this because it means that the amount paid to the investor may be less than the amount that would be received if the UIT was held until maturity, as bond prices change with market conditions.
Some UITs permit investors to exchange their holdings for a different UIT at a reduced sales charge. This flexibility can come in handy if your investment objectives change and the UIT in your portfolio no longer meets your needs.
Before You Buy
UITs are legally required to provide a prospectus to prospective investors. The prospectus highlights fees, investment objectives and other important details. Investors generally pay a load when purchasing UITs and accounts are subject to annual fees. Be sure to read about these fees and expenses before you make a purchase.
Dividend Facts You May Not Know
Money For Nothing is not only the title of a song by Dire Straits in the 80s, but also the feeling many investors get when they receive a dividend. All you have to do is buy shares in the right company and youll receive some of its earnings. How exciting is that? However, despite the advantage, there are several implications involved in the paying and receiving of dividends that the casual investor may not be aware of. This article will explain several of these. But first, lets begin with a short primer.
What Are Dividends?
Dividends are one way in which companies share the wealth generated by running the business. They are usually a cash payment, often drawn from earnings, paid to the investors in a company - the shareholders. These are paid on an annual or, more commonly, a quarterly basis. The companies that pay them are usually more stable and established, not fast growers. Those still in the rapid growth phase of their life cycle tend to retain all the earnings and reinvest them into the business.
Price Implications
When a dividend is paid, several things can happen. The first of these is what happens to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades . For most dividends this is usually not observed amidst the up and down movement of a normal days trading. However, this becomes easily apparent on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34.
The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company and this is reflected by a reduction in the companys market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the ex-dividend date, they no longer have a claim to the dividend, so the exchange adjusts the price downward to reflect this fact.
Historical prices stored on some public websites, such as Yahoo! Finance, also adjust the past prices of the stock downward by the dividend amount. Another price that is usually adjusted downward is the purchase price for limit orders. Because the downward adjustment of the stock price might trigger the limit order, the exchange also adjusts outstanding limit orders . The investor can prevent this if his or her broker permits a do not reduce (DNR) limit order. Note, however, that not all exchanges make this adjustment. The U.S. exchanges do, but the Toronto Stock Exchange, for example, does not
On the other hand, stock option prices are usually not adjusted for ordinary cash dividends unless the dividend amount is 10% or more of the underlying value of the stock.
Implications for Companies
Dividend payments, whether they are cash or stock, reduce retained earnings by the total amount of the dividend. In the case of a cash dividend, the money is transferred to a liability account called dividends payable. This liability is removed when the company actually makes the payment on the dividend payment date, usually a few weeks after the ex-dividend date. For instance, if the dividend was $0.025 per share and there are 100 million shares outstanding, retained earnings will be reduced by $2.5 million and that money eventually makes its way to the shareholders.
In the case of a stock dividend , though, the amount removed from retained earnings is added to the equity account, common stock at par value, and brand new shares are issued to the shareholders. The value of each shares par value does not change. For instance, for a 10% stock dividend where the par value is 25 cents per share and there are 100 million shares outstanding, retained earnings is reduced by $2.5 million, common stock at par value is increased by that amount and the total number of shares outstanding increases to 110 million.
This is different from a stock split, although it looks the same from a shareholders point of view. In a stock split , all the old shares are called in, new shares are issued, and the par value is reduced by the inverse of the ratio of the split. For instance, if instead of a 10% stock dividend, the above company declares an 11-to-10 stock split, the 100 million shares are called in and 110 million new shares are issued, each with a par value of $0.22727. This leaves the common stock at par value accounts total unchanged. The retained earnings account is not reduced either.
Implications for Investors
Cash dividends, the most common sort, are taxed at either the normal tax rate or at a reduced rate of 5% or 15% for U.S. investors. This only applies to dividends paid outside of a tax-advantaged account such as an IRA.
The dividing line between the normal tax rate and the reduced or qualified rate is how long the underlying security has been owned. According to the IRS, to qualify for the reduced rate, an investor has to have owned the stock for 60 consecutive days within the 121-day window centered on the ex-dividend date. Note, however, that the purchase date does not count toward the 60-day total.
Cash dividends do not reduce the basis of the stock.
Capital Gains
Sometimes, especially in the case of a special, large dividend, part of the dividend is actually declared by the company to be a return of capital. In this case, instead of being taxed at the time of distribution, the return of capital is used to reduce the basis of the stock, making for a larger capital gain down the road, assuming the selling price is higher than the basis. For instance, if you buy shares with a basis of $10 each and you get a $1 special dividend, $0.55 of which is return of capital, the taxable dividend is $0.45, the new basis is $9.45 and you will pay capital gains tax on that $0.55 when you sell your shares sometime in the future. (To read more about this, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)
There is a situation, though, where return of capital is taxed right away. This happens if the return of capital would reduce the basis below $0.00. For instance, if the basis is $2.50 and you receive $4 as a return of capital, your new basis would be $0 and you would owe capital gain tax on $1.50.
Basis is also adjusted in the case of stock splits and stock dividends. For the investor, these are treated the same way. Taking our 10% stock dividend example, assume that you hold 100 shares of the company with a basis of $11. After the payment of the dividend, you would own 110 shares with a basis of $10. The same would hold true if the company had a 11-to-10 split instead of that stock dividend.
Finally, as with everything else regarding investment record keeping, it is up to the individual investor to track and report things correctly. If you have purchases at different times with different basis amounts, return of capital, stock dividend and stock split basis adjustments must be calculated for each. Qualified holding times must also be accurately tracked and reported by the investor, even if the 1099-DIV form received during tax season states that all paid dividends qualify for the lower tax rate. The IRS allows the company to report dividends as qualified, even if they are not, if the determination of which are qualified and which are not is impractical for the reporting company.
Conclusion
Many investors see dividends as money for nothing, but the implications surrounding paying and receiving dividends can mean a lot of work for both the company and the investor. If you reinvest your dividends through a dividend reinvestment plan (DRIP) or equivalent, the paperwork and tracking of basis can become quite tedious. There is no such thing as a free lunch. As with every other aspect of investing, accurate records are important and it would probably behoove you to use a spreadsheet or similar tool to track such details.
More information can be found in various publications available from the IRS, especially Publication 550.
Should You Buy Stock Or An ETF?
After completing a thorough research of an attractive sector, you may like a couple of stocks and an exchange-traded fund (ETF) that fit your criteria. Now you need to decide, do I buy the stocks or the ETF? Investors encounter this question every day. Many are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. This is not necessarily true, depending on the characteristics of the sector.
SEE: Building An All-ETF Portfolio
Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. Of course, you want to generate a return that beats the market (create alpha.) Reducing the volatility of an investment is the general method of mitigating risk. Most rational investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio volatility an investor is exposed to. This is one way that diversification through ETFs works in your favor.
Alpha is the ability of an investment to outperform its benchmark. Any time you can fashion a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you must own stocks, rather than an ETF, to beat the market. This notion is not always correct. Being in the right sector can lead to achieving alpha, as well.
When Stock Picking Might Work
Industries or situations where there is a wide dispersion of returns, or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing, offer stock-pickers an opportunity to exceed.
Maybe you have a good legal insight on how well a company is performing, based on your research and experience. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value added investment opportunities, rewarding the stock investor .
The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products that they carry, creating an opportunity for the astute stock picker to do well.
SEE: Analyzing Retail Stocks
For example, recently you have noticed that your daughter and her friends prefer a particular retailer. Upon further investigation, you find that the company has upgraded its stores and hired new product management people. This led to the very recent roll out of new products that have caught the eye of your daughters age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.
Company insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a particular sector, where there is much return dispersion, single stock investments can provide a higher return than a diversified approach.
When an ETF Might Be the Best Choice
Sectors that do have a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar. For these sectors, the overall performance is fairly similar to the performance of any one stock. The utilities and consumer staples industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks. Since the dispersion of returns from utilities and consumer staples tends to be narrow; picking a stock does not offer sufficiently higher return for the risk that is inherent in owning individual securities. Since ETFs pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well.
Often, the stocks in a particular sector are subject to disperse returns, yet investors are unable to select those securities which are likely to continue over-performing. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.
SEE: How To Pick The Best ETF
If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess more difficult to evaluate technology or processes that cause them to underperform or do well. Perhaps their performance depends on the successful development and sale of a new unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low. The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials, or the FDA does not approve the drug application, the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.
The semiconductors, certain commodities and specialty technology groups fit the category where ETFs may be the preferred alternative. For example, if you believe that now is a good time to invest in the mining sector, you may want to gain specific industry exposure. However, you are concerned that some stocks might encounter political problems harming their production. In this case, it is prudent to buy into the sector rather than a specific stock, since it reduces your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.
When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFs, when there is a wide dispersion of returns from the mean. And you can gain an advantage using your knowledge of the industry or the stock.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, and regardless of return dispersions, an ETF is your best choice
SEE: 5 ETFs Flaws You Shouldnt Overlook
The Bottom Line
Whether picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go down the drain as time passes.
7 Lessons To Learn From A Market Downturn
You can never really understand investing until you weather a market downturn. The valuable lessons learned can help you through the bad times and can be applied to your portfolio when the economy recovers. Listed below are some common investor experiences during tough economic times and the lessons each investor can come away with after surviving the events.
Lesson #1: Evaluate Your Egg Baskets
Youre pulling your hair out because everything you invest in goes down. The lesson: Always keep a diversified portfolio, regardless of current market conditions.
If everything you own is moving in the same direction, at the same rate, your portfolio is probably not well diversified, and you could stand to reconsider your asset-allocation choices. The specific assets in your portfolio will depend on your objectives and risk-tolerance level, but you should always include multiple types of investments. (Read Personalizing Risk Tolerance to find out how much uncertainty you can stand.)
Taking a more conservative stance to preserve capital should mean changing the percentages of holdings from aggressive, risky stocks to more conservative holdings, not moving everything to a single investment type. For example, increasing bonds and decreasing small-cap growth holdings maintains diversification, whereas liquidating everything to money market securities does not. Under normal market conditions, a diversified portfolio reduces big swings in performance over time. (For more information, read Diversification: Its All About (Asset) Class.)
Lesson #2: No Such Thing as a Sure Thing
That stock you thought was a sure thing just tanked. The lesson: Sometimes the unpredictable happens. It happens to the best analysts, the best fund managers, the best advisors, and, it can happen to you.
The perfect chart interpretation, fundamental analysis, or tarot card reading wont predict every possible incident that can impact your investment.
• Use due diligence to mitigate risk as much as possible.
• Review quarterly and annual reports for clues on risks to the companys business as well as their responses to the risks.
• You can also glean industry weaknesses from current events and industry associations.
More often, an investment is impacted by a combination of events. Dont kick yourself over unpredictable or extraordinary events like supply-chain failures, mergers, lawsuits, product failures, etc. (Learn how to find companies that manage risk well in The Evolution Of Enterprise Risk Management.)
Lesson #3: Proper Risk Management
You thought an investment was risk-free, but it wasnt. The lesson: Every investment has some type of risk.
You can attempt to measure the risk and try to offset it, but you must acknowledge that risk is inherent in each trade. Evaluate your willingness to take each risk. (See Measuring And Managing Investment Risk for information on keeping necessary risk under control.)
Lesson #4: Liquidity Matters
You always stay fully invested, so you miss out on opportunities requiring accessible cash. The lesson: Having cash in a certificate of deposit (CD) or money market account enables you to take advantage of high-quality investments at fire sale prices. It also decreases overall portfolio risk.
Penny stocks are the secret to 2000% profits!
Plan ahead to replenish cash accounts. For example, use the proceeds from a called bond to invest in the money market instead of purchasing a new bond.Sometimes cash can be obtained by reorganizing debt or trimming discretionary spending. Set a specific percentage of your overall portfolio to hold in cash. (Learn how to take advantage of the safety of the money market in our Money Market tutorial.)
Lesson #5: Patience
Your account balance is lower than it was last quarter, so you overhaul your investment strategy before taking advantage of your current investments. The lesson: Sometimes it takes the market an extended period of time to bounce back.
Your overall portfolio balance on a given date is not as important as the direction it is trending and expected returns for the future. The key is preparedness for the impending market upturn based on an estimated lag time behind market indicators. Evaluate your strategy, but remember that sometimes patience is the solution. (Doing nothing can mean good returns. Find out more in Patience Is A Traders Virtue.)
Lesson #6: Be Your Own Advisor
The market news gets bleaker every day - now youre paralyzed with fear! The lesson: Market news has to be interpreted relative to your situation.
Sometimes investors overreact, particularly with large or popular stocks, because bad news is replayed continuously via every news outlet. Here are some steps you can follow to help you keep your head in the face of bad news:
• Pay attention and understand the news, then analyze the financials yourself. (Read What You Need To Know About Financial Statements for help.)
• Determine if the information represents a significant downward financial trend, a major negative shift in a companys business, or just a temporary blip.
• Listen for cues the company may be downgrading its own expected returns. Find out if the downgrade is for one quarter, one year or if it is so abstract you cant tell.
• Conduct an industry analysis of the companys competitors.
After a thorough evaluation, you can decide if your portfolio needs a change. (For more information, read Do You Need a Financial Advisor?)
Lesson #7: When to Sell and When to Hold
The market indicators dont seem to have a silver lining. The lesson: Know when to sell existing positions and when to hold on.
Dont be afraid to cut your losses. If the current value of your portfolio is lower than your cost basis and showing signs of dropping further, consider taking some losses now. Remember, those losses can be carried forward to offset capital gains for up to seven years. (For more information, read Selling Losing Securities For A Tax Advantage.)
Selective selling can produce cash needed to buy investments with better earnings potential. On the other hand, maintain investments with solid financials that are experiencing price corrections based on expected price-earnings ratios. Make decisions on each investment, but dont forget to evaluate your overall asset allocation. (Read more in Asset Allocation: One Decision To Rule Them All.)
Conclusion
Downward stock market swings are inevitable. The better-prepared you are to deal with them, the better your portfolio will endure them. You may have already learned some of these lessons the hard way, but if not, take the time to learn from others mistakes before they become yours.
Surviving Bear Country
A bear market refers to a decline in stock prices of at least 15-20%, coupled with pessimistic sentiment underlying the market. Clearly no stock investor looks forward to these periods. Dont despair, there is hope! In this article we will walk you through some of the most important investment strategies and mindsets that one can use to limit losses - or even make gains - while the stock market is performing in such a manner.
Be Realistic!
First off, having a realistic mindset is one the most important things to do during an economic slowdown. Remember that its normal for the stock market to have negative years - its all part of the business cycle.
After a raging bull market, its easy to forget the bad times. Take, for example, the late 1990s; it was a time of spectacular growth in the equity markets, punctuated by gains in the S
3 Ways To Increase Your Investment Performance
November 10 2011| Filed Under » Investing Basics, Investment, Stocks
Although buy low and sell high is a strategy that has resulted in big accumulations of wealth, this isnt how the professionals find their success. Instead, a savvy investor strategically deploys their money, in order to allow it to work in more than one way; they multitask their money.
The retail investor who is accustomed to working with stocks can simultaneously put their money to work in three ways:
• Price Action - The stock will hopefully rise in value
• Dividend - The fee a company pays you in exchange for using your money.
• Call Revenue - The money an investor pays you when you sell a covered call against your stock.
Price Action
If investing were a game, the way youd win would be to buy a stock at a low price and sell it at a higher price, on a later date. If you own a home, you understand this concept in a very practical way.
In order to make a profit on your investment, its often best to use one of two strategies to do that. The first is called value investing. Stocks, just like the products you purchase every day, go on sale from time to time and value investors wait for that sale price. This makes it even easier to make a profit, because stocks that are undervalued (on sale) have more room to grow. (Learn how to value invest, read 5 Must-Have Metrics For Value Investors. and The Value Investors Handbook.)
The second way is momentum trading. Some investors believe that the best time to buy a stock is when it continues to go higher, because just as we learned in grade school, an object in motion tends to stay in motion. The problem with momentum trading is that it tends to work better for shorter-term investors. For our strategy, we want to think long term. The more years you hold the stock, the better your potential returns could be.
How to Pick Your Stock
Your favorite stock may not work for this strategy, because it must pay a dividend, it must have a price that is cheap enough that you can purchase 100 shares, and it must trade a lot of shares each day; at least 1 million shares of daily volume is best. Remember that a companys value is not based on its price. There are a lot of high quality stocks that are under $30 per share and there are a lot of low quality stocks that trade above $100. I have found that stocks between $15 and $30, with at least a 2% dividend yield, are ideal. Finally, you dont want a highly volatile stock. If it has wild price swings, that will be much tougher to manage.
This is where you put your stock research and evaluation skills to work. Once you find your stock, assuming that you want to value invest, look for this name to be in the middle, or towards the bottom, of the trading range for the past 52 weeks. If it isnt there now, either wait for it to give you a price that you want, or find another company. There are plenty of worthy candidates for this strategy. (Learn more in Enter Profitable Territory With Average True Range.)
Dividend
In a high-tech stock trading world, investing for a dividend might be considered boring, but dividends can be a big income source for the long-term investor. Between 1929 and 1990, 40% of all stock market gains were a result of that boring, quiet dividend, according to the research report High Yield, Low Payout by Credit Suisse.
The dividend gives us two advantages that help our money work for us in more than one way. Firstly, it gives us a stable income. Sure, a company can choose to pay or not pay a dividend, as they would like, but for a high quality company, with a low payout ratio, there is a lower chance of the dividend on a quarterly payment getting cut. Secondly, it lowers your cost basis for the stock you purchased.
Lets assume that you did your research and decided on stock XYZ. You bought 100 shares for $30 per share, which at the time had a 3% dividend yield.
$3,000 x 3% = $90 each year. Not only are you making $90 each year, but since a dividend is paid to you in cash into your account (most of the time), each year that you own your 100 shares, you can apply that dividend payment to what you paid for the stock and, in this case, subtract 90 cents per share. After just five years, your stock that cost you $30 per share, goes down to $25.50 per share. Many long-term investors reduce the price they paid for a stock to $0, just from the dividend. (Learn more about this in How do I figure out my cost basis on a stock investment?)
Covered Call
Covered calls are a little more complicated. If you dont feel confident with this leg of the strategy, buying a stock and collecting the dividend as it goes higher will still be an impressive gain. (If you dont know how a covered call works, read about them here: The Basics of Covered Call.)
Before we sell the covered call we have to make two important decisions:
• What is the strike price?
• How many months into the future do we want our contract to expire?
Strike Price
A covered call is an options contract strategy that gives the holder of the contract the right to purchase your 100 shares, if it is at or above the strike price. Presumably, you dont want your shares taken from you, although you may change your mind in later years, so your strike price needs to be high enough that the stock doesnt rise above the strike price, but low enough that you can still collect a healthy premium for the risk youre taking.
This decision is tough. If your stock is in a downtrend, you can probably sell an option with a strike that isnt much higher than the stocks current price. If the stock is in an uptrend, for the sake of safety, consider waiting to sell the call, until you believe the move up has run its course, and the stock will soon go the other way. Remember, when the stock rises in value, the value of your option falls. This also adds the benefit of the covered call acting as a hedge. (For more advanced reading on these types of strategies, check out An Alternative Covered Call Options Trading Strategy.)
Expiration Date
The further into the future you take your option, the more of a premium you will be paid upfront, to sell the call, but thats also more time that your stock has to stay below the strike price, to avoid having it called away from you. For your first contract, consider going three months into the future.
The covered call will make money for you as soon as you sell it, because the premium that the buyer paid is deposited directly in to your account. It will continue to make money for you if the price of your stock falls. As the price falls, so does the premium. You can purchase the contract back from the buyer at any time, so if the premium falls, you can purchase it for less than you sold it. That equals profit. On the other hand, if the stock rises above the strike price, you can purchase the contract for more than you sold it and incur a loss, but it saves you from having to give up your 100 shares.
One of the best ways to use the covered call is for the collection of the premium at the beginning, and although you can buy the option back if it goes up or down, save this for severe circumstances. Also remember that the money you collect by selling your covered call can also be subtracted from the price you paid for the stock (For more, check out Cut Down Option Risk With Covered Calls.)
Go Virtual
The best way to learn a complicated investing strategy, like the covered call, is by using a virtual platform where you dont have to worry about losing real money. You can still purchase the stock and collect the dividend, but wait to sell the covered call until youre comfortable with how it works.
The Bottom Line
For most investors, putting money in high quality stocks for long periods of time, while harnessing dividend income, is the best way to make money in the market. Later, once you understand how to use the covered call, you can significantly increase your yield. Although the fixed income side of investing isnt as thrilling to watch, it is the most appropriate for retail investors and as we can see, the numbers can add up fast.
How To Efficiently Read An Annual Report
A companys annual report is the single most important way for it to convey itself to potential investors. As such, it should come as no surprise that an annual report serves to present the company in best light possible without violating any Securities and Exchange Commission (SEC) regulations. Unfortunately, many investors read annual reports but fail to read them effectively. In other words, while annual reports are clearly prepared without any intent to deceive or reflect dishonesty about the business, investors should always read them with a sense of skepticism. In other words, learn how to read between the lines and decipher the actual condition of the company. Annual Report Vs. 10-K Filing
Typically, a company will file both an annual report and 10-K report to the SEC. An annual report is the shorter version that often comes with pictures, nice glossy color pages, a letter from the Chairman/CEO and an overview of the financials.
The 10-K is the black and white, no color pictures document that is submitted to the SEC. Very often, a business will simply file the 10-K as its annual report since that document is mandatory for every public company. So guess which one carries more significance to the investor - the longer and more boring 10-K filing. Think of the glossy annual report as informative marketing material. If a company does file both reports, use the annual report as a great first look at a business before tackling the 10-K filing. Very often, the annual report and 10-K are merged into one document, with the annual report at the beginning to provide an overview of the years results.
The Components of an Annual Filing
If you are interested in investing in a public company you can not avoid examining and reading the 10-K filing, which I will now refer to as the annual report.
The 10-Ks begin with a detailed description of the business, followed by risk factors, a rundown of any legal issues, and, finally, the numbers and financial notes in the back. Oftentimes, the most essential components of the annual filing are the following items:
• Item 1: Business - a description of the companys operation
• Item 1A: Risk Factors
• Item 3: Legal Proceedings
• Item 6: Selected Financial Data
• Item 7: Managements Discussion and Analysis of Financial Condition
How to Tackle
People read annual reports in different ways. Some investors even prefer to start at the back and work their way to the beginning. It makes no difference how you read them, as long you absorb the essential points of the business and its financial condition. However, there is a good way to tackle these reports that is both most efficient and most effective.
Without question, you should first read Item 1, which is the business description. You cant possibly go any further in your research without knowing what the company does! Also, by getting to know the business first, you can then determine if you need to go any further. That determination is simple. Just ask yourself if you understand what the company does, who its customers are, and the industry it operates in. If you answer no, youre done. Move on to the next business.
Next, you should jump to Items 6 and 7 and examine and analyze the financial data . How has the company performed over a period of years? Has the balance sheet gotten stronger or weaker over time? Look over the cash flow statement and see if the business has been a generator of cash or a user of cash. Its possible for businesses to report net income while at the same time remaining cash flow negative. Compare the income statement with the cash flow statement for any red flags. If you like what you see, move on and if not, move on to the next company.
Afterwards its time to determine if any hidden surprises may lurk beneath the surface. So you must now go back and read the risk factors section and the legal proceedings section, if any legal matters exist. Because this is a filing to the SEC, the risk factors will be very detailed and include risks like our industry is highly fragmented with lots of competitors or our stock price may experience periods of volatility. While these are important risks to consider, they should not significantly reduce the desirability of the business.
Instead, focus on any unusual risk factors, such as if the company generates a substantial portion of its revenues for one or two customers. In addition, the Legal Proceedings section will alert you if any significant lawsuits are in the works. Again, dont ignore any legal liabilities, but if youre looking at a billion dollar company and it has a pending lawsuit against it for damages of $10 million, thats not uncommon. Pfizer, one of the largest drug companies in the world, will also have patent lawsuits and drug liability claims that may exceed hundreds of millions of dollars. But thats part of the normal course of business for any major pharmaceutical company, and a drop in the bucket for Pfizer when you see that the company has over $50 billion in cash and short-term investments on the balance sheet.
Focus on What You Know
We all have different ways of deciphering and storing information. Feel free to read the annual report in a way that works for you. But learn to concentrate on the most important aspects of a companys 10-K filing. By doing so, you will avoid wasting unnecessary time on companies that do not meet your investment suitability. But always remember that just because you arent investing in that particular business that you have wasted your time. Investing is a discipline that rewards those who are continuously learning.
Going All-In: Comparing Investing And Gambling
How many times during a discussion with friends about investing have you heard someone utter: Investing in the stock market is just like gambling at a casino? Is this adage really true? Lets examine these two activities more closely and see if we can point out some of the key differences and also some surprising similarities.
Investing and gambling both involve risk and choice. Interestingly, both the gambler and the investor must decide how much they want to risk. Some traders typically risk 2-5% of their capital base on any particular trade. Longer-term investors constantly hear the virtues of diversification across different asset classes. This, in essence, is a risk management strategy, and spreading your dollars across different investments will likely help minimize potential losses.
Gamblers must also carefully weigh the amount of capital they want to put in play. Pot odds are a way of assessing your risk capital versus your risk reward: the amount of money to call a bet compared to what is already in the pot. If the odds are favorable, the player is more likely to call the bet. Most professional gamblers are quite proficient at risk management. In both gambling and investing, a key principle is to minimize risk while maximizing profits.
Throwing It in the Pot
Sports betting is probably one of the most common gambling activities in which the average person engages. From the weekly football office pool to the Final Four, sport betting is an American tradition. Only by thinking about your betting habits will you realize that you have no way to limit your losses. If you pony up $10 a week for the NFL office pool and you dont win, you lose all of your capital. When betting on sports (or really any other pure gambling activity), there are no loss-mitigation strategies.
This is a key difference between investing and gambling. Stock investors and traders have a variety of options to prevent total loss of risked capital. Setting stop losses on your stock investment is a simple way to avoid undue risk. If your stock drops 10% below its purchase price, you have the opportunity to sell that stock to someone else and still retain 90% of your risk capital. However, if you bet $100 that the Jacksonville Jaguars will win the Super Bowl this year, you cannot get part of your money back if they just make it to the Super Bowl. Betting on sports is truly a speculative activity which prevents individuals from minimizing losses.
Another key difference between the two activities has to do with the concept of time. Gambling is a time-bound event while an investment in a company can last several years. With gambling, once the game or hand is over, your opportunity to profit from your wager has come and gone. You either have won or lost your capital. Stock investing , on the other hand, can be time-rewarding. Investors who purchase shares in companies that pay dividends are actually rewarded for their risked dollars. Companies pay you money regardless of what happens to your risk capital, as long as you hold on to their stock. Savvy investors realize that returns from dividends are a key component to making money in stocks over the long term.
Playing the Odds
Both stock investors and gamblers look for an edge in order to help enhance their performance. Good gamblers and great stock investors study behavior in some form or another. Gamblers playing poker typically look for cues from the other players at the table, and great poker players can remember what their opponents wagered 20 hands back. They also study the mannerisms and betting patterns of their opponents with the hope of gaining useful information. This information may be just enough to help predict future behavior. Similarly, some stock traders study trading patterns by interpreting stock charts. Stock market technicians try to leverage the charts to glean where the stock is going in the future. This area of study dedicated to analyzing charts is commonly referred to as technical analysis. (To learn more, see our Technical Analysis Tutorial.)
Another difference between investing and gambling is the availability of information. Information is a valuable commodity in the world of poker as well as stock investing. Stock and company information is readily available for public use. Company earnings, financial ratios and management teams can be studied before committing capital. Stock traders who make hundreds of transactions a day can use the days activities to help with future decisions. Nonetheless, stock information is far from perfect, otherwise, there would not be insider trading or the Securities and Exchange Commission (SEC).
If you sit down at a Blackjack table in Las Vegas, you have no information about what happened an hour, a day or a week ago at that particular table. You may hear that the table is either hot or cold, but that information is not quantifiable.
Conclusion
The next time you hear someone say that stock investing is the same as playing in a casino, remind them that in fact there are some similarities and some major differences. Both activities involve risk of capital with hopes of future profit. Gambling is typically a short-lived activity, while stock investing can last a lifetime. Some companies actually pay you money in the form of dividends to go along with an ownership stake. In general, most average investors will do better investing in stocks over a lifetime than trying to win the World Series of Poker.
5 Ways To Invest $5,000
In this economy, $5,000 may feel like a lot more money than it did just a few years ago. There are numerous ways that you may find yourself with an extra $5,000: a bonus at work, inheritance, an extra contract job that you werent expecting or a tax refund. Maybe you have it now or youre expecting it soon, but regardless of the time frame, what are you expecting to do with the money? Here are a few ideas that may help.
Pay off Credit Cards
If your household has credit card debt, you have, on average, $15,956 worth. Almost one third of that debt could be wiped out with that $5,000. If your credit card interest rate is average, you are paying 13% ,or $650 each year, to hold that balance. That $5,000 could reduce the interest youre building up by $54 a month. How long was it going to take you to save $5,000 for the sole purpose of paying your credit card debt? If it was two years, you just saved $1,300 making the return on your $5,000 - 26% over two years or 13% per year. Any investor would be very happy with that figure. Although its not necessarily fun, the best return youll get on your money is to service your debt.
High Quality Stocks
Investing in high quality, dividend paying stocks for a long period of time has shown to be a very safe investment. Because its nearly impossible to pick the few correct stocks that will perform better than the overall market, look at an index mutual fund or exchange traded fund (ETF) that tracks the total stock market.
Historic returns for the stock market over the past 50 years have averaged around 10%, making this a good investment, but not nearly as good as paying down debt.
Education
The cost of a college education has risen 130% in the last 20 years, according to USA Today. If you have a two-year old child now, the cost to send your child to college in 16 years will be $95,000, if he or she chooses a college in the state where you are a resident. If your child chooses a private university, the cost rises to as high $340,000, if college inflation rates stay as they are for another 16 years.
The best way to save for college is to use a 529 plan. These tax advantaged college savings accounts are similar to 401(k) plans where you contribute a certain amount into the plan, the money is invested into funds of your choice and you withdraw those funds when the child reaches college age.
Some 529 plans allow you to purchase years of college at todays rates for use when the child reaches college age, but most plans now invest the money without guaranteeing future results. That same $5,000 is a great start to put in a plan like this, and although the returns will average less than the overall stock market , the plan is one of the best ways to save for future college expenses.
Bond ETFs
An ETF is a basket of investment products packaged into one fund. They often come with low fees, yet offer the safety of a diverse portfolio. Some of these ETFs hold bonds, which are historically safer than stocks. Some bond ETFs have dividends of 7% or more and, barring any large investment market event, those dividends are quite safe, because of the hundreds or even thousands of bonds held in these funds. If you choose to invest in Bond ETFs, you may need to ask for help from a trust financial adviser.
Start a Small Business
If your debts are paid, you dont have children or youre well on your way to having your kids college education paid for, consider starting a small business. To get your business off of the ground, $5,000 may not go very far, but some service-type businesses have very little startup costs. Before committing the money to a small business , make sure to carefully weigh the time and financial commitment that will come with this type of endeavor.
Forecasting the annual return is nearly impossible due to the many variables that come with starting a business, but even more important, this might jump-start your dream of becoming an entrepreneur.
The Bottom Line
Even if it isnt $5,000, before deciding how to utilize a larger sum of money that found its way into your bank account, think more long term. Sure, you could purchase the big TV that youve wanted for a long time but is that the best decision to make for years to come?
Callable CDs: Check The Fine Print
If youre looking for bigger yields with limited risk, callable certificates of deposit (CD ) might be right for you. They promise higher returns than regular CDs and are FDIC insured. However, there are a few things in the fine print that you should be aware of before you turn your money over to the bank or brokerage firm, otherwise, you could end up very disappointed.
Just like a regular CD, a callable CD is a certificate of deposit that pays a fixed interest rate over its lifetime. The feature that differentiates a callable CD from a traditional CD is that the issuer owns a call option on the CD and can redeem, or call, your CD from you for the full amount before it matures. In this article, we will provide you with some important terms to watch for in the fine print of your callable CDs , should you decide to invest.
Important Terms
Callable CDs are similar in many ways to callable bonds.
Callable Date
This is the date that the issuer can call your certificate of deposit . Lets say, for example, that the call date is six months. This means that six months after you buy the CD, the bank can decide whether it wants to take back your CD and return your money with interest. Every six months after the call date, the bank will have that same option again. Well get to why the bank would want to call back the certificate shortly.
Maturity Date
The maturity date is how long the issuer can keep your money. The farther in the future the maturity date, the higher the interest rate you should expect to receive. Make sure you dont confuse maturity date with the call date. For instance, a two-year callable CD does not necessarily mature in two years. The two years refers to the period of time you have before the bank can call the CD away from you. The actual amount of time you must commit your money could be much longer. Its common to find callable CDs with maturities in the range of 15 to 20 years.
To Call, or Not to Call
A change in prevailing interest rates is the main reason the bank or brokerage firm will recall your CD on the callable date. Basically, the bank will ask itself if its getting the best deal possible based on the current interest rate environment. (To learn how interest rate changes affect other investments , see How Interest Rates Affect The Stock Market and Its In Your Interest.)
Interest Rates Decline
If interest rates fall, the issuer might be able to borrow money for less than its paying you. This means the bank will likely call back the CD and force you to find a new vehicle to invest your money in.
Example - Callable CD When Rates Decline
Suppose you have a $10,000 one-year callable CD that pays 5% with a five-year maturity. As the one-year call date approaches, prevailing interest rates drop to 4%. The bank has therefore dropped its rates too, and is only paying 4% on its newly issued one-year callable CDs.
Why should I pay you 5%, when I can borrow the same $10,000 for 4%?, your banker is going ask. Heres your principal back plus any interest we owe you. Thank you very much for your business.
The good news is that you got a higher CD rate for one year. But what do you do with the $10,000 now? Youve run into the problem of reinvestment risk.
Perhaps you were counting on the $500 per year interest ($10,000 x 5% = $500) to help pay for your annual vacation. Now youre stuck with just $400 ($10,000 x 4% = $400) if you buy another one-year callable CD. Your other choice is to try to find a place to put your money that pays 5% such as by purchasing a corporate bond - but that might involve more risk than you wanted for this $10,000 . (For more on the risks of these bonds, see Corporate Bonds: An Introduction To Credit Risk.)
Interest Rates Rise
If prevailing interest rates increase, your bank probably wont call your CD. Why would it? It would cost more to borrow elsewhere.
Example - Callable CD When Rates Rise
Lets look at your $10,000 one-year callable CD again. Its paying you 5%. This time, assume that prevailing rates have jumped to 6% by the time the callable date hits. Youll continue to get your $500 per year, even though newly issued callable CDs earn more. But what if youd like to get your money out and reinvest at the new, higher rates?
Sorry, your banker says, only we can decide if youll get your money early.
Unlike the bank, you cant call the CD and get your principal back - at least not without penalties called early surrender charges. As a result, youre stuck with the lower rate. If rates continue to climb while you own the callable CD, the bank will probably keep your money until the CD matures.
What to Watch For
Whos Selling
Anyone can be a deposit broker to sell CDs. There are no licensing or certification requirements. This means you should always check with your states securities regulator to see whether your broker or your brokers company has any history of complaints or fraud.
Early Withdrawal
If you want to get your money before the maturity date, there is a possibility youll run into surrender charges. These fees cover the maintenance costs of the CD and are put in place to discourage you from trying to withdraw your money early. You wont always have to pay these fees; if you have held the certificate for a long enough period of time these fees will often be waived.
Check the Issuer
Each bank or thrift institution depositor is limited to $100,000 in FDIC insurance. There is a potential problem if your broker invests your CD money with an institution where you have other FDIC insured accounts. If the total is more than $100,000, you run the risk of exceeding your FDIC coverage. (To learn more, read Are Your Bank Deposits Insured?)
Wrap Up: Callable or Non-Callable?
With all of the extra hassle they involve, why would you bother to purchase a callable CD rather than a non-callable one? Ultimately, callable CDs shift the interest-rate risk to you, the investor. Because youre taking on this risk, youll tend to receive a higher return than youd find with a traditional CD with a similar maturity date.
Before you invest, you should compare the rates of the two products. Then, think about which direction you think interest rates are headed in the future. If you have concerns about reinvestment risk and prefer simplicity, callable CDs probably arent for you.
Use this checklist when you are shopping for callable CDs to help you keep track of the important information.
Callable CD Checklist
Traditional CD Callable CD #1 Callable CD #2
Callable Date N/A
Maturity Date
Seller Background
Surrender Fee
Issuer
Interest Rate
9 Tips For Safeguarding Your Accounts
Wisely managing your investments includes taking advantage of all possible protections. While you may already be aware of the Federal Deposit Insurance Corporation (FDIC) insurance for your bank-deposited funds, there are other ways to divide up your funds, lower your potential risk of loss and guarantee your moneys safety. Read on for some ways to keep your money safe that you may want to consider in a bear market. (For background reading, see Are Your Bank Deposits Insured?)
No. 1: Use a brokerage account to invest in brokered CDs.
By opening an account with a brokerage firm you can invest in brokered CDs. These are typically CDs with large denominations, which are issued by banks to brokerage firms for their customers investments. Brokers pool investors funds to purchase the CDs, enabling investors to get a share in larger CDs (with potentially higher interest rates) than what they would be able to access by investing on their own. Brokered CDs also allow investors to buy multiple CDs issued by different banks and qualify for FDIC coverage for each CD held.
Before investing in brokered CDs be sure that:
• You understand the terms and features of each CD you invest in
• The bank offering the CD is an FDIC-insured bank
• You dont invest in a CD offered by a bank where you already hold accounts (because you may inadvertently exceed the FDIC insured limit)
• You get documentation of your ownership (or partial ownership) of the CD from your broker (i.e. a copy of the CDs title) to ensure that you qualify as a depositor for the FDIC coverage. (To learn more, read Are Your Bank Deposits Insured?)
No. 2: Bank with a credit union that carries private excess share insurance.
Some credit unions that are members of the National Credit Union Association (NCUA) carry excess share insurance to provide members with additional coverage for their deposit accounts. (To read more about credit unions, see Tired Of Banks? Try A Credit Union and Choose To Beat The Bank.)
No. 3: Open an account with a DIF- or SIF-insured bank.
The Deposit Insurance Fund (DIF) is a private company headquartered in Massachusetts that provides insurance on deposit accounts for participating state-chartered savings banks. The Share Insurance Fund (SIF) is also a private fund that insures deposit accounts for Massachusetts-chartered co-operative banks. DIF and SIF member banks guarantee depositors funds above the FDIC limit, regardless of both the FDIC limit and the amount of money held by the depositor. All deposit account types are guaranteed, including savings and checking accounts, CDs, money market and retirement deposit accounts. By providing both FDIC insurance and DIF or SIF insurance, member banks can guarantee that their depositors funds are fully insured. Once you open a deposit account with a DIF or SIF member bank, there are no additional qualification tests to meet or forms to complete. In addition, you do not need to be a Massachusetts residents to do business with a DIF or SIF member bank.
No. 4: Invest in CDs with a CDARS network member institution.
When you invest at least $10,000 in a CD with a Certificate of Deposit Account Registry Service (CDARS) member bank, you can get up to $50 million in FDIC insurance. Thats because a CDARS bank can take your large deposit, divide it up into smaller denominations and invest in multiple CDs across the network of member banks, ensuring that you qualify for FDIC insurance protection with each investment at each member bank. By using a CDARS network member bank, you can secure one interest rate on multiple CD investments and choose the maturities that best suit your investment goals. You pay an annual fee for the service and receive one statement summarizing all of your CD investments. (For related reading, see Are CDs Good Protection For The Bear Market?)
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No. 5: Open an MMAX money market account.
The Institutional Deposits Corporation (IDC) offers the Money Market Account Xtra (MMAX) through its network of participating community banks nationwide to depositors looking for additional FDIC insurance. When you open an MMAX Account, your participating IDC bank uses its relationship with other participating IDC network members to guarantee FDIC insurance for your total account balance up to $5 million. You are limited to making six withdrawals from your MMAX account monthly.
No. 6: Research your broker and brokerage firm.
While you are responsible for making and approving decisions related to your investments, its important to know your brokers, and his or her firms, record to avoid becoming a potential victim of fraud. You should check into whether your broker is properly licensed and registered and that he or she has not been the subject of investor complaints or investigation. (To learn more, read Broker Gone Bad? What To Do If You Have A Complaint and Evaluating Your Broker.)
No. 7: Check for SIPC Protection.
Check to make sure your brokerage accounts are protected by the Securities Investor Protection Corporation (SIPC). SIPC guarantees up to $500,000 of your invested funds (up to $100,000 in cash) in the event that your stocks or securities are stolen by a dishonest broker or the firm holding your investments fails and your assets are found missing. (To learn more, read Are My Investments Insured Against Loss?)
No. 8: Know your investment time horizon.
Make sure that money you will need in the short-term is invested in low-risk vehicles such as CDs, T-bills and bonds or bond funds. The closer you are to the time when you will need to access your funds, the less risk you can afford to take that you might lose your principal. (For more insight, read Personalizing Risk Tolerance.)
No. 9: Keep good records of all your investment transactions.
If you are concerned that you may be a victim of fraud or if you are simply concerned that there may be inaccurate information on your investment accounts, you will need copies of your account activity to rectify the error(s), file a complaint or take legal action. (To learn more about personal responsibility in the investing process, read Are You A Good Client?)
Conclusion
Investing is never risk-free, but there are ways to reduce your risk and gain additional insurance coverage for your funds. Take the time to protect your funds and your peace of mind by checking out options available beyond FDIC bank deposit insurance.
Uncovering The Securities Firm
December 31 2011| Filed Under » Brokers, Careers, Investing Basics, Portfolio Management
As individual investors, many of us trust our money to large securities firms or investment dealers. Typically employing tens of thousands of employees, the most recognized firms give investors confidence that their investment funds are managed by a seasoned team of professionals. However, we usually interact with these large businesses only by means of a single intermediary, such as our investment advisor or broker. So how does a large securities house really work? In this article, we will look at a typical securities firm, including its different departments and the roles of various employees. (To learn more about financial planners read Financial Planners: Practice What You Preach.)
TUTORIAL: Investing 101 For Beginner Investors
Departments and Divisions
Typically, a large firm has the following departments: sales, underwriting and financing, trading, research and portfolio, and administration. There are many small boutique firms that may serve only a single department of a business (i.e. retail sales), but even in this limited operation, their activities might resemble those of the respective department of a larger firm.
Sales
Sales is likely the department employing the largest number of people in the firm and it is the area that individual retail investors interact with the most. Within the retail sales force, investment advisors may focus on servicing a specific area of the investment industry, or they may provide a one-stop-shop for all retail investment needs. For example, an investment advisor may perform only those services that are associated with a stock broker, or offer other services as well, such as stock and mutual fund transactions, bond trading, life insurance sales and so forth. In a small firm, the activities of the investment advisor are likely to be more diverse.
A second division within the sales department is institutional sales. It is primarily involved in selling new securities issues to traders working at institutional client firms, such as pension funds and mutual funds. If a hot new securities issue generates so much interest that it quickly becomes oversubscribed, the job of institutional sales is as simple as allocating shares to the best clients (as a reward for their ongoing business).
Due to the large dollar volume of transactions and the commissions from both new issues and existing accounts, the institutional sales department often generates a significant portion of the firms profits (making institutional salespeople some of the best-paid personnel in the entire firm). The institutional sales department works closely with the firms trading department (discussed below) to maintain accounts in good standing.
Underwriting / Financing
The firms institutional sales division also works closely with the underwriting or financing department, which coordinates new securities issues and/or follow-up securities issues on the secondary market. The underwriting or finance department negotiates with the companies or governments issuing the securities, establishing their type of security, its price, an interest rate (if applicable) and other special features and protective provisions.
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The firms underwriting or financing department may be split into two divisions: the first relating to matters of corporate finance and the second to those of government finance. In a fully-integrated firm, these departments would be quite distinct, as the needs of corporations and governments vary widely. For example, the corporate finance department would require familiarity with stocks, bonds, and other securities, while the government department might be more geared toward bond and Treasury bill issues.
Trading
The firms trading department also has separate divisions, most likely according to the type of securities being traded: bonds, stocks and various other specialized financial instruments. Traders in the bond division may have sub-specializations, such as government or corporate money market instruments or bonds, or even such instruments as debentures.
The stock-trading department executes orders from retail and institutional sales staff. Stock traders maintain close links with traders on the floor of stock exchanges; although, with the rise of electronic trading, the interaction may be with a trading computer instead of a human being.
The firms trading department may also include a division geared toward various other specialized instruments, perhaps mutual funds or exchange-traded options, or commodity and financial futures contracts.
Research and Portfolio
The research department supports all other departments. Its securities analysts provide vital analysis and data to aid traders, salespeople and underwriters. This data is necessary for the selling and pricing of existing securities trades and new issues. The firms research department may consist of economists, technical analysts, and research analysts who specialize in specific types of securities or specific industries (within the equities specialization).
The research department may be further divided into retail and institutional divisions, although if the firm has only one research department, research reports geared to institutional clients may also be made available to retail investors. If the firm hosts a single institutional research department, it would be geared toward analyzing potential new issues, takeovers, and mergers, in addition to providing ongoing coverage of securities held by institutional clients. Together with the retail department, analysts may be further involved in structuring portfolios for individual and small-business accounts.
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Administration
The administration department is a vital component of the firms organization. It not only maintains proper paperwork and accounting for all trades and transactions, but also ensures compliance with securities legislation and oversees internal human resources matters. All trades made by the firm must be accounted for, and all incoming and outgoing funds and securities must be continually balanced. Securities must be checked for registration, and delivery requirements and dividend payments must be credited to accounts as received.
In the credit and compliance division, client accounts are constantly monitored for industry and firm compliance, ensuring that payments and securities are received by their due dates and that margin accounts fulfill applicable margin requirements. The financial division oversees accounting matters such as payroll, budgeting, and financial reports and statements. Minimum capital levels are maintained according to industry requirements, ensuring that the various departments within the firm hold sufficient funds to accommodate changes in the firms business.
The Bottom Line
Despite their importance to the investment industry and the economy at large, securities firms are still somewhat of a mystery to the average investor. Securities firms tend to maintain a rather secretive culture of inner-circle participants, due largely to the players specialized roles and occupations. Many retail investors interact with only their personal financial advisor or broker, and therefore lack insight into the larger set of roles within the firm. It benefits every investor to know whos who behind that set of magnificent oak doors, as each of the employees in a securities firm affects the real returns of ones investment portfolio.
An Introduction To Shareholder Activism
Share and Share Alike
The power of followership cannot be overrated. A hackneyed phrase, strength in numbers can and has been used to desired effect by shareholders for their benefit. The shareholders themselves can also be large institutions, such as public employee retirement systems. The recent results for say-on-pay at various annual general meetings are but one example. Management misdeeds and corporate fraud in the early and late 2000s led to the passage of Sarbanes-Oxley (2002) and Dodd-Frank (2010) legislation that has empowered shareholders to some degree. Here is an overview of the mechanics of shareholder voting and its true motivation.
SEE: Proxy Voting Gives Fund Shareholders A Say
Activists Toolkit
Shareholder activism is expressed through the proxy statement. More than mere ballots describing a particular issue to a shareowner requesting him or her to take action, proxy statements are assets as the decisions that they ask stockholders to make impact the value of their company. Voting on these matters is akin to taking a decision on a referendum at the ballot box on the merits (or lack thereof) of a political candidate. Investors need to do their homework, rather than merely rubberstamping managements recommendations. Once they have done so, they have the choice of completing the card accompanying the proxy statement and mailing it in or attending the annual general meeting to vote the shares in person. The latter option may be preferable if issues to be discussed are particularly important.
In this way, the shareholder is able to ask questions, the answers to which may inform his ultimate decision. While management often files the proxy statement, outside parties may do so as well. The latters interest may differ from management. Investors should note that whereas public companies are required to file an annual proxy statement, investment companies, by contrast, only do so when a specific issue needs to be put before the shareholders.
SEE: Knowing Your Rights As A Shareholder
Requisite disclosures are part of every proxy statement, varying by the issue at hand:
• Types of voting shares must be disclosed and the control accorded to each share class, along with disclosure of ownership by management and individuals with greater than 5% of outstanding shares.
• The independent public accountant must be disclosed, fees paid for audit services, and records kept of any disputes and whether firm representatives will attend the AGM. The investor should look for any sign that independence and objectivity on the part of the auditor is somehow compromised.
A summary of typical proxy proposals and their required disclosures:
Issue Required Disclosure
Election of Company Directors Names, ages, tenure, role(s) in the company, business relationships with the company, meetings that the board held in the past twelve months.
Remuneration A clear description of who gets paid what for their respective roles (e.g.(non) employee directors)
Executive Compensation Plan features, eligible persons, funding links to service (e.g defined benefit plan), prices, expiry dates, strike prices of warrants, rights or options, which do (not) require shareholder approval, tax consequences to the company/recipient.
Capital Structure Title, amount of securities to be issued or modified, fee for the transaction and anticipated use of funds; financial statements with managements discussion of financial condition.
Corporate Actions (mergers, acquisitions, spinoffs, etc.) Transaction details, financials of acquirer and acquired companies, discussion of effects of the corporate action, financials.
Property Acquisition or Disposition Type and location, fee paid or received, including basis therefore, name and address of seller or buyer.
Restatement of Financial Accounts The type of restatement and when effective, rationale for restatement and date anticipated resultant effect on company accounts.
Investment Advisory and Fee Changes A table with current and anticipated fees (e.g advisory, transfer, custody)
Distribution Fee Changes The 12b-1 fee rate, to whom the fee may be paid and the payment amounts to those affiliated with the fund or advisor.
Investments Permitted/Strategy A clear description of the change in permissible investments or strategy.
Investors should look for potential conflicts of interest. Are the interests of management sufficiently aligned with those of shareholders?
Shareholder activism is an outgrowth of corporate governance. Company directors are supposed to mind the store. If they do not, it is the responsibility of shareholders to step forward, weigh the merits of proposals and vote accordingly.
SEE: Putting Management Under The Microscope
In Whose Interest?
Traditionally a tool for exacting changes in the public company to benefit shareholders, shareholder activism is not without its critics who contend that certain interest groups stand behind the aegis of corporate democracy to advance (an) agenda(s) that might not necessarily benefit the shareholder, such as the pursuit of public policy initiatives and legislative or regulatory agendas. Socially responsible investment funds (SRI) may have a reform-minded, rather than profit-maximizing goal (e.g. environmental issues, human rights, practices that accord with religious beliefs, such as Christian values and Islamic finance).
The number of shareholder proposals is a function of a companys industry. Energy and mineral companies with the ability to harm the environment would, ceteris paribus, come in for greater criticism than technology groups. At issue in the maelstrom of shareholder activism is whether certain proposals advanced properly fall within the remit of a shareholder vote. Might they not be better resolved at the ballot box? A practice referred to as interest-group capture uses the share vote where the legislation might be a preferable alternative. Some examples of this are proposals on corporate political spending and the Taft-Hartley plans share votes to obtain concessions from management.
The Bottom Line
When evaluating any proposal, the investor needs to ask the right questions. What does the proposal ask him or her to evaluate, who is putting forth the proposal and, ultimately, whom does it serve? The answers to these questions will determine who truly benefits from such proposals.
Institutional Knowledge/Research
In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a companys disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given companys management team than the average individual investor. (Read more about the role of Reg FD in Defining Illegal Insider Trading.)
Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge.
This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time. (You can piece together your own analysis if you have the right information. Read Do-It-Yourself Analyst Predictions to find out how.)
This is compounded by the fact that analysts can sit and wait for new information ,while the average Joe has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.
Keeping Tabs on Institutions Is Tough
Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.
Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter.
In fact, take T. Rowe Price as an example. According to the companys website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. Thats big. This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.
What happens in between? Frankly, those looking to mimic the institutions portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market. (Learn some ways you can keep track of institutional investment activities in Keeping An Eye On The Activities Of Insiders And Institutions.)
Trading Costs Can Be Huge, and Treatment May Vary
By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.
Funds often receive favorable treatment. In fact, its not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock – whereas individual investors will typically pay 5-10 cents per share.
In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points. (ReadPatience Is A Traders Virtue and A Look At Exit Strategies for a discussion of setting entry and exit points.)
In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall.
Bottom Line
While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.
Does Tax Loss Harvesting Really Work?
Its about as traditional as putting up your holiday themed decorations, having the holiday office party, and exchanging gifts. For investors, tax loss harvesting has been a December tradition for as long as theyve been an investor, and to say anything negative about it could make you the Wall Street Grinch. As an investor you should always have data to back up your decision. Well look at whether the data supports the stated benefits of tax harvesting. (To learn more, read Tax-Loss Harvesting: Reduce Investment Losses.)
What Is It?
Not too up on this whole tax loss harvesting thing? Lets say in 2011 you were absolutely sure that gold was going to $2,100 so when it hit $1,900 you pulled the trigger on some shares of SPDR Gold Shares (ARCA:GLD), the most popular exchange traded fund (ETF) that tracks the price of gold. Your call hasnt materialized so you youve lost $2,000 on that position. Youre still sure its going to push through the $2,100 level so you would really like to hold on to it, but youve had a good year and you have $8,000 that are subject to capital gains taxes.
Heres your plan. Youre going to take your loss on your GLD position and put the $2,000 against your $8,000 in gains so you only have to pay taxes on $6,000 of capital gains. You know you have to avoid something called a wash-sale rule that doesnt allow you to sell and immediately repurchase GLD so you may put your money to work somewhere else for 30 days and then reinvest in GLD after that. Thats tax loss harvesting. (For related reading, see Selling Losing Securities For A Tax Advantage.)
The Problem
Trying to beat the system is often a fools game and in the case of tax loss harvesting, that may be true. The Wall Street Journal took on the role of the investing Grinch when they looked at how well tax loss harvesting actually works. They found that it wasnt as much of a gift under the tree that some people think.
Tax expert Kent Smetters is a professor of risk management at the University of Pennsylvanias Wharton School and cites a few of the normal culprits that remain a thorn in the side of investors: inflation and tax rates.(Check out Timeless Ways To Protect Yourself From Inflation.)
Because tax loss harvesting isnt removing your tax liability, youre going to pay the taxes sometime in the future. When you sold your GLD position at a loss, you lowered your entry point, or tax basis by $2,000 for the next position you open.
Later on, presuming your call of $2,100 gold comes to fruition, you now owe that extra $2,000 that you harvested in 2011 and youll pay the taxes on that gain at what could be a higher tax rate and using dollars that are worth less in the future than they are today. All of that, according to Smetters adds up to minuscule savings, if any at all.
The Bottom Line
Smetters analysis doesnt suggest that all tax loss harvesting is ill advised. Investors along with their financial and tax advisers should instead carefully consider and calculate the potential savings involved in this strategy instead of believing conventional wisdom.
Investing During Uncertainty
Every day it seems like the world is getting smaller. If you watch any financial television station or read the newspaper, you are most likely aware of how events in one country seem to have an ever-increasing effect on other countries around the world. We are more interconnected now than at any other time in history. It goes without mention that globalization definitely has its positives, but when threats of financial crisis, war, global recession, trade imbalances, etc, do occur it often leads to talk of moving money to safer investments and increasing government deficits. This rising uncertainty can confuse even the well-informed investor.
Uncertainty
Any time you put money at risk for the chance of profit there is an inherent level of uncertainty. When new threats such as war or recession arise, the level of uncertainty increases significantly as companies can no longer accurately predict their future earnings. As a result,institutional investors will reduce their holdings in stocks considered unsafe and move the funds to other sources like precious metals, government bonds and money-market instruments. This selloff, which occurs as large portfolios reposition themselves, can cause the stock market to depreciate.
Effects of Uncertainty
Uncertainty is the inability to forecast future events; people cant predict the extent of a possible recession, when its going to start/end, how much it will cost, or what companies will be able to make it through unscathed. Most companies normally predict sales and production trends for theinvesting public to follow assuming normal market conditions, but increasing levels of uncertainty can make these numbers significantly inaccurate.
Uncertainty itself can affect the economy on both the micro and macro level; a description of uncertainty on a micro level focuses on the effect on individual companies within an economy faced with the threat of war or recession, whereas the view of uncertainty on a macro level looks at the economy as a whole (To learn more, see Economics Basics.):
• From a company-specific point of view, uncertainty provides a major concern for those that produce consumer goods every day. For example, consumption may fall on the threat of a recession as individuals refrain from purchasing new cars, computers and other non-essentials. This uncertainty may force the companies in certain sectors to lay off some of their employees to combat the impacts of lower sales. The level of uncertainty that surrounds a companys sales also extends into the stock market. Consequently, stock prices of companies that produce non-essential goods sometimes experience a selloff when levels of uncertainty rise. (For more, see The Impact Of Recession On Businesses.)
• On a macro level, uncertainty is magnified if the countries at war are major suppliers or consumers of goods. A good example is a country that supplies a large portion of the worlds oil. Should this country go to war, uncertainty regarding the level of the worlds oil reserves would grow. Because the demand for oil would be high and the supply uncertain, a country unable to produce enough oil within its own borders would be required to ensure that enough oil was stored to cover operations. As a result, the price of oil would increase.
• Another macro-level event that affects companies and investors is the flight of capital and devaluation of exchange rates. When a country faces the threat of war or recession, its economy is considered uncertain. Investors attempt to move their currency away from unstable sources to stable ones; the currency of a country under a threat of war is sold and the currencies from countries without the threat are bought. The average investor probably would not do this, but the large institutional investors and currency futures traders would. These actions translate into a devaluation of exchange rates.
Whats an Investor to Do?
When situations of heightened uncertainty arise, the best defense is to be as well informed as possible. Keep updated by reading the newspaper and researching individual companies. Analyze which sectors have more to gain and lose in a crises and decide on a long-term plan. Times of heightened uncertainty can lead to great opportunities for investors who position themselves to take advantage of it. Some investors might decide to be offensive and search for companies that provide goods or services that will lead to great returns when things turn around. It is difficult to commit capital during uncertain times, but it can often reap huge rewards in the long run. Those who want to mitigate uncertainty and risk might be content leaving their money where it is or perhaps moving it to safer securities.
Regardless of which strategy you decide to take (if any), you cant go wrong over the long term by keeping yourself well informed and getting into a position so that you can take advantage of prices when the things reverse.
Getting Into International Investing
Diversification is an essential investing principle. It protects a portfolio from being seriously affected by negative events isolated to only a few stocks. In this article, we take a look at diversification that ventures into an international level, looking at its benefits and the different types of international investments available to the average investor. (To learn more, see The Importance Of Diversification.)
Why International?
Most investors tend to invest in what they know. This isnt necessarily a bad thing as its important to have a good understanding of your investments; however, it becomes detrimental when the blinders are put on and people refrain from learning about other investments. International investing, in particular, is a strategy sometimes overlooked by investors as a means of diversification.
With all the volatility found in stock markets, its difficult enough to pick winning stocks let alone winning economies. This is where diversification through international investing can help. Every year, the economic performance of a country will fluctuate and this undoubtedly affects the stock market. By buying securities in different markets as opposed to purchasing only U.S. stocks and bonds, you can reduce the impact of country or region-specific economic problems. (For more information, see Can You Learn The Stock Market?)
Take a look at the following chart:
Year Japan Nikkei
U.S. S
J.D. Rockefeller: From Oil Baron To Billionaire
John D. Rockefeller still ranks as one of the richest men in modern times. According to Forbes Magazines Most Wealthy Historical Figures 2008, his adjusted fortune of more than $300 billion rivals the relative wealth controlled by the Pharaohs of ancient Egypt or the Roman emperors. Rockefeller remains one of the great figures of Wall Street - reviled as a villain, applauded as an innovator and universally recognized as one of the most powerful men in history. Read on for a look at his life and achievements.
Son of a Peddler
Rockefeller was born on July 8, 1839. His father led a nomadic life selling goods across the country while his mother raised the children. Rockefeller received an unusually good education for his time and found work as a clerk at a commission house at the age of 16. He left thecommission house to form a partnership at the age of 24.
Oil Refiner
The first thing that distinguished Rockefeller from others was his understanding of risk. He knew that speculators in oil had the potential for huge profits if they hit a deposit, but they were also losing money when they didnt. Instead of getting into the speculation business, Rockefeller chose the refining business, where the profits were smaller but more stable
Putting all of his money into his first refining business, Rockefeller transformed it by emphasizing what we now call research and development (R
The NYSE And Nasdaq: How They Work
Whenever someone talks about the stock market as a place where equities are exchanged between buyers and sellers, the first thing that comes to mind is either the New York Stock Exchange (NYSE) or Nasdaq, and theres no debate over why. These two exchanges account for the trading of a major portion of equities in North America and worldwide. At the same time, however, the NYSE and Nasdaq are very different in the way they operate and in the types of equities traded therein. Knowing these differences will help you better understand the function of a stock exchange and the mechanics behind the buying and selling of stocks.
Location, Location, Location
The location of an exchange refers not so much to its street address but the place where its transactions take place. On the NYSE, all trades occur in a physical place, on the trading floor in New York City. So, when you see those guys waving their hands on TV or ringing a bell before opening the exchange, you are seeing the people through whom stocks are transacted on the NYSE.
The Nasdaq, on the other hand, is located not on a physical trading floor but on a telecommunications network. People are not on a floor of the exchange matching buy and sell orders on behalf of investors. Instead, trading takes place directly between investors and their buyers or sellers, who are the market makers (whose role we discuss below in the next section), through an elaborate system of companies electronically connected to one another.
Dealer vs. Auction Market
The fundamental difference between the NYSE and Nasdaq is in the way securities on the exchanges are transacted between buyers and sellers. The Nasdaq is a dealers market, wherein market participants are not buying from and selling to one another directly but through a dealer, which, in the case of the Nasdaq, is a market maker . The NYSE is an auction market, wherein individuals are typically buying and selling between one another and there is an auction occurring; that is, the highest bidding price will be matched with the lowest asking price. (For more on different types of markets, see Markets Demystified.)
Traffic Control
Each stock market has its own traffic control police officer. Yup, thats right, just as a broken traffic light needs a person to control the flow of cars, each exchange requires people who are at the intersection where buyers and sellers meet, or place their orders. The traffic controllers of both exchanges deal with specific traffic problems and, in turn, make it possible for their markets to work. On the Nasdaq, the traffic controller is known as the market maker, who, we already mentioned, transacts with buyers and sellers to keep the flow of trading going. On the NYSE, the exchange traffic controller is known as the specialist, who is in charge of matching up buyers and sellers.
The definitions of the role of the market maker and that of the specialist are technically different; a market maker creates a market for a security, whereas a specialist merely facilitates it. However, the duty of both the market maker and specialist is to ensure smooth and orderly markets for clients. If too many orders get backed up, the traffic controllers of the exchanges will work to match the bidders with the askers to ensure the completion of as many orders as possible. If there is nobody willing to buy or sell, the market makers of the Nasdaq and the specialists of the NYSE will try to see if they can find buyers and sellers and even buy and sell from their own inventories.
Perception and Cost
One thing that we cant quantify but must acknowledge is the way in which the companies on each of these exchanges are generally perceived by investors. The Nasdaq is typically known as a high-tech market, attracting many of the firms dealing with the internet or electronics. Accordingly, the stocks on this exchange are considered to be more volatile and growth oriented. On the other hand, the companies on NYSE are perceived to be more well established. Its listings include many of the blue chip firms and industrials that were around before our parents, and its stocks are considered to be more stable and established.
Whether a stock trades on the Nasdaq or the NYSE is not necessarily a critical factor for investors when they are deciding on stocks to invest in. However, because both exchanges are perceived differently, the decision to list on a particular exchange is an important one for many companies. A companys decision to list on a particular exchange is affected also by the listing costs and requirements set by each individual exchange. The entry fee a company can expect to pay on the NYSE is up to $250,000 while on the Nasdaq, it is only $50,000-$75,000. Yearly listing fees are also a big factor: on the NYSE, they based on the number of shares of a listed security, and are capped at $500,000, while the Nasdaq fees come in at around $27,500. So we can understand why the growth-type stocks (companies with less initial capital) would be found on the Nasdaq exchange. (For further reading, see What are the listing requirements for the Nasdaq?)
Public vs. Private
Prior to March 8, 2006, the final major difference between these two exchanges was their type of ownership: the Nasdaq exchange was listed as a publicly-traded corporation, while the NYSE was private. This all changed in March 2006 when the NYSE went public after being a not-for-proft exchange for nearly 214 years. Most of the time, we think of the Nasdaq and NYSE as markets or exchanges, but these entities are both actual businesses providing a service to earn a profit for shareholders. The shares of these exchanges, like those of any public company, can be bought and sold by investors on an exchange. (Incidentally, both the Nasdaq and the NYSE trade on themselves.) As publicly traded companies, the Nasdaq and the NYSE must follow the standard filing requirements set out by the Securities and Exchange Commission. Now that the NYSE has become a publicly traded corporation, the differences between these two exchanges are starting to decrease, but the remaining differences should not affect how they function as marketplaces for equity traders and investors.
Conclusion
Both the NYSE and the Nasdaq markets accommodate the major portion of all equities trading in North America, but these exchanges are by no means the same. Although their differences may not affect your stock picks, your understanding of how these exchanges work will give you some insight into how trades are executed and how a market works.
Getting Into International Investing
Diversification is an essential investing principle. It protects a portfolio from being seriously affected by negative events isolated to only a few stocks. In this article, we take a look at diversification that ventures into an international level, looking at its benefits and the different types of international investments available to the average investor. (To learn more, see The Importance Of Diversification.)
Why International?
Most investors tend to invest in what they know. This isnt necessarily a bad thing as its important to have a good understanding of your investments; however, it becomes detrimental when the blinders are put on and people refrain from learning about other investments. International investing, in particular, is a strategy sometimes overlooked by investors as a means of diversification.
With all the volatility found in stock markets, its difficult enough to pick winning stocks let alone winning economies. This is where diversification through international investing can help. Every year, the economic performance of a country will fluctuate and this undoubtedly affects the stock market. By buying securities in different markets as opposed to purchasing only U.S. stocks and bonds, you can reduce the impact of country or region-specific economic problems. (For more information, see Can You Learn The Stock Market?)
Take a look at the following chart:
Year Japan Nikkei
U.S. S
4 Signs A Private Company Is Going Public
When a private company makes plans to go public, there is rarely any fanfare or advance notice. Some of the radio silence is due to SEC requirements in relation to official filings of notices and the prospectus, and some is simply due to the fact that a company going public is often big news and puts the corporation under a magnifying glass. It is easier for a company to make preparations in the relative solitude of anonymity. There are, however, several signs, prior to the official notification and filing, that can indicate that a company is about to make the big leap.
SEE: IPO Basics
Corporate Governance Upgrades
Public companies that trade on U.S. stock exchanges are required under the Sarbanes-Oxley Act of 2002 (SOX) to maintain certain standards in the management of the corporation. These standards include having an external board of directors, developing and assessing an effective set of internal controls over the financial management of the company, and creating a formal process where employees and others can have direct access to the audit committee to report on illegal activities, as well as those that violate company policy. A sudden flurry of new policies and procedures could be an indication of a move towards an initial public offering (IPO).
Big Bath Write-Downs
Public companies, and those that are about to go public, have their annual and quarterly financial statements scrutinized by investors and analysts. Private companies considering going public often assess their own financial statements and take any write-offs they are allowed under GAAPall at once, to present better income statements in the future.
For example, accounting rules require that companies write down inventory that is unsalable or worth less than its original cost. However, there is substantial leeway in making that determination. Companies often keep inventory on their balance sheets as long as possible to ensure that they are meeting asset ratios for banks and other lenders . Once a company contemplates going public, it often makes sense to write off the inventory sooner rather than later, when it would impact shareholder profitability.
Sudden Changes in Senior Management
Once a company contemplates going public, it has to think about how qualified its current management is and whether it is need of some spring cleaning. To attract investors , a public company needs to have officers and managers who are experienced and have a track record of leading companies to profitability. If there is a full scale overhaul in the upper echelons of a company, it may be a signal that it is trying to improve its image in advance of going public.
Selling-Off Non-Core Business Segments
A company that springs up from scratch can often have some business units attached to it that are ancillary to its core, or main, business purpose. An example of this is an office supplies company that has a payroll processing business; the secondary business does not connect directly to the main business. In order to market a company in an initial public offering, the prospectus is expected to show a clear business direction. If a company is shedding its non-core operations, it may be a sign that it is getting lean and mean in preparation for a public share offering.
The Bottom Line
Because of the ability of a private company to keep quiet on its intentions to go public until the formal SEC-required filings and announcements, it can be difficult to assess whether a company is heading in that direction. However, there are always more subtle signals for those seeking them out.
Trade Smarter With Equivalent Positions
How can two trades have the same risk and reward when they look so very different?
Thats the frequent response when investors first learn that every option position is equivalent to a different option position. For clarification, equivalent refers to the fact that the positions will earn/lose the same amount at any price (when expiration arrives) for the underlying stock. It does not mean the positions are identical.
Of all the ideas that a rookie options trader encounters, the idea of equivalence is a real eye-opener. Those who grasp the significance of this concept have an increased chance of succeeding as a trader. (For a background reading, see our Options Basics Tutorial.)
Different but Equal
Lets begin with an example, and then well discuss why equivalent positions exist and how you can use them to your advantage. And it is an advantage. Sometimes you discover that theres an extra $5 or $10 to be earned by making the equivalent trade . At other times, the equivalent saves money on commissions.
There are two commonly used trading strategies that are equivalent to each other. But you would never know it by the way stock brokers handle these positions. Im referring to writing covered calls and selling naked puts. (For more, readUnderstanding Option Pricing.)
These two positions are equivalent:
1. Buy 300 shares of QZZ
Sell 3 QZZ Aug 40 calls
2. Sell 3 QZZ Aug 40 puts
What happens when expiration arrives for each of these positions?
Buying the Covered Call:
• If QZZ is above 40, the call owner exercises the options, your shares are sold at $40 per share, and you have no remaining position.
•
If QZZ is below 40, the options expire worthless and you own 300 shares
Selling the Naked Puts:
• If QZZ is above 40, the puts expire worthless and you have no remaining position.
•
If QZZ is below 40, the put owner exercises the options and you are obligated to purchase 300 shares at $40 per share. You own 300 shares.
Trade Conclusion
After expiration, your position is identical. For those who are concerned with details (and option traders must be concerned) the question arises as to what happens when the stocks final trade at expiration is 40. The answer is that you have two choices:
1. Do Nothing
You can do nothing and wait to see whether the option owner allows the calls to expire worthless or decides to exercise. This places the decision in the hands of someone else.
2. Repurchase the Options
Before the market closes for trading on expiration Friday, you can repurchase the options you sold. Once you do that, you can no longer be assigned an exercise notice. The goal is to buy those options for as little as possible, and I suggest bidding 5 cents for those options. You may want to be more aggressive and raise the bid to 10 cents, but that should not be necessary if the stock is truly trading at the strike price as the closing bell rings.
If you do buy back the options sold earlier, you may write new options expiring in a later month. This is a common practice, but its a separate trade decision.
The positions are equivalent after expiration. But does that show that the profit/loss is always equivalent? No, it doesnt. But the truth is that options are almost always efficiently priced. When priced inefficiently, professional arbitrageurs arrive on the scene and trade to take the free money offered. This is not a trading idea for you. Instead, its a reassurance that you will not find options mispriced too often. The available profit from these arbitrage opportunities is very limited, but the arbs are willing to take the time and effort to frequently earn those few pennies per share. (Read Arbitrage Squeezes Profit From Market Inefficiency.)
Proof
To determine if one position is equivalent to another, all you need to know is this simple equation:
S = C – P
This equation defines the relationship between stocks (S), calls (C) and puts (P). Being long 100 shares of stock is equivalent to owning one call option and selling one put option when those options are on the same underlying and the options have the same strike price and expiration date.
The equation can be rearranged to solve for C or P as follows:
C = S P
P = C - S
This gives us two more equivalent positions:
1. A call option is equivalent to a long stock plus a long put (this is often called a married put).
2. A put option is equivalent to a long call plus a short stock .
From the last equation, if we change the signs of each attribute, we get:
-P = S – C, or a short put equals a covered call
As long as you are cash-secured, meaning you have enough cash in your account to buy the shares if you are assigned an exercise notice, there are two very practical reasons for selling a naked put:
1. Reduced Commissions
The naked put is a single trade. The covered call requires that you buy stock and sell a call. Thats two trades.
• Exiting the Trade Prior to Expiration
Sometimes the spread turns into a quick winner when the stock rallies way above the strike price. Its often easy to close the position and take your profit easily when you sold the put. All you must do is buy that put at a very low price, such as 5 cents. With the covered call, buy the deep-in-the-money call options. Those usually have a very wide market and there is almost no chance to buy that call at a good price (and then quickly sell the stock). Thus, the strategic edge belongs to the put seller, not the covered call writer.
• Other Equivalent Positions
These positions are equivalent only when the options have the same strike price and expiration date.
Selling a put spread is equivalent to buying a call spread, so:
• Sell ZXQ Oct 50/60 Put Spread = Buy ZYQ Oct 50/60 Call Spread
Selling a call spread is equivalent to buying a put spread, so:
• Sell JJK Dec 15/20 Call Spread = Buy JJK Dec 15/20 Put Spread
Selling put spread is equivalent to a buying collar. so:
• Sell XYZ Nov 80/85 Put Spread = Buy 100 XYZ; Buy one Nov 80 put; Sell one Nov 85 call
To convert a call into a put, just sell stock (because C - S = P)
To convert a put into a call, just buy stock (because P S = C)
The Bottom Line
There are other equivalent positions. In fact, by using the basic equation (S = C – P) you can find an equivalent for any position. From a practical perspective, the more complex the equivalent position, the less easily it can be traded. The idea behind understanding that some positions are equivalent to others is that it may help your trading become more efficient . As you gain experience, you will find it takes very little effort to recognize when an equivalent is beneficial. It just takes a little practice thinking in terms of equivalents.
6 Common Misconceptions About Dividends
During periods of low yields and market volatility, more than a few experts recommend dividend stocks and funds. This may sound like good advice, but unfortunately, it is often based on misconceptions and anecdotal evidence.
It is time to take a closer look at the six most common reasons why advisors and other experts recommend dividends and why, based on these reasons, such recommendations are often unsound advice.
Misconception No. 1: Dividends are a good income-producing alternative when money market yields are low.
Taking cash and buying dividend stocks isnt consistent with being a conservative investor, regardless of what money markets are yielding. Additionally, there is no evidence that money market yields signal the right time to invest in dividend-focused mutual funds. In fact,money market yields were anemic throughout 2009, a year that is also one of the worst periods for dividend-focused funds in history.
Many advisors also call dividends a good complement to other investments during times of high volatility and low bank yields. In an October 22, 2009 article, financial guru Suze Orman recommended the following dividend funds: iShares Dow Jones Select Dividend Index (NYSE:DVY), WisdomTree Total Dividend (NYSE:DTD)
The Most Profitable Investing Trends Right Now
The stock market has been very volatile the last few years. While volatility brings risk, but it also brings opportunities for large gains if you are able to spot the right trends early. Here are some of the most profitable investing trends right now. (Growing a small sum poses big challenges. Find out why and learn what you can do about it. Check out Start Investing With Only $1000.)
1. Cloud Computing
A big trend in computing is offloading your local computing and data storage needs into the cloud. Ultimately, the cloud computing movement sees individual computers becoming primarily web terminals used to connect to powerful servers hosting our personal and business data, as well as web-based applications.
There are very few good pure-play companies in cloud computing. Amongst publicly-traded names, one of the leaders in cloud computing is Amazon (AMZN) with its EC2 virtual computing environments. Google (GOOG) is also a major player in the field with its web-based Google Docs service, as well as its Google Apps for Business line. Microsoft (MSFT) is also in the game with its Business Productivity Suite and its Office 365 offering.
2. Tablet PCs
Almost every major computer maker is debuting new tablet computers this year. The tablet segment is expected to grow quickly over the next few years, with one research firm projecting a growth from approximately 4 million units sold in 2010 to 57 million units being sold in 2015. A clear leader in the field is Apple (AAPL), with over 75% of the worldwide market share. In addition, Apples Ipad 2 is expected to start shipping soon.
Another perspective is that Googles Android-based systems may be where the real growth is. In the fourth quarter of 2010, Android-based systems went from 2.3% market share to nearly 21.6%. Unfortunately there is not a good pure-play on Android tablets, since major computer makers sell a wide variety of systems. Investors may want to look into the profit-boosting potential of Dells (DELL) new tablet or HPs (HPQ) TouchSmart series of tablets. Another idea would be to look into Intel (INTC) which makes the processors powering most non-Apple tablets.
3. Solar/Alternative Energy
Alternative sources of energy are gaining in popularity, but as an investor, you have to be careful where you put your money. For example, the Market Vectors Global Alternative Energy ETF (GEX) has delivered a negative-50% return since its inception in 2007. The alternative energy sector includes a lot of yet-unproven technologies and small early-stage firms, which presents a high risk for investors. You may want to be more selective and pick out some of the better individual firms. First Solar, Inc. (FSLR) is one of the biggest names, with a $13 billion market cap; it is up nearly 5000% since 2007. (Setting goals is the first step in determining which investment vehicles are right for you.
4. Streaming Movies
Watching streaming movies and television shows on demand is quickly catching on as a preferred method of media delivery. The old style physical rental chains, like Blockbuster, are fast disappearing from the competitive landscape.
The leader in streaming movies is Netflix (NFLX), which is up approximately 700% over the past five years. New investors may wish to exercise caution, however, since Netflix is currently trading at relatively high valuation levels, and several major companies seem to be eyeing an entrance into the market. The most interesting new entrant to the space is Amazon. Amazon launched its new streaming video service on February 22, 2011 which makes approximately 5,000 titles available on demand for free to Amazon Prime members.
5. Lithium
Commodities as an asset class have seen a tremendous run-up in price over the last several years. One of the more compelling long-term commodity stories is lithium, where increased demand is expected for the metal for use in batteries. Lithium batteries are used in electric cars, so if plug-in electric vehicles catch on, that may be a very large new source of demand.
If you are looking for a broad exposure to lithium, you may be interested in the Global X Lithium ETF (LIT) which is up 30% since its inception in 2010. One of the major individual names in lithium is the Chemical and Mining Company of Chile (SQM) which is up about 350% over the last five years.
The Bottom Line
These investing trends have been very profitable for investors who got in early. If you are considering investing now, conduct careful research to make sure you arent buying in at overvalued levels. Another approach would be to analyze these trends, identify common themes, and try to spot a new trend in the early stages.