Register for free to join our community of investors and share your ideas. You will also get access to streaming quotes, interactive charts, trades, portfolio, live options flow and more tools.
Register for free to join our community of investors and share your ideas. You will also get access to streaming quotes, interactive charts, trades, portfolio, live options flow and more tools.
How To Invest When Youre Deep In Debt
Its natural that if you have some money saved or invested, you want to see it grow. There are many factors that can prevent this from happening, but for many people, one of the biggest obstacles is debt. If you have debt to deal with - be it a mortgage, line of credit, student loan orcredit card - fear not, you can still learn how to balance your debt with saving and investing .
Types of Debt
Generally speaking, having debt can make it very difficult for investors to make money. In some cases, investing while in debt is like trying to bail out a sinking ship with a coffee cup. In other words, if you have a debt on your line of credit at 7% interest, the money you are investing will have to make more than 7% to make it more profitable than simply paying down the debt. There are investments that deliver such high returns, but you have to be able to find them knowing you are under the burden of debt.
It is important to briefly distinguish the different kinds of debt here:
1. High-Interest Debt - This is your credit card. High interest is relative, but anything above 10% is a good candidate for this category. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before starting to invest .
2. Low-Interest Debt - This can be a car loan, a line of credit, or a personal loan from a bank. The interest rates are usually described as prime plus or minus a certain percentage, so there is still some performance pressure from investing with this type of debt. It is, however, much less daunting to make a portfolio that returns 12% than one that has to return 25%.
3. Tax-Deductible Debt - If there is such a thing as good debt, this is it. Tax-deductible debts include mortgages, student loans, business loans, investing loans and all the other loans in which interest paid is returned to you in the form of tax deductions. Because this debt is generally low interest as well, you can easily build a portfolio while paying it down.
The types of debt we will cover in this article are long-term low-interest and tax-decductible debt (like personal loans or mortgage payments). If you dont have high-interest debt or, better yet, all your debts are tax deductible, then read on. If you do have high-interest debt, youll need to pay it off before you begin your investing adventure.
Why Invest?
Debt elimination, particularly of something like a loan that will take long-term capital, robs you of time and money. In the long term, the time (in terms of compounding time of your investment) you lose is worth more to you than the money you actually pay (in terms of the money and interest that you are paying to your lender). You want to give your money as much time as possible to compound. This is one of the reasons to start a portfolio in spite of debt (but not the only one). Your investments may be small, but they will pay off more than investments you would make later in life because these small investments will have more time to mature.
The Plan
Instead of making a traditional portfolio with high and low-risk investments that are adjusted according to your tolerance and age, the idea is to make your loan payments in the place of low-risk and/or fixed-income investments. This means that you will be seeing returns from the lessening of your debt load and interest payments rather than the 4-8% return on a bond or similar investment. The rest of your portfolio should focus on the higher-risk, high-return investments like stocks. If your risk tolerance is very low, the bulk of your investing money will still be going toward loan payments, but there will be a percentage that does make it into the market to produce returns for you. (To learn how to design your portfolio, read A Guide To Portfolio Construction.)
Even if you have a high risk tolerance, you may not be able to put as much as youd like into your investment portfolio because, unlike bonds, loans require a certain amount in monthly payments. Your debt load may force you to create a conservative portfolio in that most of your money is being invested in your loans with only a little going into your high-risk and return investments. As the debt gets smaller, you can adjust your distributions accordingly. (To learn more, check out Rebalance Your Portfolio To Stay On Track.)
Conclusion
You can invest in spite of debt. The important question is whether or not you should. The answer is very personal. There is no denying that there can be benefits from getting your money into the market as soon as possible, but there is no guarantee that your portfolio will perform like it needs to. Such things depend on how adept you become at investing.
The biggest benefit of investing while in debt is psychological (as much of finance is). Paying down long-term debts can be tedious and disheartening if you are not the type of person who puts your shoulder into a task and keeps pushing until it is done. For many people who are servicing debt, it seems like they are struggling to get to the point where their normal financial life - that of saving, investing, etc. - can begin. Debt becomes like a limbo state where things seem to be happening in slow motion. By having even a modest portfolio to distract you from the tedium, you can keep your enthusiasm about your finances from ebbing. Knowing that the sun will come up and being able to see the dawn are very different experiences. For some people, building a portfolio while in debt provides a much needed ray of light.
Portfolio Management Tips For Young Investors
Too many young people rarely, or never, invest for their retirement years. Some distant date, 40 or so years in the future, is hard to imagine. However, without investments to supplement retirement income, if any, retirees will have a difficult time paying for lifes necessities. TUTORIAL:Stocks Basics
Smart, disciplined, regular investment in a portfolio of diverse holdings, can yield good long-term returns for retirement and provide additional income throughout an investors working life.
An often stated reason for not investing is a lack of knowledge and understanding of the stock market. This objection can be overcome through self-education and step-by-step through the years, as an investor learns by investing. Classes in investing are also offered by a variety of sources, including city and state colleges, civic and not-for-profit organizations, and there are numerous books targeted to the beginning investor.
However, youve got to start investing now; the earlier you begin, the more time your investments will have to grow in value. Heres a good way to start building a portfolio, and how to manage it for the best results. (For related reading, see Top 5 Books For Young Investors.)
Start Early
Start saving as soon as you go to work by participating in a 401(k) retirement plan, if its offered by your employer. If a 401(k) plan is not available, establish an Individual Retirement Account (IRA) and earmark a percentage of your compensation for a monthly contribution to the account. An easy, convenient way to save in an IRA or 401(k) is to create an automatic monthly cash contribution. Keep in mind, the savings accumulate and the interest compounds without taxes, as long as the money is not withdrawn, so its wise to establish one of these retirement investment vehicles early in your working life.
Another reason to start saving early is that usually the younger you are, the less likely you are to have burdensome financial obligations: a spouse, children and mortgage, for example. That means you can allocate a small portion of your investment portfolio to higher risk investments, which may return higher yields.
When you start investing while young, before your financial commitments start piling up, youll probably also have more cash available for investing and a longer time horizon before retirement. With more money to invest for many years to come, youll have a bigger retirement nest egg.
To illustrate the advantage of value investing as soon as possible, assume you invest $200 every month starting at age 25. If you earn a 7% annual return on that money, when youre 65 your retirement nest egg will be approximately $525,000. However, if you start saving that $200 monthly at age 35 and get the same 7% return, youll only have about $244,000 at age 65. (For additional reading, see Accelerating Returns With Continuous Compounding.)
Diversify
Select stocks across a broad spectrum of market categories. This is best achieved in an index fund. Invest in conservative stocks with regular dividends, stocks with long-term growth potential, and a small percentage of stocks with better returns, along with higher risk potential. If youre investing in individual stocks, dont put more than 4% of your total portfolio into one stock. That way, if a stock or two suffers a downturn, your portfolio wont be too adversely effected. Certain AAA rated bonds are also good investments for the long term, either corporate or government. Long-term U.S. Treasury bonds, for example, are safe and pay a higher rate of return than short- and mid-term bonds. (To learn more on investing in bonds, read Bond Basics: Different Types Of Bonds.)
Keep Costs to a Minimum
Invest with a discount brokerage firm. Another reason to consider index funds when beginning to invest is that they have low fees. Because youll be investing for the long-term, dont buy and sell regularly in response to market ups and downs. This saves you commission expenses and management fees, and may prevent cash losses when the price of your stock declines.
Discipline and Regular Investing
Make sure that you put money into your investments on a regular, disciplined basis. This may not be possible if you lose your job, but once you find new employment, continue to put money into your portfolio.
Asset Allocation and Re-Balance
Assign a certain percentage of your portfolio to growth stocks, dividend paying stocks, index funds and stocks with a higher risk, but better returns.
When your asset allocation changes (i.e., market fluctuations change the percentage of your portfolio allocated to each category), re-balance your portfolio by adjusting your monetary stake in each category to reflect your original percentage. (For more information, read Five Things To Know About Asset Allocation.),
Tax Considerations
A portfolio of holdings in a tax-deferred account, a 401(k), for example, builds wealth faster than a portfolio with tax liability. You pay taxes on the amount of money withdrawn from a tax deferred retirement account. A Roth IRA also accumulates tax free savings, but the account owner doesnt have to pay taxes on the amount withdrawn. To qualify for a Roth IRA, your modified adjusted gross income must meet IRS limits and other regulations. Earnings are federally tax free if youve owned your Roth IRA for at least five years and youre older than 59.5, or if youre younger than 59.5, have owned your Roth IRA for at least five years and the withdrawal is due to your death or disability, or for a first time home purchase.
The Bottom Line
Disciplined, regular, diversified investment in a tax deferred 401(k), IRA or a potentially tax-free Roth IRA, and smart portfolio management can build a significant nest egg for retirement. A portfolio with tax liability, dividends and the sale of profitable stock can provide cash to supplement employment or business income. Managing your assets by re-allocation and keeping costs, such as commissions and management fees, low, can produce maximum returns. If you start investing as early as possible, your stocks will have more time to build value. Finally, keep learning about investments throughout your life, both before and after retirement. The more you know, the more your potential portfolio return, with proper management, of course.
Forces That Move Stock Prices
Have you ever wondered about what factors affect a stocks price? Stock prices are determined in the marketplace, where seller supply meets buyer demand. But unfortunately, there is no clean equation that tells us exactly how a stock price will behave. That said, we do know a few things about the forces that move a stock up or down. These forces fall into three categories: fundamental factors, technical factors and market sentiment.
Fundamental Factors
In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things: 1) An earnings base (earings per share (EPS), for example) and 2) a valuation multiple (a P/E ratio, for example).
An owner of a common stock has a claim on earnings, and earnings per share (EPS) is the owners return on his or her investment. When you buy a stock , you are purchasing a proportional share of an entire future stream of earnings. Thats the reason for the valuation multiple: it is the price you are willing to pay for the future stream of earnings.
Part of these earnings may be distributed as dividends, while the remainder will be retained by the company (on your behalf) for reinvestment. We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.
As shown in the diagram, the valuation multiple (P/E), or the stock price as some multiple of EPS, is a way of representing the discounted present value of the anticipated future earnings stream.
Copyright © 2008 Investopedia.com
About the Earnings Base
Although we are using EPS, an accounting measure, to illustrate the concept of earnings base, there are other measures of earnings power . Many argue that cash-flow based measures are superior. For example, free cash flow per share is used as an alternative measure of earnings power.
The way earnings power is measured may also depend on the type of company being analyzed. Many industries have their own tailored metrics. Real estate investment trusts (REITs), for example, use a special measure of earnings power called funds from operations (FFO). Relatively mature companies are often measured by dividends per share, which represents what the shareholder actually receives.
About the Valuation Multiple
The valuation multiple expresses expectations about the future. As we already explained, it is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are 1) the expected growth in the earnings base, and 2) the discount rate, which is used to calculate the present value of the future stream of earnings. A higher growth rate will earn the stock a higher multiple, but a higher discount rate will earn a lower multiple.
What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which in turn earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are worth less in inflationary environments).
In summary, the key fundamental factors are:
• The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)
• The expected growth in the earnings base
• The discount rate, which is itself a function of inflation
• The perceived risk of the stock.
Technical Factors
Things would be easier if only fundamental factors set stock prices! Technical factors are the mix of external conditions that alter the supply of and demand for a companys stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.) Technical factors include the following:
• Inflation - We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.
• Economic Strength of Market and Peers - Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a companys individual performance - determines a majority of a stocks movement. (There has been research cited that suggests the economic/market factors account for 90%!) For example, a suddenly negative outlook for one retail stock often hurts other retail stocks as guilt by association drags down demand for the whole sector.
• Substitutes - Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate and foreign equities. The relation between demand for U.S. equities and their substitutes is hard to figure, but it plays an important role.
• Incidental Transactions - Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official votes cast for or against the stock, they do impact supply and demand and therefore can move the price.
• Demographics - Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) middle-aged investors, who are peak earners that tend to invest in the stock market , and 2) older investors who tend to pull out of the market in order to meet the demands of retirement. The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples.
• Trends - Often a stock simply moves according to a short-term trend. On the one hand, a stock that is moving up can gather momentum, as success breeds success and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean. Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are trendy does not help us predict the future. (Note: trends could also be classified under market sentiment.)
• Liquidity - Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Wal-Marts stock is highly liquid and therefore highly responsive to material news; the average small-cap company is less so. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community). Large-cap stocks have high liquidity: they are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent liquidity discount because they simply are not on investors radar screens.
Market Sentiment
Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category because we know it matters critically, but we are only beginning to understand it. Market sentiment is often subjective, biased and obstinate. For example, you can make a solid judgment about a stocks future growth prospects, and the future may even confirm your projections, but in the meantime the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
Market sentiment is being explored by the relatively new field of behavioral finance. It starts with the assumption that markets are apparently not efficient much of the time, and this inefficiency can be explained by psychology and other social sciences. The idea of applying social science to finance was fully legitimized when Daniel Kahneman, a psychologist, won the 2002 Nobel Memorial Prize in Economics. (He was the first psychologist to do so.) Many of the ideas in behavioral finance confirm observable suspicions: that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains; and that investors tend to persist in a mistake.
Some investors claim to be able to capitalize on the theory of behavioral finance. For the majority, however, the field is new enough to serve as the catch-all category, where everything we cannot explain is deposited.
Summary
Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: technical factors and market sentiment often overwhelm the short run, but fundamentals will set the stock price in the long-run. In the meantime, we can expect more exciting developments in the area of behavioral finance since traditional financial theories cannot seem to explain everything that happens in the market.
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
Whats The Minimum I Need To Retire?
Can I retire with $1 million dollars? Of course you can. Truth be told, you might be able to retire with much less. Then again, you might not be able to retire with $1 million or $2 million or perhaps even $10 million. It all depends on your personal situation. On thing is sure: you want to make sure your golden years are golden, not merely a struggle for existence. (To learn more read, 10 Steps To Retire A Millionaire.)
Most advisors and financial professionals have been able to boil it down to one number, also known as the holy grail of retirement analysis: the amazing 4% sustainable withdrawal rate. Essentially, this is the amount you can withdraw through thick and thin and still expect your portfolio to last at least 30 years, if not longer. This will determine how long your retirement savings will last, and will help you determine how much money you need for the retirement you want.
So, I Can Retire With $1 Million?
If you are 65 with $1 million, you can expect your portfolio of properly diversified investments to provide $40,000 per year (in todays dollars ) until you are 95. Add that to your Social Security income and you should be bringing in roughly $70,000 a year.
Now, if this isnt enough for you to maintain the lifestyle you want, you have come to your unfortunate answer rather quickly: no, you cannot retire with $1 million.
Now wait a minute, you say, what about my spouse, who is also getting Social Security? What if Im 75, not 65? What if I want to die broke? What if Im getting a government pension and benefits? What if Im planning to retire in Costa Rica? There are many what ifs, but the math is still the math: If you plan on needing a lot more than $40,000 from you retirement nest egg, then the probability of a successful retirement on $1 million is not good.
Projecting Future Expenses
There are a lot of books and articles that discuss longevity risks, sequence of returns, healthcare costs and debt. But knowing how much you need to retire still boils down to projecting your future expenses until the day you die. Ideally, that yearly figure will add up to less than 4% of your nest egg.
So a $1 million dollar portfolio should give you, at most, $40,000 to budget. If you are forced to take out more than $40,000 adjusted for time during your retirement, you are tempting fate and relying on luck to get you by. So, if you want at least $40,000 per year, $1 million is really the least amount of money - the bare minimum - you should have before you launch into retirement.
Retirement planning means maximizing your lifestyle while maintaining a high probability of being able to maintain that lifestyle until the day you die. So scraping together a bare minimum nest egg is like an explorer heading into the jungle for a week with just enough supplies. What if something happens? Why not take extra? As a result, for the vast majority of people, $1 million is not enough if you want a high probability of a great retirement .
Three Types Of Retirees
Typically, we see three categories of people trying to decide if they are ready to retire:
1. Of course you can retire! Live it up and enjoy! If you are at least in your 70s with reasonable expenses, then there is a good chance you and your $1 million fall in this category.
2. The probability for your retirement looks good. Just dont go crazy and buy a Porsche. If you are at least 62 and have always lived a frugal lifestyle, then you and your $1 million are likely going to fall in this category.
3. Lets redefine retirement for you. This is just about everyone else - including early retirees with $1 million living frugally and 70-year-olds with $1 million spending lavishly.
Early retirement , meaning before Social Security and Medicare kick in, with only $1 million is extremely risky. You leave yourself with so few options if things go terribly wrong. Sure, you can go to Costa Rica and eat fish tacos every day. But what if you want to move back to the U.S. someday? What if you want to change? Having more money set aside will provide you with more flexibility and increase the likelihood of continued financial independence to do what you want within reason until the day you die. If you are forced to stay in Costa Rica or get a job, then you didnt make a good decision and plan.
So, once you have your $1 million, concentrate on what you can control - or at least affect. You cant control when you die but you can affect your health costs by doing your best to stay healthy until you qualify for Medicare. You cant control investment returns but you can affect the range of returns. You cant control inflation but you can affect your fixed costs and your variable costs.
Spending and Expenses
A few quick bits on expenses and spending. To a certain extent, retirement planning is the art of accurately matching future income with expenses. People seem to ignore certain expenses. For example, family vacations and a grandchilds wedding gift count the same as dental surgery and car repairs in retirement planning, but people neither include these enjoyable expenses when they are projecting their costs nor do they recognize how hard it is to cut them - try telling one child that you cant help with his wedding after paying for your other childrens weddings!
Conclusion
As a general rule, people who try to determine the minimum amount of retirement savings are usually the least likely to retire. Just getting by isnt a good way to start 30 years of unemployment and diminishing employability. If something unexpected happens, what are your options? Re-enter the work force, change your lifestyle or get more aggressive with your investments? Most people try the latter and pray. Some get lucky, but most dont. This is the equivalent of doubling down in black jack.
If you want to retire with $1 million dollars, it is going to come down to a combination of 1) how you define retirement, 2) your personal inventory of everything in your life: assets, debts, medical, family, etc. and 3) what the future holds. Remember, stuff happens in life. Do you really want to start this 30 year adventure with the bare minimum? Retirement is like most good things, it is much better to be overprepared than to wing it. You can you retire with $1 million dollars, but its better to be safe than sorry – shoot for $2 million!
Portfolio Management Pays Off In A Tough Market
When you think about investing, you have a very long decision tree - the question of passive or active, long or short, stocks or funds, China or Brazil and on and on. These topics seem to occupy the majority of the media as well as individuals minds. However, these decisions are far down the investing process relative to portfolio management. Portfolio management is basically looking at the big picture. This is the classic forest and trees analogy; many investors spend too much time looking at each tree (stock, fund, bond, etc) and not enough - if any - time looking at the forest (portfolio management).
Prudent portfolio management begins after the client and his or her advisor have reviewed the total picture and completed an investment policy statement (IPS). Embedded in the IPS is the asset allocation strategy of which there are four: integrated, strategic, tactical and insured. Most people recognize how critical asset allocation is, but most investors are unfamiliar with asset allocation rebalancing strategies, of which there are also four: buy-hold, constant-mix, constant proportion and option based. A lack of familiarity with rebalancing strategies helps explain why many confuse the constant-mix rebalancing strategy with buy-hold. Here is a side-by-side comparison of these two most common asset allocation rebalancing strategies.
Buy-Hold Rebalancing
The objective of buy-hold is to buy the initial allocation mix and then hold it indefinitely, without rebalancing regardless of performance. The asset allocation is allowed to vary significantly from the starting allocation as risky assets, such as stocks, increase or decrease. Buy-hold essentially is a do not rebalance strategy and a truly passive strategy. The portfolio becomes more aggressive as stocks rise and you let the profits ride, no matter how high the stock value gets. The portfolio becomes more defensive as stocks fall and you let the bond position become a greater percentage of the account. At some point, the value of the stocks could reach zero, leaving only bonds in the account.
Constant-Mix Investing
The objective of constant-mix is to maintain a ratio of, for example, 60% stocks and 40% bonds , within a specified range by rebalancing. You are forced to buy securities when their prices are falling and sell securities when they are rising relative to each other. Constant-mix strategy takes a contrarian view to maintaining a desired mix of assets, regardless of the amount of wealth you have. You essentially are buying low and selling high as you sell the best performers to buy the worst performers. Constant-mix becomes more aggressive as stocks fall and more defensive as stocks rise.
Returns in Trending Markets
The buy-hold rebalancing strategy outperforms the constant-mix strategy during periods when the stock market is in a long, trending market such as the 1990s. Buy-hold maintains more upside because the equity ratio increases as thestock markets increase. Alternately, constant-mix has less upside because it continues to sell risky assets in an increasing market and less downside protection because it buys stocks as they fall.
Figure 1 shows the return profiles between the two strategies during a long bull and a long bear market. Each portfolio began at a market value of 1,000 and an initial allocation of 60% equities and 40% bonds. From this figure, you can see that buy-hold provided superior upside opportunity as well as downside protection.
Figure 1: Buy-hold vs. constant-mix rebalancing
Copyright ? 2009 Investopedia.com
Returns in Oscillating Markets
However, there are very few periods that can be described as long-trending. More often than not, the markets are described as oscillating. The constant-mix rebalancing strategy outperforms buy-hold during these up and down moves. Constant-mix rebalances during market volatility, buying on the dips as well as selling on the rallies.
Figure 2 shows the return characteristics of a constant-mix and buy-hold rebalancing strategy, each starting with 60% equity and 40% bonds at Point 1. When the stock market drops, we see both portfolios move to Point 2, at which point our constant-mix portfolio sells bonds and buys stocks to maintain the correct ratio. Our buy-hold portfolio does nothing. Now, if the stock market rallies back to initial value, we see that our buy-hold portfolio goes to Point 3, its initial value, but our constant-mix portfolio now moves higher to Point 4, outperforming buy-hold and surpassing its initial value. Alternatively, if the stock market falls again, we see that buy-hold moves to Point 5 and outperforms constant-mix at Point 6.
Figure 2
Copyright ? 2009 Investopedia.com
Conclusion
Most professionals working with retirement clients follow the constant-mix rebalancing strategy. Most of the general investing public has no rebalancing strategy or follows buy-hold out of default rather than a conscious portfolio management strategy. Regardless of the strategy you use, in difficult economic times, you will often hear the mantra stick to the plan, which is preceded by be sure you have good plan. A clearly defined rebalancing strategy is a critical component of portfolio management.
Evaluating A Companys Capital Structure
For stock investors that favor companies with good fundamentals, a strong balance sheet is an important consideration for investing in a companys stock. The strength of a companys balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this article, well look at evaluating balance sheet strength based on the composition of a companys capital structure.
A companys capitalization (not to be confused with market capitalization) describes the composition of a companys permanent or long-term capital, which consists of a combination of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a companys capital structure is an indication of financial fitness.
Clarifying Capital Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a companys capital structure, equity consists of a companys common and preferred stock plus retained earnings, which are summed up in the shareholders equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a companys capitalization, i.e. a permanent type of funding to support a companys growth and related assets.
A discussion of debt is less straightforward. Investment literature often equates a companys debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities - it is the latter that forms the debt component of a companys capitalization - but thats not the end of the debt story.
Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a companys capitalization is simply a balance sheets long-term debt. This definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a companys capitalization should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors.
Its worth noting here that both international and U.S. financial accounting standards boards are proposing rule changes that would treat operating leases and pension projected-benefits as balance sheet liabilities. The new proposed rules certainly alert investors to the true nature of these off-balance sheet obligations that have all the earmarks of debt.
Is There an Optimal Debt-Equity Relationship?
In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments.
A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share .
Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a companys line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.
Capital Ratios and Indicators
In general, analysts use three different ratios to assess the financial strength of a companys capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, its the capitalization ratio that delivers the key insights to evaluating a companys capital position.
The debt ratio compares total liabilities to total assets . Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.
The capitalization ratio (total debt/total capitalization) compares the debt component of a companys capital structure (the sum of obligations categorized as debt total shareholders equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt.
Additional Evaluative Debt-Equity Considerations
Companies in an aggressive acquisition mode can rack up a large amount of purchased goodwill in their balance sheets. Investors need to be alert to the impact of intangibles on the equity component of a companys capitalization. A material amount of intangible assets need to be considered carefully for its potential negative effect as a deduction (or impairment) of equity, which, as a consequence, will adversely affect the capitalization ratio.
Funded debt is the technical term applied to the portion of a companys long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter how problematic a companys financial condition may be, the holders of these obligations cannot demand payment as long the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investors perspective, the greater the percentage of funded debt to total debt disclosed in the debt note in the notes to financial statements, the better. Funded debt gives a company more wiggle room.
Lastly, credit ratings are formal risk evaluations by credit-rating agencies - Moodys, Standard
When To Sell A Mutual Fund
If your mutual fund is yielding a lower return than you anticipated, you may be tempted to cash in your fund units and invest your money elsewhere. The rate of return of other funds may look enticing, but be careful; there are both pros and cons to the redemption of your mutual fund shares. Lets examine the circumstances in which liquidation of your fund units would be most optimal and when it may have negative consequences.
Mutual Funds Are Not Stocks
The first thing you need to understand is that mutual funds are not synonymous with stocks. So, a decline in the stock market does not necessarily mean that it is time to sell the fund. Stocks are single entities with rates of return associated with what the market will bear. Stocks are driven by the buy low, sell high rationale, which explains why, in a falling stock market, many investors panic and quickly dump all of their stock-oriented assets.
Mutual funds are not singular entities; they are portfolios of financial instruments, such as stocks and bonds, chosen by a portfolio or fund manager in accordance with the funds strategy. An advantage of this portfolio of assets is diversification. There are many types of mutual funds, and their degrees of diversification vary. Sector funds, for instance, will have the least diversification, while balanced funds will have the most. Within all mutual funds, however, the decline of one or a few of the stocks can be offset by other assets within the portfolio that are either holding steady or increasing in value.
Because mutual funds are diverse portfolios rather than single entities, relying only on market timing to sell your fund may be a useless strategy since a funds portfolio may represent different kinds of markets. Also, because mutual funds are geared toward long-term returns, a rate of return that is lower than anticipated during the first year is not necessarily a sign to sell.
When Selling Your Fund
When you are cashing-in your mutual fund units, there are a couple of factors to consider that may affect your return:
• Back-end loads - If you are an investor who holds a fund that charges a back-end load, the total you receive when redeeming your units will be affected. Front-end loads, on the other hand, are sales fees charged when you first invest your money into the fund. So, if you had a front-end sales charge of 2%, your initial investment would have been reduced by 2%. If your fund has a back-end load, charges will be deducted from your total redemption value. For many funds, back-end loads tend to be higher when you liquidate your units earlier rather than later, so you need to determine if liquidating your units now is optimal.
• Tax consequences - If your mutual fund has realized significant capital gains in the past, you may be subject to capital gains taxes if the fund is held within a taxable account. When you redeem units of a fund that has a value greater than the total cost, you will have a taxable gain. The IRS has more detailed information on capital gains and their calculations in Publication 564: Mutual Fund Distributions.
When Your Fund Changes
Do keep in mind that even if your fund is geared to yielding long-term rates of returns, that does not mean you have to hold onto the fund through thick and thin. The purpose of a mutual fund is to increase your investment over time, not to demonstrate your loyalty to a particular sector or group of assets or a specific fund manager. To paraphrase Kenny Rogers, the key to successful mutual fund investing is knowing when to hold em and knowing when to fold em.
The following four situations are not necessarily indications that you should fold, but they are situations that should raise a red flag:
Change in a Funds Manager
When you put your money into a fund, you are putting a certain amount of trust into the fund managers expertise and knowledge, which you hope will lead to an outstanding return on an investment that suits your investment goals. If your quarterly or annual report indicates that your fund has a new manager, pay attention. If the fund mimics a certain index or benchmark, it may be less of a worry as these funds tend to be less actively managed. For other funds, the prospectus should indicate the reason for the change in manager. If the prospectus states that the funds goal will remain the same, it may be a good idea to watch the funds returns over the next year. For further peace of mind, you could also research the new managers previous experience and performance.
Change in Strategy
If you researched your fund before investing in it, you most likely invested in a fund that accurately reflects your financial goals. If your fund manager suddenly starts to invest in financial instruments that do not reflect the mutual funds original goals, you may want to re-evaluate the fund you are holding. For example, if your small-cap fund starts investing in a few medium or large-cap stocks, the risk and direction of the fund may change. Note that funds are typically required to notify shareholders of any changes to the original prospectus.
Additionally, some funds may change their names to attract more customers, and when a mutual fund changes its name, sometimes its strategies also change. Remember, you should be comfortable with the direction of the fund, so if changes bother you, get rid of it.
Consistent Underperformance
This can be tricky since the definition of underperformance differs from investor to investor. If the mutual fund returns have been poor over a period of less than a year, liquidating your holdings in the portfolio may not be the best idea since the mutual fund may simply be experiencing some short-term fluctuations. However, if you have noticed significantly poor performance over the last two or more years, it may be time to cut your losses and move on. To help your decision, compare the funds performance to a suitable benchmark or to similar funds. Exceptionally poor comparative performance should be a signal to sell the fund.
The Fund Becomes Too Big
In many cases a funds quick growth can hinder performance. The bigger the fund, the harder it is for a portfolio to move assets effectively. Note that fund size usually becomes more of an issue for focused funds or small-cap funds, which either deal with a smaller number of shares or invest in stock that has low volume and liquidity.
When Your Personal Investment Portfolio Changes
Besides changes in the mutual fund itself, other changes in your personal portfolio may require you to redeem your mutual fund units and transfer your money into a more suitable portfolio. Here are two reasons which might prompt you to liquidate your mutual fund units:
• The need to rebalance your portfolio - If you have a set asset allocation model to which you would like to adhere, you may need to rebalance your holdings at the end of the year in order to return your portfolio back to its original state. In these cases, you may need to sell or even purchase more of a fund within your portfolio to bring your portfolio back to its original equilibrium. You may also have to think about rebalancing if your investment goals change. For instance, if you decide to change your growth strategy to one that provides steady income, your current holdings in growth funds may no longer be appropriate.
• Need a tax break - If your fund has suffered significant capital losses and you need a tax break to offset realized capital gains of your other investments, you may want to redeem your mutual fund units in order to apply the capital loss to your capital gains.
The Bottom Line
Selling a mutual fund isnt something you do impulsively, without a great deal of thought and consideration. Remember that you originally invested in your mutual fund because you were confident in it, so make sure you are clear on your reasons for letting it go. However, if you have carefully considered all the pros and cons of your funds performance and you still think you should sell it, do it and dont look back.
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.
A Beginners Guide To Managing Your Money
Online brokers and easy access to financial data make investing your money as easy as starting a savings account, but in a world where the Internet has made do-it-yourselfers out of many, is investing a do-it-yourself activity and if it is, why not just fire your financial advisor or pay less fees to your mutual funds and set up a portfolio of your own? See: Risk and Diversification
The Internet has changed the way we live our lives. Not long ago purchasing stock was not as easy as it is now. The order went through a complex network of brokers and specialists before the execution was completed. In 1983, that all changed with a dentist in Michigan who made the first online stock transaction using a system developed by what is now E*TRADE Financial. (For related reading, see Brokers and Online Trading.)
The Effect
That one trade changed how investment products are transacted, researched and discussed. Computerized trading has resulted in highly liquid markets making it easy to buy and sell most securities quickly. The do-it-yourselfer now has access to the same free financial data that the professionals use, and websites like Stocktwits set up entire communities of investors and traders who exchange information in real time.
But just because its possible, does that mean that managing your own money is a good idea? Professional investors have a saying, The stock market is an expensive place to learn how to invest . They understand that its easier to lose money than it is to make money, and because of that, some argue that the wealth of information available to people with little financial background may offer a false sense of security.
Tools are only as good as the knowledge and experience of the person using them. Does a high priced software package used by the worlds best composers result in beautiful music? Does the newest innovation in surgical technology make a person with no prior training in medicine a top performing surgeon?
Theres no doubt that the Internet has given the retail investor the tools that they need to effectively manage their own money, but what about the knowledge and experience to use the tools effectively? For an investor who wants to manage their own money, what types of fundamental knowledge should they have before firing their financial adviser? (To learn more, read 4 Steps To Building A Profitable Portfolio.)
Modern Portfolio Theory
First, understand modern portfolio theory (MPT) and gain an understanding of how asset allocation is determined for an individual based on their individual factors. In order to gain a true understanding of these principals, youll have to dig deeper than the top level Internet blog articles that tell you that MPT is simply understanding allocation. MPT is not just about the allocation but also its efficiency. The best money managers understand how to position your money for maximum return with the least amount of risk. They also understand that efficiency is highly dynamic as the person ages and their financial picture changes.
Along with efficiency comes the dynamic nature of risk tolerance. At certain points in our lives, our risk tolerance may change. Along with retirement, we might have intermediate financial goals like saving for college or starting a new business, the portfolio has to be adjusted to meet those goals. Financial advisors often use proprietary software that produces detailed reports not available to the retail investor. (Read how to determine What Is Your Risk Tolerance?)
Academic Understanding of Risk
In the plethora of free resources, risk is treated too benignly. The term risk tolerance has been so overused that retail investors may believe that they understand risk if they understand that investing may involve losing money from time to time. Its much more than that.
Risk is a behavior that is hard to understand rationally because investors often act opposite of their best interests. A study conducted by Dalbar, Inc. showed that inexperienced investors tend to buy high and sell low, which often leads to losses in short-term trades.
Since risk is a behavior, its extremely difficult for an individual to have an accurate, unbiased picture of their true attitude towards risk. Day traders, often seen as having a high risk tolerance, may actually have an extremely low tolerance because theyre unwilling to hold an investment for longer periods. Great investors understand that success comes with fending off emotion and making decisions based on facts. Thats hard to do when youre working with your own money.
Efficient Market Hypothesis
Do you know how likely you are to out invest the overall market? What is the likelihood of any one football player being better than most of the other NFL players, and if they are better for a season what is the likelihood that they will be the best of the best for decades?
Efficient Market Hypothesis (EMH) might contain the answer. EMH states that everything known about an investment product is immediately factored into the price. If Intel releases information that sales will be light this quarter, the market will instantly react and adjust the value of the stock. According to EMH, there is no way to beat the market for sustained periods because all prices reflect true or fair value.
For the retail investor trying to pick individual stock names hoping to achieve gains that are larger than the market as a whole, this may work in the short term, just as gambling can sometimes produce short-term profits, but over a sustained period of decades, this strategy breaks down, say the proponents of EMH.
Even the brightest investment minds employing teams of researchers all over the world havent been able to beat the market over a sustained period. According to famed investor Charles Ellis in his book, Winning The Losers Game: Timeless Strategies For Successful Investing.
Opponents of this theory cite investors like Warren Buffett who have beat the market for most of his life, but what does EMH mean for the individual investor? Before deciding on your investing strategy , you need the knowledge and statistics to back it up.
If youre going to pick individual stocks in the hopes that theyll appreciate in value faster than the overall market, what evidence leads you to the idea that this strategy will work? If youre planning to invest in stocks for dividends, is there evidence that proves that an income strategy works? Would investing in an index fund be the best way? Where can you find the data needed to make these decisions? (For additional reading, see 7 Controversial Investing Theories.)
Experience
What do you do for a living? If you have a college degree, you might be one of the people who say that you didnt become highly skilled as a result of your degree but instead, because of the experience you amassed. When you first started your job were you highly effective from the very beginning?
Before managing your own money, you need experience. Gaining experience for investors often means losing money, and losing money in your retirement savings isnt an option.
Experience comes from watching the market and learning first-hand how it reacts to daily events. Professional investors know that the market has a personality that is constantly changing. Sometimes its hypersensitive to news events and other times it brushes them off. Some stocks are highly volatile while others have muted reactions.
The best way for the retail investor to gain experience is by setting up a virtual or paper trading account. These accounts are perfect for learning to invest while also gaining experience before committing real money to the markets. (Learn to trade with the Investopedia Stock Simulator, risk free!)
The Bottom Line
Many people have found success in managing their own money, but before putting your money at risk, become a student in the art of investing. If somebody wanted to do your job based on what they read on the Internet, would you advise it? If you were looking for a financial advisor, would you hire yourself based on your current level of knowledge? Your answer might be yes, but until you have the knowledge and experience as a money manager, managing a brokerage account with money that you could stand to lose might be OK, but leave your retirement money to the professionals.
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
Is Your Portfolio Overweight?
Over time, the makeup of your portfolio changes as various sectors and stocks perform better or worse than the market. Your original well-planned portfolio allocation evolves to one where the best performing stocks or ETFs become a more heavily-weighted part of your portfolio. Then the stocks that have underperformed make up less of the total allocation of your portfolio. This is a very unappealing - and unhealthy - shape for a portfolio to be in and it signals that its time to make some adjustments.
Get On the Scale
As time passes, it will become necessary for investors to re-examine their portfolios allocation. Being overweight in some sectors may not be the best strategy going forward. Stocks do not increase in value at the same rate. One asset category might appreciate more, causing an imbalance in your original allocation. In a 2000 study by Ibbotson and Kaplan, asset allocation was found to explain 93.6% of the variability of an assets performance. Placing your assets in the right sector leads to overweighting that sector in your portfolio.
Over time, one sector will become the leader and another will lag. For example, during the height of the dotcom boom, technology returned 66.69%, while consumer staples lost 14.49%. In this case, your portfolio would have been overweight in the technology sector. In 2000, as the dotcom boom ended, consumer staples delivered a 26.04% return and technology lost 42.04%. If you adjusted the weight of technology and increased the weight of consumer staples, your portfolio would have thanked you. Adjusting your portfolio to reduce its overweight condition usually leads to success. (Learn more about the dotcom boom and bust in our Market Crashes Tutorial.)
So how can you tell if your portfolio is out of balance? The best place to begin is with your original assessment of the market that led you to form your current portfolio allocation . Some questions to ask are:
• What has changed since your evaluation of the economy, the business cycle and the market? If your assessment has changed, then the weighting of your portfolio needs to change.
• What is the current level of risk in your portfolio and how has it changed since your last assessment? If the risk has increased beyond your comfort level, it is time to adjust your allocation to bring your risk back to levels that are more normal. Often when a sector has risen dramatically, it increases the risk that you might lose much or all of what you have gained. Reducing this overweight condition by selling part of these securities can help to lower the risk in the portfolio.
• Has the splendid performance of one or more stocks caused your portfolio to be less diversified, increasing its dependence on the performance of a few stocks? Diversification is a way to spread the risk across asset classes. As your portfolio over weighs toward one or a few stocks, your first-rate diversification has fallen off. (Find out how to find the right balance of diversification in Introduction To Diversification.)
If answering any of these questions leads you to conclude your portfolio is overweight, it is time to reallocate by selling some of the shares of the securities that have performed well and putting that money to work in stocks or ETFs that have the best potential to outperform in the future.
When to Make an Adjustment
An overweight portfolio requires you to address underperforming stocks or ETFs as well as those that are your best performers. Stocks and ETFs do not grow at the same rate. One asset category might appreciate more causing an imbalance from your original allocation.
When you make an adjustment, recognize that you will be dealing with underperforming stocks or ETFs as well as your best performing stocks or ETFs.
For your underperforming stocks or ETFs, the following are some of the questions you should ask:
• Are there problems with the company missing its earnings or revenue expectations?
• Are there changes in management that raise concern?
• Is the sector likely to continue to perform poorly over the next year?
For your better performing stocks or ETFs, here are some of the questions you should ask:
• Has the stock or ETF performed as expected?
• Has the growth in revenues and earnings slowed or are the prospects for growth still in place?
• How does the stock compare to its peers in terms of growth in revenues, margin, free cash flow and profit?
• Will the sector continue to outperform over the next year or is another sector about to take over? Buying in a bad year can lead to better performance in the next year. Selling after a good year captures profit should the sector have a bad year. It is a good strategy to capture some of your profits by selling your best performing shares.
Most successful long-term investors review their portfolios on a regular basis. While you do not have to make changes every quarter, it is a good idea to reassess your original assumptions and analysis. Moreover, evaluate the risk of a reversal in the course of the market. You goal is to avoid incurring unexpected losses and confirm your current allocation reflects your view of the market.
When to Stay the Course
So far, we have discussed when to make adjustments in your portfolio as the weighting of the stocks or ETFs changes. However, sometimes it is best to stay the course.
During your assessment of your best performing stocks or ETFs, you continue to believe they represent the best opportunities going forward. Often the underlying trend lasts for several years. In this case, should the trend continue, you and your portfolio will continue to benefit from the current overweighting.
Maybe your portfolio is weighted to sectors , funds or stocks that have underperformed. In this case, you might be properly positioned for a rebound. After all, you could have been early. In this case, it makes sense to stay the course or even add to your underperforming segments.
The tax man always has a say on when you can make changes in your portfolio. Capital gains on stocks or funds held for one year or less receive regular income tax treatment, whereas, securities held for more than one year receive more favorable tax treatment. While you should not make a decision to hold or sell a security only for tax reasons, it is one of the factors to consider.
The Bottom Line
A portfolio that is overweight in a sector, fund or stock should cause you to assess whether you should rebalance your portfolio. Simple allocation steps can help you to decide if you should rebalance or stay the course. Being proactive in your assessment will help to keep your portfolio properly aligned with the market, and is a lot better than sitting back and hoping everything will work out.
The Christmas Saints Of Wall Street
There is something about twinkling lights, garlands and gifts that causes a change in people - not the same change as a good eggnog with double the rum does, but its not far off. At Christmas time, people are merrier and more generous than usual. The Red Cross and UNICEF see moredonations in December than they do in all the other 11 months combined. People that usually sprint toward the office with their collars up and their eyes straight may be more likely to drop change into an outstretched hand or donation pot. Strangers exchange greetings instead of suspicious glares - this is the Christmas spirit.
This Christmas season, we will look at some people whose Christmas spirit doesnt leave when the pine needles drop. They may not be in the same league as ol Saint Nick, but they arent far off.
The Old Guard
Philanthropy on Wall Street is not a recent event. It has, however, been in need of a pick-up since the recession pinched, squeezed and finally stemmed the flow of big money into charity. The original saints of Wall Street can still be felt by tracing your finger down a list of libraries, hospitals, foundations, research centers, womens shelters and other projects aimed at helping the less fortunate. If you do this, youll find that some names occur more often than others.
Steel, Oil and Cars
The old guard, consisting of Andrew Carnegie, John D. Rockefeller, Andrew W. Mellon and Henry Ford, all made their fortunes in oil, steel or a combination of the two - cars, ships, etc. Charity came to these men late in life, and it is sometimes said that much of their philanthropy was giving back the money they made from crushing unions and creating unfair monopolies. While there is truth to these claims, it is also true that most of what we call unsavory business practices in hindsight were commonplace in their time. Carnegie, Rockefeller, Mellon and Fords devotion to education, medical care and the fight against poverty made them stand out at a time when the worlds richest people hoarded their money within their families. These men, and the foundations they left behind, have given billions of dollars to improve life in America.
The Next Generation
Whereas the philanthropists of the past were based in heavy industry, the next generation is largely made of tech street barons and stock gurus. Here are few of the members of the new generation of philanthropists:
Gordon and Betty Moore (Intel)
Gordon Moore was one of the co-founders of Intel Corporation. With his wife Betty, he has made donations in the hundreds of millions of dollars to two main causes: environmental conservation (with a focus on marine life) and medicine. The latter grew out of Betty Moores bad experiences with hospitals. Betty and her husband have funded training programs for nurses in the hope of preventing common medical mistakes. The Moores also have given generously to improving secondary education, culminating in a $600-million gift to the California Institute of Technology in 2001.
Michael and Susan Dell
Michael Dell, founder of Dell Computers, and his wife Susan have been increasing their involvement in philanthropy every year since Michael stepped down as the CEO in July 2004, leaving behind a profitable company through which he amassed a large personal fortune. Having four young children of their own, the Dells have used their wealth to advance childrens causes (heath, education and medicine). The Michael
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.
A Beginners Guide To Managing Your Money
Online brokers and easy access to financial data make investing your money as easy as starting a savings account, but in a world where the Internet has made do-it-yourselfers out of many, is investing a do-it-yourself activity and if it is, why not just fire your financial advisor or pay less fees to your mutual funds and set up a portfolio of your own? See: Risk and Diversification
The Internet has changed the way we live our lives. Not long ago purchasing stock was not as easy as it is now. The order went through a complex network of brokers and specialists before the execution was completed. In 1983, that all changed with a dentist in Michigan who made the first online stock transaction using a system developed by what is now E*TRADE Financial. (For related reading, see Brokers and Online Trading.)
The Effect
That one trade changed how investment products are transacted, researched and discussed. Computerized trading has resulted in highly liquid markets making it easy to buy and sell most securities quickly. The do-it-yourselfer now has access to the same free financial data that the professionals use, and websites like Stocktwits set up entire communities of investors and traders who exchange information in real time.
But just because its possible, does that mean that managing your own money is a good idea? Professional investors have a saying, The stock market is an expensive place to learn how to invest . They understand that its easier to lose money than it is to make money, and because of that, some argue that the wealth of information available to people with little financial background may offer a false sense of security.
Tools are only as good as the knowledge and experience of the person using them. Does a high priced software package used by the worlds best composers result in beautiful music? Does the newest innovation in surgical technology make a person with no prior training in medicine a top performing surgeon?
Theres no doubt that the Internet has given the retail investor the tools that they need to effectively manage their own money, but what about the knowledge and experience to use the tools effectively? For an investor who wants to manage their own money, what types of fundamental knowledge should they have before firing their financial adviser? (To learn more, read 4 Steps To Building A Profitable Portfolio.)
Modern Portfolio Theory
First, understand modern portfolio theory (MPT) and gain an understanding of how asset allocation is determined for an individual based on their individual factors. In order to gain a true understanding of these principals, youll have to dig deeper than the top level Internet blog articles that tell you that MPT is simply understanding allocation. MPT is not just about the allocation but also its efficiency. The best money managers understand how to position your money for maximum return with the least amount of risk. They also understand that efficiency is highly dynamic as the person ages and their financial picture changes.
Along with efficiency comes the dynamic nature of risk tolerance. At certain points in our lives, our risk tolerance may change. Along with retirement, we might have intermediate financial goals like saving for college or starting a new business, the portfolio has to be adjusted to meet those goals. Financial advisors often use proprietary software that produces detailed reports not available to the retail investor. (Read how to determine What Is Your Risk Tolerance?)
Academic Understanding of Risk
In the plethora of free resources, risk is treated too benignly. The term risk tolerance has been so overused that retail investors may believe that they understand risk if they understand that investing may involve losing money from time to time. Its much more than that.
Risk is a behavior that is hard to understand rationally because investors often act opposite of their best interests. A study conducted by Dalbar, Inc. showed that inexperienced investors tend to buy high and sell low, which often leads to losses in short-term trades.
Since risk is a behavior, its extremely difficult for an individual to have an accurate, unbiased picture of their true attitude towards risk. Day traders, often seen as having a high risk tolerance, may actually have an extremely low tolerance because theyre unwilling to hold an investment for longer periods. Great investors understand that success comes with fending off emotion and making decisions based on facts. Thats hard to do when youre working with your own money.
Efficient Market Hypothesis
Do you know how likely you are to out invest the overall market? What is the likelihood of any one football player being better than most of the other NFL players, and if they are better for a season what is the likelihood that they will be the best of the best for decades?
Efficient Market Hypothesis (EMH) might contain the answer. EMH states that everything known about an investment product is immediately factored into the price. If Intel releases information that sales will be light this quarter, the market will instantly react and adjust the value of the stock. According to EMH, there is no way to beat the market for sustained periods because all prices reflect true or fair value.
For the retail investor trying to pick individual stock names hoping to achieve gains that are larger than the market as a whole, this may work in the short term, just as gambling can sometimes produce short-term profits, but over a sustained period of decades, this strategy breaks down, say the proponents of EMH.
Even the brightest investment minds employing teams of researchers all over the world havent been able to beat the market over a sustained period. According to famed investor Charles Ellis in his book, Winning The Losers Game: Timeless Strategies For Successful Investing.
Opponents of this theory cite investors like Warren Buffett who have beat the market for most of his life, but what does EMH mean for the individual investor? Before deciding on your investing strategy , you need the knowledge and statistics to back it up.
If youre going to pick individual stocks in the hopes that theyll appreciate in value faster than the overall market, what evidence leads you to the idea that this strategy will work? If youre planning to invest in stocks for dividends, is there evidence that proves that an income strategy works? Would investing in an index fund be the best way? Where can you find the data needed to make these decisions? (For additional reading, see 7 Controversial Investing Theories.)
Experience
What do you do for a living? If you have a college degree, you might be one of the people who say that you didnt become highly skilled as a result of your degree but instead, because of the experience you amassed. When you first started your job were you highly effective from the very beginning?
Before managing your own money, you need experience. Gaining experience for investors often means losing money, and losing money in your retirement savings isnt an option.
Experience comes from watching the market and learning first-hand how it reacts to daily events. Professional investors know that the market has a personality that is constantly changing. Sometimes its hypersensitive to news events and other times it brushes them off. Some stocks are highly volatile while others have muted reactions.
The best way for the retail investor to gain experience is by setting up a virtual or paper trading account. These accounts are perfect for learning to invest while also gaining experience before committing real money to the markets. (Learn to trade with the Investopedia Stock Simulator, risk free!)
The Bottom Line
Many people have found success in managing their own money, but before putting your money at risk, become a student in the art of investing. If somebody wanted to do your job based on what they read on the Internet, would you advise it? If you were looking for a financial advisor, would you hire yourself based on your current level of knowledge? Your answer might be yes, but until you have the knowledge and experience as a money manager, managing a brokerage account with money that you could stand to lose might be OK, but leave your retirement money to the professionals.
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
What Makes Investors Tick?
Comparing individual investors to institutional investors is like comparing apples to oranges. While any individual polled on the street may claim to act independently and make current investment decisions based solely on a long-term plan, it is rare to see this in practice. Individual investors differ from institutions in their investment horizons, how they define risk and how they behave in response to changes in the economy and investment markets. This does not mean that individual investors are any less successful than institutional ones at investing - just that their style of investing presents unique challenges.
Types of Investors
Many attempts have been made to categorize the characteristics of individual investors; the Bailard, Biehl and Kaiser (BB
APR and APY: Why Your Bank Hopes You Cant Tell The Difference
It is often purported that Albert Einstein referred to compound interest as the greatest force on earth. Strong words from one of the smartest men to ever live. Although this articles intention is not to ponder Einsteins most compelling views, we do intend to demonstrate the importance of understanding the difference between annual percentage rate (APR) and annual percentage yield (APY). For most people, these terms are applied to loans and investment products, but they are not created equal and they significantly affect how much you earn or must pay in these transactions.
What Is Compounding?
At its most basic, compounding refers to earning interest on previous interest. All investors want to maximize compounding on their investments , while at the same time minimize it on their loans. (For more detail on this subject, see Investing 101: The Phenomenal Concept Of Compounding.)
Compounding is especially important in our APR vs. APY discussion because many financial institutions have a sneaky way of quoting interest rates that use compounding principles to their advantage. Being financially literate in this area will help you spot which interest rate you are really getting.
Defining APR and APY
APR is the annual rate of interest without taking into account the compounding of interest within that year. Alternatively, APY does take into account the effects of intra-year compounding. This seemingly subtle difference can have important implications for investors and borrowers. Here is a look at the formulas for each method:
For example, a credit card company might charge 1% interest each month; therefore, the APR would equal 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest. The APY for a 1% rate of interest compounded monthly would be 12.68% [(1 0.01)^12 – 1= 12.68%] a year. If you only carry a balance on your credit card for one months period you will be charged the equivalent yearly rate of 12%. However, if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of compounding each month.
The Borrowers Perspective
As a borrower, you are always searching for the lowest possible rate. When looking at the difference between APR and APY, you need to be worried about how a loan might be disguised as having a lower rate .
For example, when looking for a mortgage you are likely to choose a lender that offers the lowest rate. Although the quoted rates appear low, you could end up paying more for a loan than you originally anticipated.
This is because banks will often quote you the annual percentage rate (APR). As we learned earlier, this figure does not take into account any intra-year compounding either semi-annual (every six months), quarterly (every three months), or monthly (12 times per year) compounding of the loan. The APR is simply the periodic rate of interest multiplied by the number of periods in the year. This may be a little confusing at first, so lets look at an example to solidify the concept:
As you can see, even though a bank may have quoted you a rate of 5%, 7%, or 9% depending on the frequency of compounding (this may differ depending on the bank, state, country, etc), you could actually pay a much higher rate. In the case of a bank quoting an APR of 9%, this does not consider the effects of compounding. However, if you were to consider the effects of monthly compounding, as APY does, you will pay 0.38% more on your loan each year - a significant amount when you are amortizing your loan over a 25- or 30-year period.
This example should illustrate the importance of asking your potential lender what rate he or she is quoting when seeking a loan. It is also important when comparing borrowing prospects to compare apples to apples so to speak (comparing the same figures), so that you can make the most informed decision.
The Lenders Perspective
Now as you may have already guessed, it is not hard to see how standing on the other side of the lending tree can affect your results in an equally significant fashion, and how banks and other institutions will often entice individuals by quoting APY. Just as individuals who are seeking loans want to pay the lowest possible rate of interest, the same individual wants to receive the highest rate of interest when they themselves are the lender.
For example, suppose that you are shopping around for a bank to open a savings account with; obviously, you are seeking the highest rate of interest. It is in the banks best interest to quote you the APY, as opposed to the APR. They want to quote the highest possible rate they can to entice you with to their bank. They are much less likely to quote you the APR because this rate is lower than the APY given that there is some compounding during the year.
Again, it is important for the individual to acknowledge the distinction between these two rates, because they can significantly affect that amount of interest that can be accumulated in a savings account.
It should be noted that different countries have different rules and regulations in place to combat some of the unscrupulous activity surrounding quoting rates that has arisen in the past; however, there is no better insulator against these ruses than knowledge.
Summary
Whether you are shopping for a loan or seeking the highest rate of return on a savings account, be mindful of the different rates that a bank or institution quotes. Depending on which side of the lending tree you stand on, banks and institutions have different motives for quoting different rates. Always ensure you understand which rates they are quoting and then compare the equivalent rates between alternatives.
Managing A Portfolio Of Mutual Funds
After youve built your portfolio of mutual funds, you need to know how to maintain it. This week, we talk about how to manage a mutual-fund portfolio by walking through four common strategies:
The Wing-It Strategy
This is the most common mutual-fund strategy. Basically, if your portfolio does not have a plan or a structure, then it is likely that you are employing a wing-it strategy. If you are adding money to your portfolio today, how do you decide what to invest in? Are you one that searches for a new investment because you do not like the ones you already have? A little of this and a little of that? If you already have a plan or structure, then adding money to the portfolio should be really easy. Most experts would agree that this strategy will have the least success because there is little to no consistency.
Market-Timing Strategy
The market timing strategy implies the ability to get into and out of sectors or assets or markets at the right time. The ability to market time means that you will forever buy low and sell high. Unfortunately few investors buy low and sell high because investor behavior is usually driven by emotions instead of logic. The reality is most investors tend to do exactly the opposite – buy high and sell low. This leads many to believe that market timing does not work in practice. No one can accurately predict the future with any consistency.
Buy-and-Hold Strategy
This is by far the most commonly preached investment strategy . The reason for this is that statistical probabilities are on your side. Markets generally go up 75% of the time and down 25% of the time. If you employ a buy-and-hold strategy and weather through the ups and downs of the market, you will make money 75% of the time. If you are to be more successful with other strategies to manage your portfolio, you must be right more than 75% of the time to be ahead. The other issue that makes this strategy most popular is it is easy to employ. This does not make it better or worse. It is just easy to buy and hold.
Performance-Weigthing Strategy
This is somewhat of a middle ground between market timing and buy and hold. With this strategy, you will revisit your portfolio mix from time to time and make some adjustments. Lets walk through an oversimplified example using real performance figures.
Lets say that at the end of 1996, you started with an equity portfolio of four mutual funds and split the portfolio into equal weightings of 25% each.
After the first year of investing, the portfolio is no longer an equal 25% weighting because some funds performed better than others.
The reality is that after the first year, most investors are inclined to dump the loser (Fund D) for more of the winner (Fund A). However, the right strategy is to do the opposite to practice sell high, buy low. Performance weighting simply means that you sell some of the funds that did the best to buy some of the funds that did the worst. Your heart will go against this logic but it is the right thing to do because the one constant in investing is that everything goes in cycles.
In year four, Fund A has become the loser and Fund D has become the winner.
Performance weighting this portfolio year after year means that you would have taken the profit when Fund A was doing well to buy Fund D when it was down. In fact, if you had re-balanced this portfolio at the end of every year for five years, you would be further ahead as a result of performance weighting.
Its all about discipline.
The key to portfolio management is to have a discipline that you adhere to. The most successful money managers in the world are successful because they have a discipline to manage money and they have a plan. Warren Buffet said it best: To invest successfully over a lifetime does not require a stratospheric I.Q., unusual business insight or inside information. What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
The Frosty, Festive World Of Investing
The store windows are frosted with artificial snow, the eggnog is flowing, and frantic shoppers are crowding the malls - thats right, its Christmas time. In keeping with the yuletide spirit, lets take a look at the investing vocabulary that goes along with this credit card-shattering time of year.
Santa Claus Rally
Hes bearded, hes jolly and hes permanently associated with Coca-Cola - yep, thats Santa Claus. Santas origins are a matter of speculation, but according to popular belief, he is derived from a Dutch mythical character based on the historical figure Saint Nicholas, who supposedly gave presents to the poor. The modern-day Santa spends his time spreading cheer and promoting world peace by delivering gifts all over the globe.
In the investing world, Santa brings investors a gift in the form of a jump in the price of stocks, known as the Santa Claus rally. This rally usually occurs between Christmas and New Years day. There are many theories as to why this happens. Some people believe it is a result of year-end tax considerations, while others say its because all the market pessimists are away on holidays or because people are buying stock in anticipation of the January effect. Those of us who believe in the magic of Christmas think the rally may be due to seasonal cheer infecting the usually dour inhabitants of Wall Street - a true Christmas miracle.
Boston Snow Indicator
In 1942, Irving Berlin wrote a song called White Christmas, which Bing Crosby brought to life in an immensely popular recording. Since then, a snowy landscape is the ideal place to spend Christmas day.
The Boston snow indicator is a market theory that posits that a white Christmas in Boston will cause stock prices to climb. This is one of several dubious indicators that, while it may appear to be accurate, teaches us more about the fallibility of statistics than the behavior of the market. Other popular indicators of this sort include the skirt-length indicator and the attention paid to the ties worn by Alan Greenspan (the Federal Reserve Boards former chairman). The accuracy of the Boston snow indicator is perhaps best summed up by its nickname: BS indicator.
Elves
In contemporary tales of Santa Claus, the man in red uses an army of small, spry laborers to produce the incalculable amount of toys needed to supply all of the worlds children. Elves most recognizable features are the pointed tips of their ears and their sunny dispositions.
In the investing world, elves are the technical analysts who try to predict the direction of the market. More specifically, the term refers to the guests appearing on the PBS television show Wall Street Week. The elves of Wall Street are not exactly spry, nor do they have pointed ears, but they do seem to have an unfaltering sense of optimism. (To read more, see Elves And Gnomes: A Fairytale World Of Investing.)
Evergreen Funding/Loan
The origin tales of the Christmas tree are as varied and conflicting as those of any of the other Christmas traditions. It is said that the Romans often cut down a fir tree to keep in their houses during the sparse winter months as a form of appeasement to the goddess Ceres (originally Demeter, Greek goddess of the hearth). In the 1500s, Germany became the first nation to associate evergreens, trees that stay green year-round, with the Christian celebration. Martin Luther, founder of the Lutheran branch of Christianity, is fabled to have set up the first Christmas tree lit by candles. Since the late-eighteenth century, Christmas trees have become part of the secular Christmas celebration, and millions of trees - both artificial and real - are purchased every year.
There are two types of evergreens in the business world. For those in the United Kingdom, the term refers to the gradual infusion of capital into a new or recapitalized enterprise. Evergreen funding, like its namesake, is a source of capital that is forever green, in that it is continually replenished. This can take many forms: for example, government assistance or even help from an angel investor. Evergreen funding is very rare in the world of business. For Americans, an evergreen loan is a short-term loan that is continually renewed rather than repaid. This allows people or businesses to defer repayment until they have the funds to do so. But beware: an evergreen loan is not always the gift that it appears to be. (For further reading, see When Companies Borrow Money and Debt Reckoning.)
January Effect
For most people, January is a time of optimism regarding hastily formed resolutions. The fitness industry has an entirely separate type of January effect that sees a spike in sales of home exercise equipment, diet programs and gym memberships. This is followed by the spring slump, when membership cancellations and returned products cause a significant drop in profits.
The January effect is also a stock market phenomenon that occurs at the end of the year as investors begin to fret over taxes. Investors whose portfolios have been very successful may sell any stocks that are down. This locks in the loss and allows the investor to write it off against his or her capital gains. When enough investors do this simultaneously, it causes stocks to go down near the end of the year. However, the stocks are driven back up in January when investors buy back the stocks they sold. The January effect is said to affect small caps more than mid/large caps, but it has not happened in years because the markets have adjusted for the effects. Also, more people are using tax-sheltered retirement plans. The tax shelters remove any reason for selling in order to create a tax loss. Thus, in recent years, the January effect has become somewhat of a non-event - much like the tradition of making New Years resolutions. (For more insight, read Understanding Investor Behavior.)
Thats it for our look at all things frosty and festive on Wall Street. Now, grab yourself a cup of eggnog, relax in front of the fire and fall asleep with dreams of robust ROIs dancing in your head.
How To Invest In Private Companies
The internet has revolutionized the world of retail stock investing by making vast amounts of financial information quickly and easily available to individual investors. And though still in the early stages, the advent of digital information exchange is also making it easier for more individuals to invest in privately-held companies. Just as eBay has put buyers in contact with sellers of collectibles that used to collect dust on attic shelves, today private companies are much more able to seek out buyers of their securities to allow them to raise capital. TUTORIAL: Advanced Financial Statement Analysis
The drawback to vast amounts of information is the difficultly in knowing what to focus on. Below is a comparison of private companies to public ones, overview of private company types and varieties, investment options currently available for interested investors, and a survey of other considerations to make when investing in private companies.
Private Companies versus Public Companies
Overall, it is much easier to invest in a publicly-traded firm. Public companies, especially larger ones, can easily be bought and sold on the stock market and therefore have superior liquidity and a quote market value. Conversely, it can be years before a private firm can again be sold and prices must be negotiated between the seller and buyer.
In addition, public companies must file financial statements with the Securities and Exchange Commission (SEC), making it easy to track how they are doing on a quarterly and annual basis. Private companies are not required to provide any information to the public, so it can be extremely difficult to determine their financial soundness, historical sales and profit trends.
Investing in a public company may seem far superior to investing in a private one, but there are a handful of benefits to not being public. A major criticism of many public firms is that they are overly focused on quarterly results and meeting Wall Street analyst short-term expectations. This can cause them to miss out on long-term value creating opportunities, such as investing in a product that may take years to develop, hurting profits in the near term. Private firms can be better managed for the long term as they are out of Wall Streets reach. An annual report by the World Economic Forum has detailed that productivity increases when a public firm is taken private. They can also create more jobs when run more efficiently and profitably.
Being an owner of a private firm also means sharing more directly in the underlying firms profits. Earnings may grow at a public, firm but they are retained unless paid out as dividends or used to buy back stock. Private firm earnings can be paid directly to the owners. Private owners can also have a larger role in the decision-making process at the firm, especially those with large ownership stakes.
Types of Private Companies
From an investment standpoint, a private company is defined by its stage in development. For instance, when an entrepreneur is first starting a business he or she usually receives funding from a friend or family member on very favorable terms. This stage is referred to as angel investing, while the private company is known as an angel firm. Past the start-up phase is venture capital: investing where a group of more savvy investors comes along and offers growth capital and managerial know-how and other operational assistance. At this stage a firm is seen to have at least some long-term potential.
Past this stage can be mezzanine investing, which consists of equity and debt, the last of which will convert to equity if the private company cant meet its interest payment obligations. Later-stage private investing is simply referred to as private equity and is currently a multi-billion dollar business with many large players.
For investors, the stage of development a private company is in can help define how risky it is as an investment. For instance, approximately 40% of angel investments fail and the risk falls the more developed and profitable a private company becomes. And although the goal of many private firms is to eventually go public and provide liquidity for company founders or other investors, other private business may prefer to stay private given the benefits given above. Family businesses may also prefer privacy and the handing of ownership across generations. These are important matters to become aware of when deciding to invest in a private company. (To learn more, see What Is Private Equity?)
How to Invest in Private Companies
Early-stage private investing offers the most investment opportunities but is also the most risky. As a result, joining an angel investor organization or investment group may be a good idea to make the process easier and potentially spread the investment risks across a wide group of firms. Venture funds also exist and solicit outside partners for investing capital.
As noted above, the internet has quickly become a central source to find these types of organizations, while other websites have sprung up to fill a void and put buyers and sellers of many types of private companies together. Online sources also have made it easier to at least locate basic information on a private firm. This can be done by visiting the companys websites, and reading online blogs and articles that discuss the firm and its industry.
Other resources that can be used include small or private business brokers that specialize in buying and selling these firms. Private equity is also an option, and ironically a number of the largest private equity firms are publicly traded so can be purchased by any investor. A number of mutual funds can also offer at least some exposure to private companies.
Other Considerations
Overall, it is important to reiterate that private companies are illiquid and require very long investing time frames. Most investors will also need an eventual liquidity event to cash out. This includes when the company goes public, buys out private shareholders, or is bought out by a rival or another private equity firm. And just like with any security, private companies need to be valued to determine if they are fairly valued, overvalued or undervalued.
It is also important to note that investing directly in private firms is usually reserved only for wealthy individuals. The motivation is that they can handle the additional illiquidity and risk that goes with private investing. The SEC definition calls these wealthy individuals accredited investor or qualified institutional buyer (QIB) when considering institutions.
The Bottom Line
It is now easier than ever to invest in private companies, but an investor still has to do his or her homework. Investing directly is still not going to be a viable option for most investors, but there are still ways to gain exposure to private firms through more diversified investment vehicles. Overall, an investor definitely has to work harder an overcome more obstacles when investing in a private firm as compared to a public one, but they work can be worth it as there are a number of advantages to be gained by investing in private companies.
Daily Candlestick Chart for ASIBY
[img]stockcharts.com/c-sc/sc?s=ASIBY
Daily Candlestick Chart for FRCN
[img]stockcharts.com/c-sc/sc?s=FRCN
Daily Candlestick Chart for DLKM
[img]stockcharts.com/c-sc/sc?s=DLKM
Daily Candlestick Chart for BRWC
[img]stockcharts.com/c-sc/sc?s=BRWC
Daily Candlestick Chart for OLEPF
[img]stockcharts.com/c-sc/sc?s=OLEPF
Daily Candlestick Chart for GSML
[img]stockcharts.com/c-sc/sc?s=GSML
Daily Candlestick Chart for ORGN
[img]stockcharts.com/c-sc/sc?s=ORGN
Daily Candlestick Chart for APPA
[img]stockcharts.com/c-sc/sc?s=APPA
Daily Candlestick Chart for AMNF
[img]stockcharts.com/c-sc/sc?s=AMNF
Daily Candlestick Chart for TRUE
[img]stockcharts.com/c-sc/sc?s=TRUE
Daily Candlestick Chart for SBRH
[img]stockcharts.com/c-sc/sc?s=SBRH
Daily Candlestick Chart for NHVCF
[img]stockcharts.com/c-sc/sc?s=NHVCF
Daily Candlestick Chart for GFPOF
[img]stockcharts.com/c-sc/sc?s=GFPOF
Daily Candlestick Chart for MNEAF
[img]stockcharts.com/c-sc/sc?s=MNEAF
Daily Candlestick Chart for MINE
[img]stockcharts.com/c-sc/sc?s=MINE
Daily Candlestick Chart for GELV
[img]stockcharts.com/c-sc/sc?s=GELV
Daily Candlestick Chart for MDXG
[img]stockcharts.com/c-sc/sc?s=MDXG
Daily Candlestick Chart for TFER
[img]stockcharts.com/c-sc/sc?s=TFER
Daily Candlestick Chart for TRUE
[img]stockcharts.com/c-sc/sc?s=TRUE