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10 Tips For The Successful Long-Term Investor
While it may be true that in the stock market there is no rule without an exception, there are some principles that are tough to dispute. Lets review 10 general principles to help investors get a better grasp of how to approach the market from a long-term view. Every point embodies some fundamental concept every investor should know.
1. Sell the losers and let the winners ride!
Time and time again, investors take profits by selling their appreciated investments, but they hold onto stocks that have declined in the hope of a rebound. If an investor doesnt know when its time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice. The following information might help:
• Riding a Winner - Peter Lynch was famous for talking about tenbaggers, or investments that increased tenfold in value. The theory is that much of his overall success was due to a small number of stocks in his portfolio that returned big. If you have a personal policy to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a sell-after-I-have-tripled-my-money mentality has ever had a tenbagger. Dont underestimate a stock that is performing well by sticking to some rigid personal rule - if you dont have a good understanding of the potential of your investments , your personal rules may end up being arbitrary and too limiting. (For more insight, see Pick Stocks Like Peter Lynch.)
• Selling a Loser - There is no guarantee that a stock will bounce back after a protracted decline. While its important not to underestimate good stocks, its equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because its also an acknowledgment of your mistake. But its important to be honest when you realize that a stock is not performing as well as you expected it to. Dont be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses. (For related reading, check out To Sell Or Not To Sell.)
2. Dont chase a hot tip.
Whether the tip comes from your brother, your cousin, your neighbor or even your broker, you shouldnt accept it as law. When you make an investment, its important you know the reasons for doing so; do your own research and analysis of any company before you even consider investing your hard-earned money. Relying on a tidbit of information from someone else is not only an attempt at taking the easy way out, its also a type of gambling. Sure, with some luck, tips sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run. (Find what you should pay attention to - and what you should ignore in Listen To The Markets, Not Its Pundits.)
3. Dont sweat the small stuff.
As a long-term investor, you shouldnt panic when your investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitablevolatility of the short term. Also, dont overemphasize the few cents difference you might save from using a limit versus market order.
Granted, active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself. (Learn the difference between passive investing and apathy in Ostrich Approach To Investing A Bird-Brained Idea.)
4. Dont overemphasize the P/E ratio.
Investors often place too much importance on the price-earnings ratio (P/E ratio). Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesnt necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued. (For further reading, see our tutorial Understanding the P/E Ratio.)
4. Resist the lure of penny stocks .
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way youve lost 100% of your initial investment . A lousy $5 company has just as much downside risk as a lousy $75 company. In fact, a penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.
6. Pick a strategy and stick with it.
Different people use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick with it. An investor who flounders between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors should avoid. Take Warren Buffetts actions during the dotcom boom of the late 90s as an example. Buffetts value-oriented strategy had worked for him for decades, and - despite criticism from the media - it prevented him from getting sucked into tech startups that had no earnings and eventually crashed. (Want to adopt the Oracle of Omahas investing style? See Think Like Warren Buffett.)
7. Focus on the future.
The tough part about investing is that we are trying to make informed decisions based on things that have yet to happen. Its important to keep in mind that even though we use past data as an indication of things to come, its what happens in the future that matters most.
A quote from Peter Lynchs book One Up on Wall Street (1990) about his experience with Subaru demonstrates this: If Id bothered to ask myself, How can this stock go any higher? I would have never bought Subaru after it already went up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that. The point is to base a decision on future potential rather than on what has already happened in the past.
8. Adopt a long-term perspective.
Large short-term profits can often entice those who are new to the market. But adopting a long-term horizon and dismissing the get in, get out and make a killing mentality is a must for any investor. This doesnt mean that its impossible to make money by actively trading in the short term. But, as we already mentioned, investing and trading are very different ways of making gains from the market. Trading involves very different risks that buy-and-hold investors dont experience. As such, active trading requires certain specialized skills.
Neither investing style is necessarily better than the other - both have their pros and cons. But active trading can be wrong for someone without the appropriate time, financial resources, education and desire.
9. Be open-minded.
Many great companies are household names, but many good investments are not household names. Thousands of smaller companies have the potential to turn into the large blue chips of tomorrow. In fact, historically, small-caps have had greater returns than large-caps; over the decades from 1926-2001, small-cap stocks in the U.S. returned an average of 12.27% while the Standard
5 Ways To Protect Your Portfolio From Volatility
Is it possible to gauge the level of anxiety in the investment markets? Certainly, and The Chicago Board of Exchange Volatility Index (VIX) measures it. The VIX reacts in real time - just as a stock does - and measures the level of volatility in the U.S. markets over the next 30 days. When the VIX is at 30, in the next 30 days the market could move as much as 2.5% in either direction, (30% divided by 12 months equals 2.5%). The VIX has hovered around 30 for the latter part of 2011, indicating that the market is still highly volatile.
Although short-term traders may call periods of high volatility great times to make money, the truth is that traders of all skill levels will face challenges in this market. What can you do to protect your portfolio against the wild stock market swings? Though it may not sound exciting to the average active trader, the best defense is to stick with conservative, boring strategies.
Hedge
Think of hedging as an insurance policy. Lets assume that you own Bank of America stock and it is now in a market decline. One way to hedge would be to purchase a put option, with a strike price below where you purchased the stock. You wont lose money on any move below your strike price. Other hedging options include short selling a stock and purchasing put options on index funds, like popular exchange traded fund SPDR S
The Key To High Returns Is A Disciplined Strategy
Having a disciplined investment strategy differentiates the professional from the do-it-yourself investor. An investment strategy does not have to be complicated. If you were to sum up Warren Buffetts investing strategy it might be to buy good businesses at a fair price with the intention of holding them forever. An investment strategy helps provide focus and ensures emotions are held in check when making decisions. Having an investment strategy for both asset mix and security will provide discipline to be a successful investor over the long term. In this article, we will look at different investment strategies and how you can pick the right one for you.
See also: 4 Steps To Creating A Better Investment Strategy
Strategic Asset Mix
Central to any investment plan is the strategic or long-term asset mix. In general, its purpose is to capture the benefits of diversification and the advantages of investing in assets that have a low correlation to each other. The strategic asset mix is essentially the link between your long-term investment goals and the capital markets.
Many investors want to keep the current asset mix of their portfolios close to their strategic asset mix. A simple rebalancing strategy is all that is required. Typically, as each asset class will perform differently over time, the asset mix will deviate from the strategic asset mix. (For related reading, see Diversification: Its All About (Asset) Class.)
For example, a balanced portfolio of 60% equity and 40% fixed income could become 70% equity and 30% fixed income after a strong stock market. Rebalancing would require selling equities and using the proceeds to buy fixed-income assets, so the asset mix then will get back to the long-term asset mix. The rebalancing could be done on a regular basis, semiannually, annually or when an asset class deviates by a set percentage.
A rebalancing strategy is effectively a sell high, buy low strategy, because it will always sell the assets that have been the best relative performers and buy the assets with relatively weak performance. (For more insight, read 6 Asset Allocation Strategies That Work .)
Tactical Asset Allocation
A tactical asset mix strategy attempts to add value by overweighting the asset classes that are expected to outperform, and underweighting those asset classes that are expected to underperform.
As an example, if an investor believes that over the next year the U.S. equities market will be weak, the investor might decide to underweight his exposure to equities and overweight cash or bonds. Unlike a rebalancing strategy, which is mechanical, tactical asset allocation requires some forecasting ability to make the correct decisions. (To learn more about asset allocation, read Achieving Optimal Asset Allocation.)
Security Selection Strategies
There is no shortage of strategies to choose from when buying and selling stocks. Countless books have been written describing many strategies in detail. Strategies range from growth, to value and momentum. There are fundamentally based strategies, as well as technical or quantitative strategies. There are also top-down and bottom-up strategies. (For related reading, see A Top-Down Approach To Investing.)
Each type of strategy will have its proponents, but any logical, rational strategy that is followed consistently is always better than no strategy at all. The value is in the disciplined approach a strategy provides.
Developing Your Strategy
The value of an investing strategy is not in the strategy itself, but in how it is followed and implemented.
In investing, there are two different approaches: a top-down or a bottom-up approach. In a top-down approach, the investor analyzes the major factors that will influence the capital market and the companies in it. The main factors will be the overall economy, monetary and fiscal policy, demographic changes, inflation, industrial sector trends and interest rates. Other investors will take a bottom-up approach, analyzing individual companies, their financial statements, growth prospects and industry trends.
One approach is not necessarily better than the other. However, depending on your own interests, knowledge and experience, one approach might be more appropriate for you. As an example, an economist will likely take a top-down approach to investing and an accountant might feel more comfortable with a bottom-up approach. Your orientation to analyzing investments will determine the types of investment strategies to follow.(For more insight, see Where Top Down Meets Bottoms Up.)
In addition, the amount of time you are able to commit to your investment program determines the type of strategies to use and how much of the investment decision-making you will delegate. For example, with limited time, an investor might build a portfolio using a few exchanged-traded funds (ETFs) and then rebalance once a year. Similarly, the investor might have all of their investments in a couple of balanced funds or have their funds managed by a discretionary money manager.
Information and knowledge are important to the success of any investment strategy. One should identify the sources of data, investment commentary or investment research. The biggest challenge as an investor is to be able to filter out truly useful information from the needless noise. A disciplined investment strategy forces you to focus on the information that is important for your decision-making process.
Delegating Decision Making
Recognize the fact that it is difficult to do it all when it comes to investing. If you have a well-diversified portfolio and you invest in the major assets classes - and maybe some of the sub-asset classes as well - you are not likely to be able to actively manage all your investments effectively, unless you have a lot of time to allocate. The question then becomes, what to do yourself and what to delegate to others. It is important to stick to your strengths and interests and delegate out the asset classes in which you have a limited expertise.
As an example, an investor might feel confident trading large cap value stocks. As such, this person should concentrate their efforts on that asset class and delegate the investment management of other asset classes to someone else. Investors have several choices here, including active or passive management of the funds or assets they are looking to delegate. From the passive management side, you can find an advisor to handle the areas that you have little time to manage or research; you could also purchase a mutual fund or an ETF that provides exposure to these areas.
The Bottom Line
Having an investment strategy for both asset mix and security selection is important to ensure consistent success as an investor. Having the discipline to follow an investment strategy is more important than the actual strategy chosen. Equally important to any strategy, is determining what to manage yourself and what to delegate to others.
Achieving Optimal Asset Allocation
The important task of appropriately allocating your available investment funds among different assets classes can seem daunting, with so many securities to choose from. Here we will illustrate what asset allocation is, its importance and how you can determine your appropriate asset mix and maintain it.
What is Asset Allocation?
Asset allocation refers to the strategy of dividing your total investment portfolio among various asset classes, such as stocks, bonds and money market securities. Essentially, asset allocation is an organized and effective method of diversification.
To help determine which securities, asset classes and subclasses are optimal for your portfolio, lets define some briefly:
• Large-cap stock - These are shares issued by large companies with a market capitalization generally greater than $10 billion.
• Mid-cap stock - These are issued by mid-sized companies with a market cap generally between $2 billion and $10 billion.
• Small-cap stocks - These represent smaller-sized companies with a market cap of less than $2 billion. These types of equities tend to have the highest risk due to lower liquidity.
• International securities - These types of assets are issued by foreign companies and listed on a foreign exchange. International securities allow an investor to diversify outside of his or her country, but they also have exposure to country risk - the risk that a country will not be able to honor its financial commitments.
• Emerging markets - This category represents securities from the financial markets of a developing country. Although investments in emerging markets offer a higher potential return, there is also higher risk, often due to political instability, country risk and lower liquidity. (For further reading, see What Is An Emerging Market Economy?)
• Fixed-income securities - The fixed-income asset class comprises debt securities that pay the holder a set amount of interest, periodically or at maturity, as well as the return of principal when the security matures. These securities tend to have lower volatility than equities, and have lower risk because of the steady income they provide. Note that though payment of income is promised by the issuer, there is a risk of default. Fixed-income securities include corporate and government bonds.
• Money market - Money market securities are debt securities that are extremely liquid investments with maturities of less than one year. Treasury bills (T-bills) make up the majority of these types of securities.
• Real-estate investment trusts (REITs) - Real estate investment trusts (REITs) trade similarly to equities, except the underlying asset is a share of a pool of mortgages or properties, rather than ownership of a company.
Maximizing Return While Minimizing Risk
The main goal of allocating your assets among various asset classes is to maximize return for your chosen level of risk, or stated another way, to minimize risk given a certain expected level of return. Of course to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes. Figure 1 compares the risk and potential return of some of the more popular ones:
Figure 1
Equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk since they are backed by the government, but they also provide the lowest potential return.
Figure 1 also demonstrates that when you choose investments with higher risk, your expected returns also increase proportionately. But this is simply the result of the risk-return tradeoff. They will often have high volatility and are therefore suited for investors who have a high risk tolerance(can stomach wide fluctuations in value), and who have a longer time horizon.
Its because of the risk-return tradeoff - which says you can seek high returns only if you are willing to take losses - that diversification through asset allocation is important. Since different assets have varying risks and experience different market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. So, while part of your portfolio may contain more volatile securities - which youve chosen for their potential of higher returns - the other part of your portfolio devoted to other assets remains stable. Because of the protection it offers, asset allocation is the key to maximizing returns while minimizing risk.
Deciding Whats Right for You
As each asset class has varying levels of return for a certain risk, your risk tolerance, investment objectives, time horizon and available capital will provide the basis for the asset composition of your portfolio.
To make the asset allocation process easier for clients, many investment companies create a series of model portfolios, each comprising different proportions of asset classes. These portfolios of different proportions satisfy a particular level of investor risk tolerance. In general, these model portfolios range from conservative to very aggressive:
Conservative model portfolios generally allocate a large percent of the total portfolio to lower-risk securities such as fixed-income and money market securities.
The main goal with a conservative portfolio is to protect the principal value of your portfolio. As such, these models are often referred to as capital preservation portfolios.
Even if you are very conservative and prefer to avoid the stock market entirely, some exposure can help offset inflation. You could invest the equity portion in high-quality blue chip companies, or an index fund, since the goal is not to beat the market. (For further reading, see the tutorialAll about Inflation.)
A moderately conservative portfolio is ideal for those who wish to preserve a large portion of the portfolios total value, but are willing to take on a higher amount of risk to get some inflation protection.
A common strategy within this risk level is called current income. With this strategy, you chose securities that pay a high level of dividends or coupon payments.
Moderately aggressive model portfolios are often referred to as balanced portfolios since the asset composition is divided almost equally between fixed-income securities and equities in order to provide a balance of growth and income.
Since these moderately aggressive portfolios have a higher level of risk than those conservative portfolios mentioned above, select this strategy only if you have a longer time horizon (generally more than five years), and have a medium level of risk tolerance.
Aggressive portfolios mainly consist of equities, so these portfolios value tends to fluctuate widely. If you have an aggressive portfolio, your main goal is to obtain long-term growth of capital. As such the strategy of an aggressive portfolio is often called a capital growth strategy.
To provide some diversification, investors with aggressive portfolios usually add some fixed-income securities.
Very aggressive portfolios consist almost entirely of equities. As such, with a very aggressive portfolio, your main goal is aggressive capital growth over a long time horizon.
Since these portfolios carry a considerable amount of risk, the value of the portfolio will vary widely in the short term.
Nothing is Set in Stone
Note that the above outline of model portfolios and the associated strategies offer only a loose guideline - you can modify the proportions above to suit your own individual investment needs. How you fine tune the models above can depend on your future needs for capital and on what kind of an investor you are. For instance, if you like to research your own companies and devote time to stock picking, you will likely further divide your equities portion of your portfolio among subclasses of stocks. By doing so, you can achieve a specialized risk-return potential within one portion of your portfolio. (For further reading, see the tutorial Guide to Stock-Picking Strategies.)
Also, the amount of cash and equivalents, or money market instruments you place in your portfolio will depend on the amount of liquidity and safety you need. If you need investments that can be liquidated quickly or you would like to maintain the current value of your portfolio, you might want to put a larger portion of your investment portfolio in money market or short-term fixed-income securities. Those investors who do not have liquidity concerns and have a higher risk tolerance will have a small portion of their portfolio within these instruments.
Maintaining Your Portfolio
Once you have chosen your portfolio investment strategy, it is important to conduct periodic portfolio reviews, as the value of the various assets within your portfolio will change, affecting the weighting of each asset class. For example, if you start with a moderately conservative portfolio, the value of the equity portion may increase significantly during the year, making your portfolio more like that of an investor practicing a balanced portfolio strategy , which is higher risk!
In order to reset your portfolio back to its original state, you need to rebalance your portfolio. Rebalancing is the process of selling portions of your portfolio that have increased significantly, and using those funds to purchase additional units of assets that have declined slightly or increased at a lesser rate. This process is also important if your investment strategy or tolerance for risk has changed.
Conclusion
Asset allocation is a fundamental investing principle, because it helps investors maximize profits while minimizing risk. The different asset allocation strategies described above can help any investor do this regardless of their risk tolerance and investment goals. In turn, choosing an appropriate asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term investment goals and reach your desired return at the lowest amount of risk possible.
Do You Understand Investment Risk?
A study conducted by Englands Financial Services Authority (FSA) in 2004 called Consumer Understanding Of Financial Risk has shed some light on how well people understand their investments. Such understanding or, in some cases, the lack of understanding, leads to specific types of behavior. It is important for both investors and providers to be aware of the differences. In this article, well go over this study and what it can teach investors about their own understanding of their personal finances.
Types of Investors
The respondents in the study were divided into three main groups:
• Trusters
were defined as unsophisticated investors who primarily rely on their advisors.
• Partners are those with an intermediate level of sophistication who work together with their advisors to some extent.
• Controllers are sophisticated and often experienced investors who rely on their own understanding and make their own decisions. This simple categorization provides considerable insight into the nature of investors, what they do and expect, and the associated risks and opportunities that exist for both buyers and sellers. (Learn more in What Is Your Risk Tolerance?)
Education and Financial Sophistication Are Not the Same Thing
It is important to note that general or even business education doesnt necessarily translate into specific knowledge about the world of investment. A business graduate is certainly likely to know something about investments, but this knowledge may be very theoretical and, therefore, less applicable to the graduates own experiences. Conversely, a doctor who happens to be very interested in getting the most bang for his buck on his investments may turn out to have a relatively sophisticated understanding of investing. Likewise, retired people with no formal financial education or qualifications may spend hours pouring over the financial pages of the newspaper every day. In this case, they may know more than their advisors about day-to-day developments.
Lets look in more detail at each of the three groups.
Trusters Rely On Others
Not surprisingly, the lower the level of sophistication, the less people understand about the risks to which their money is exposed and the more naive they tend to be about what their advisors or investment companies can really do for them. The FSA study points out that this naiveté can lead to excessive reliance on people in the industry, which can open the door for potential abuse. Alternatively, it may lead nervous and distrusting people to adopt a savings approach, which may be too risk averse to benefit the investor. (For related reading, see Determining Risk And The Risk Pyramid.)
When investors lack understanding of their investments, this often means that they are uninformed about what is meant by high, medium and low risk, the three standard categories prevalent in much of the investment literature. The problem is compounded by the failure of many brokers to present people with clear options with clear risk labels. Investors often think that anything to do with shares is risky, or that fund managers generally buy shares with such astuteness and expertise that there is little risk involved. Generally speaking, the reality is that the greater the value of equities that an investor has in his or her portfolio, the greater the amount of risk the person is taking on compared to leaving that money in a savings account.
While many investors understand the principles of diversification and risk well enough to know it is bad to put all of their eggs in one basket, they do not always know how to avoid this in practice. Trusters, for example, were shown to have a poor understanding of asset classes and very little, if any, awareness of the range of products available in the market. As a result, they tend to delegate most of the responsibility to others, which predictably leads to somewhat mixed results. (For more insight, see Introduction To Diversification and The Importance Of Diversification.)
Partners Make Mutual Decisions
Partners tend to have a medium level of sophistication and often want to be involved in the decision-making process. They generally read newspapers or magazines in and attempt to follow the markets. They also rely on advisors for help, but certainly not for the basic-level financial matters. They are interested in the second opinion that brokers or advisors provide, and also seek professional assistance to ensure that paperwork is completed correctly and that they understand any applicable legal jargon.
The main difficulty with partners is finding the right balance between control and delegation. While some advisors do not welcome client input, and others tend to think customers know more than they really do, it is essential for the investor-advisor roles to be quite clear to both parties. It may be best to have some form of written agreement - even if its an informal one - that highlights the nature of each players respective roles.
Controllers Want to Run the Show
Controllers are sophisticated investors (or at least think they are!) and prefer to take charge of the investing process. They are very interested in the financial sector and have a good understanding of both products and markets. They are aware of and understand the array of products that are available and they know what they want. They also spend a considerable amount of time researching products and markets, and they actively send off for financial statements, buy the latest books, and even attend investment seminars and conferences. This does not necessarily make them risk friendly, but they understand risk and know how to construct an optimal portfolio. Such investors often purchase on execution only, which means that they dont seek an advisors advice.
With respect to controllers who think they are sophisticated, there are certainly those who ought to delegate more of their investing tasks to a professional. Investors who seriously overestimate their knowledge or abilities can get into trouble.
Who Are You and Who Are You Dealing With?
The FSA study reinforces the need for informed financial planning; it also suggests the vulnerability of investors who are either too trusting or not trusting enough. For trusters, and to a lesser extent, partners, ease of understanding is fundamental and checks need to be built into any investment process to ensure that peoples personal and financial circumstances and willingness to take risk are taken into account. If investors are to be served well, what they know and, more importantly, what they do not know, must form a fundamental component of the advisory process. Advisors must take the level of investor knowledge and understanding very seriously.
Biggest Industry Ups And Downs Of 2011
February 06, 2012 | Filed Under » Bear Market, Bull Market, Economy, Investing Basics
2011 was an eventful year for the American economy, and it seems to be slowly getting back on track. The last few weeks of 2011 started seeing some positive activity in consumer spending. Banking is slowly recovering, as is the demand for cars. Employment opportunities have improved with unemployment down to 8.5%. However, it was a recession-hit year for the economy, with greater focus on creating higher consumption through greater government spending.
SEE: Consumer Spending As A Market Indicator
According to the Chief Financial Officer of Washington DC, Natwar Gandhi, There is no consumer demand as we speak. The businesses are not investing, as they do not see any demand out there. So the only player who can really generate demand is government. The government needs to spend money. There is a need to spend money on our infrastructure, which is abysmal. Unless government spends money to generate demand, I see very likely a lost decade, the kind that the Japanese have experienced over the last 10 years.
Lets take a look at the industries that performed the best and the worst in the year 2011. We will keep the Standard and Poors (S
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
Breaking Down The Balance Sheet
A companys financial statements - balance sheet, income and cash flow statements - are a key source of data for analyzing the investment value of its stock. Stock investors, both the do-it-yourselfers and those who follow the guidance of an investment professional, dont need to be analytical experts to perform a financial statement analysis. Today, there are numerous sources of independent stock research, online and in print, which can do the number crunching for you. However, if youre going to become a serious stock investor, a basic understanding of the fundamentals of financial statement usage is a must. In this article, we help you to become more familiar with the overall structure of the balance sheet.
The Structure of a Balance Sheet
A companys balance sheet is comprised of assets, liabilities and equity. Assets represent things of value that a company owns and has in its possession, or something that will be received and can be measured objectively. Liabilities are what a company owes to others - creditors, suppliers, tax authorities, employees, etc. They are obligations that must be paid under certain conditions and time frames. A companys equity represents retained earnings and funds contributed by its shareholders, who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment.
The relationship of these items is expressed in the fundamental balance sheet equation:
Assets = Liabilities Equity
The meaning of this equation is important. Generally, sales growth, whether rapid or slow, dictates a larger asset base - higher levels of inventory, receivables and fixed assets (plant, property and equipment). As a companys assets grow, its liabilities and/or equity also tends to grow in order for its financial position to stay in balance.
How assets are supported, or financed, by a corresponding growth in payables, debt liabilities and equity reveals a lot about a companys financial health. For now, suffice it to say that depending on a companys line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a sign of a financially healthy company. While it may be an overly simplistic view of the fundamental accounting equation, investors should view a much bigger equity value compared to liabilities as a measure of positive investment quality, because possessing high levels of debt can increase the likelihood that a business will face financial troubles.
Balance Sheet Formats
Standard accounting conventions present the balance sheet in one of two formats: the account form (horizontal presentation) and the report form (vertical presentation). Most companies favor the vertical report form, which doesnt conform to the typical explanation in investment literature of the balance sheet as having two sides that balance out. (For more information on how to decipher balance sheets, see Reading The Balance Sheet.)
Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that positions the various account entries into five sections:
Assets = Liabilities Equity
• Current assets (short-term): items that are convertible into cash within one year
• Non-current assets (long-term): items of a more permanent nature
As total assets these =
• Current liabilities (short-term): obligations due within one year
• Non-current liabilities (long-term): obligations due beyond one year
These total liabilities
• Shareholders equity (permanent): shareholders investment and retained earnings
Account Presentation
In the asset sections mentioned above, the accounts are listed in the descending order of their liquidity (how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of their priority for payment. In financial reporting, the termscurrentand non-current are synonymous with the terms short-term and long-term, respectively, and are used interchangeably. (For related reading, see The Working Capital Position.)
It should not be surprising that the diversity of activities included among publicly-traded companies is reflected in balance sheet account presentations. The balance sheets of utilities, banks, insurance companies, brokerage and investment banking firms and other specialized businesses are significantly different in account presentation from those generally discussed in investment literature. In these instances, the investor will have to make allowances and/or defer to the experts.
Lastly, there is little standardization of account nomenclature. For example, even the balance sheet has such alternative names as a statement of financial position and statement of condition. Balance sheet accounts suffer from this same phenomenon. Fortunately, investors have easy access to extensive dictionaries of financial terminology to clarify an unfamiliar account entry.
The Importance of Dates
A balance sheet represents a companys financial position for one day at its fiscal year end, for example, the last day of its accounting period, which can differ from our more familiar calendar year. Companies typically select an ending period that corresponds to a time when their business activities have reached the lowest point in their annual cycle, which is referred to as their natural business year.
In contrast, the income and cash flow statements reflect a companys operations for its whole fiscal year - 365 days. Given this difference in time, when using data from the balance sheet (akin to a photographic snapshot) and the income/cash flow statements (akin to a movie) it is more accurate, and is the practice of analysts, to use an average number for the balance sheet amount. This practice is referred to as averaging, and involves taking the year-end (2004 and 2005) figures - lets say for total assets - and adding them together, and dividing the total by two. This exercise gives us a rough but useful approximation of a balance sheet amount for the whole year 2005, which is what the income statement number, lets say net income, represents. In our example, the number for total assets at year-end 2005 would overstate the amount and distort the return on assets ratio (net income/total assets). The Bottom Line
Since a companys financial statements are the basis of analyzing the investment value of a stock, this discussion we have completed should provide investors with the big picture for developing an understanding of balance sheet basics.
Do Your Investments Have Short-Term Health?
For companies, being able to meet short-term financial obligations is an integral part of maintaining operations and growing in the future. After all, if its not able to meet todays debts, a company might not live to see another day! Thats why its essential for investors to know how to evaluate a companys short-term financial health. Here we take you through a few of the ratios that are the foremost tools for doing so.
The Basics of Liquidity
A large factor determining a companys short-term financial health is liquidity, the definition of which depends on context. In stock trading , liquidity is the degree to which the market is willing to buy a particular stock. As a characteristic of an asset, liquidity refers to the ease with which an asset can be converted into cash. This is the definition of liquidity we are interested in.
Lets compare two different kinds of assets: a building and a money market account. Even if these two assets are valued at $100,000 on a companys financial statement, their liquidities have different implications for the companys short-term health. The money market account, an asset referred to as a cash equivalent, can be converted into cash within a day or two, if not immediately. The building, however, is very illiquid. For the company to get its cash, it must sell the building, which could take months, if not years.
Essentially, a companys short-term liquidity determines how well it can make its necessary payments (cash outflows) - which include employee wages, interest and supplier costs - given the revenue it generates (cash inflows). If a company has no cash equivalents, its inflows need to match or exceed cash outflows. So, if a company has a bad month and it has no supply of liquid assets like a money market account , it will be unable to make its necessary payments.
The Current Ratio
The first ratio we will look at is the current ratio, which compares all of a companys current assets to all of its current liabilities. In general, the term current means less than one year. So, current assets include cash, accounts receivable, inventory, prepaid expenses and other assets that can be converted to cash within one year. Current liabilities include short-term debt, interest, accounts payable and any other outstanding liabilities that are due within a years time.
When calculating this ratio, you are essentially trying to determine whether a company can meet its short-term obligations. It will likely be able to do so if the ratio is above 1; if the ratio is less than 1, the company is likely to fall short. We say likely because although a ratio of 1 or greater indicates that the company has more current assets than current liabilities, it may be inappropriate to judge certain industries by a rigid standard.
For industries that generally have a large portion of current assets tied up in inventory, a ratio of 1.5 or even 2 might be a better standard. When analyzing the current ratio, as when looking at any ratio, an investor should make comparisons between companies that operate in the same industry. Different industries have different business needs, so investors must modify their analyses accordingly.
Finally, bigger is not necessarily better in the case of the current ratio. A really high ratio, 10 for example, should probably sound some alarm bells, because it indicates that the company has a large amount of current assets that could - and probably should - be invested back into the company. Although a company with a very high current ratio may be stable in the short term, it probably has no means of sustaining its long-term growth and performance.
The Acid Test or Quick Ratio
The acid test is a more rigorous version of the current ratio. It indicates whether a firm, without selling inventory, has enough short-term assets to cover its immediate liabilities. Companies with ratios of less than 1 cannot pay their current liabilities without selling inventories and should be viewed with extreme care. An acid test that is much lower than the current ratio signals that current assets are highly dependent on inventory - retail is a type of business in which this would occur. In general, a ratio of 1 is considered satisfactory, although, as with the current ratio, the acid test should be compared only within a similar industry.
Interest Coverage
Interest coverage indicates what portion of debt interest is covered by a companys cash flow. A ratio of less than 1 means the company is having problems generating enough cash flow to pay its interest expenses. Ideally, you want the ratio to be over 1.5. A company with no long-term debt doesnt have any interest expense; this situation causes the current ratio to give enviable results. Companies with a poor interest coverage ratio can improve it by improving cash flow and/or lowering interest expenses by paying off debt.
This ratio is popular not only among investors, but also with creditors, who want to see that a companys short-term health is strong and that the company has sufficient cash flow to make principal and interest payments.
Another notable fact about the ratio is that sometimes different numerators will be used. For example, some analysts or creditors will use EBITDA in place of EBIT.
Activity Ratios
There are a few different activity ratios, but essentially, their main function is to help determine the companys cash flow cycle, giving a picture of how efficiently assets are being used. Almost any current account can be analyzed in terms of this cycle, but the three most common activity ratios each measure one of the following:
1. How long a company takes to collect receivables
2. How long a company takes to sell inventory
3. How long it takes to pay suppliers
The calculation of activity ratios is a little complex, but to give you an idea of how these ratios work, well look at the activity ratio dedicated to accounts receivable. Suppose that a company has total credit sales of $22 million. At the beginning of the year, accounts receivable is at $4.5 million, and at the end its $1.5 million. By using the accounts receivable turnover ratio we can determine that the companys receivables turn over at a rate of approximately 7.3 times per year. This means receivables remain outstanding for an average of 50 days. Here the calculations are represented mathematically:
Although we only demonstrate one activity ratio calculation here, the others are calculated in a similar fashion. All it takes is some research into the company and some number crunching.
Lets look at an example to put this all into context. Suppose that the above company has to pay suppliers within 90 days of purchase and suppose that, by calculating another activity ratio, we find the company holds inventory for 80 days. As the companys accounts receivable remain outstanding for 50 days, we find it has a cash cycle of 130 days (80 50). In other words, from the time it purchases its product from the supplier, the company takes approximately 130 days to collect payment from the customer.
The supplier, however, requires a payment within 90 days of the purchase. This 40-day discrepancy may create short-term liquidity problems for the company. This means investors should conduct more research to determine whether there is justification for this difference, and whether it is likely to cause hardship for the company. Examining activity ratios and determining a companys cash flow cycle are important elements of determining a companys short-term health and should be analyzed in conjunction with the other short-term liquidity ratios.
Conclusion
By honing in on crucial aspects of a companys financial health, ratios shed light on how well a company will do in the short term. More importantly, they help investors determine whether a company has the stability to get through unexpected problems today. If a company cannot maintain operations in the short term, it will not have the ability to provide investors with any benefits in the long term.
Warren Buffetts Bear Market Maneuvers
In times of economic decline, many investors ask themselves, What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target? The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices. In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy. (For more on Warren Buffett and his current holdings, sign up for our Coattail Investor newsletter.)
The Buffett Investment Philosophy
Buffett has a set of definitive assumptions about what constitutes a good investment. These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price. (For further reading, see Warren Buffett: The Road To Riches and What Is Warren Buffetts Investing Style?)
Buffett looks for businesses with a durable competitive advantage. What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source. (For more insight, see Competitive Advantage Counts, 3 Secrets Of Successful Companies and Economic Moats Keep Competitors At Bay.)
Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.
In addition, he assumes the following points to be true:
• The global economy is complex and unpredictable.
• The economy and the stock market do not move in sync.
• The market discount mechanism moves instantly to incorporate news into the share price.
• The returns of long-term equities cannot be matched anywhere else.
Buffett Investment Activity
Berkshire Hathaway investment industries over the years have included:
• Insurance
• Soft drinks
• Private jet aircraft
• Chocolates
• Shoes
• Jewelry
• Publishing
• Furniture
• Steel
• Energy
• Home building
The industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?
Buffett Investment Criteria
Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions . While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:
1. The candidate company has to be in a good and growing economy or industry.
2. It must enjoy a consumer monopoly or have a loyalty-commanding brand.
3. It cannot be vulnerable to competition from anyone with abundant resources.
4. Its earnings have to be on an upward trend with good and consistent profit margins.
5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio.
6. It must have high and consistent returns on invested capital.
7. The company must have a history of retaining earnings for growth.
8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow.
9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments.
10. The company must be free to adjust prices for inflation.
The Buffett Investment Strategy
Buffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices. Buffett does not buy tech shares because he doesnt understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadnt been around long enough to provide sufficient performance history for his purposes.
And even in a bear market , although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.
Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown. (To learn about the disadvantage of being confined to blue chip stocks , read Why Warren Buffett Envies You.)
Buffetts selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low. And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.
Conclusion
Buffetts strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices. Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made. Buffett also benefits from a huge cash war chest that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.
Testing 3 Types Of Analysts
There are several types of analysts on Wall Street, and they produce different kinds of reports because they have different kinds of clients. Lets take a look at the different responsibilities required for each analyst, so that you can do your own litmus test to see which ones you need to pay attention to.
Sell-Side Analysts
These are the analysts that are dominating todays headlines. They are employed by brokerage houses to analyze companies and write in-depth research reports, conducting what is sometimes called primary research. These reports are used to sell an idea to individuals and institutional clients. Individual investors gain access to these reports mainly by having accounts with the brokerage firm. For example, to get free research from Merrill Lynch, you need to have an account with a Merrill Lynch broker. Sometimes the reports can be purchased through a third party such as Multex.com. Institutional clients (i.e. mutual fund managers) get research from the brokerages institutional brokers. (Keep reading about fund managers in Should You Follow Your Fund Manager? and Choose A Fund With A Winning Manager.
A good sell-side research report contains a detailed analysis of a companys competitive advantages and provides information on managements expertise and how the companys operating and stock valuation compares to a peer group and its industry. The typical report also contains an earnings model and clearly states the assumptions that are used to create the forecast.
Writing this type of report is a time consuming process. Information is obtained by reading the companys filings for the Securities
Pros And Cons Of Offshore Investing
Offshore investing is often demonized in the media, which paints a picture of investors stashing their money with some illegal company located on an obscure Caribbean island where the tax rate is next to nothing. While its true that there will always be instances of shady offshore deals, the vast majority of offshore investing is perfectly legal. In fact, depending on your situation, offshore investing may offer you many advantages.
What Is Offshore Investing?
Offshore investing refers to a wide range of investment strategies that capitalize on advantages offered outside of an investors home country. We will briefly touch on the advantages and disadvantages of offshore investing. The particulars are far beyond the scope of this introductory article.
There is no shortage of money-market, bond and equity assets offered by reputable offshore companies that are fiscally sound, time-tested and, most importantly, legal.
Advantages
There are several reasons why people invest offshore:
Tax Reduction - Many countries (known as tax havens) offer tax incentives to foreign investors. The favorable tax rates in an offshore country are designed to promote a healthy investment environment that attracts outside wealth. For a tiny country with very few resources and a small population, attracting investors can dramatically increase economic activity. Simply put, offshore investment occurs when offshore investors form a corporation in a foreign country. The corporation acts as a shell for the investors accounts, shielding them from the higher tax burden that would be incurred in their home country. Because the corporation does not engage in local operations, little or no tax is imposed on the offshore corporation. Many foreign companies also enjoy tax-exempt status when they invest in U.S. markets. As such, making investments through foreign corporations can hold a distinct advantage over making investments as an individual. (For additional information, read What is an Emerging Market Economy?)
In recent years, however, the U.S. government has become increasingly aware of the tax revenue lost to offshore investing, and has created more defined and restrictive laws that close tax loopholes. Investment revenue earned through offshore investment is now a focus of regulators and the tax man alike. According to the U.S. Internal Revenue Service (IRS), U.S. citizens and residents are now taxed on their worldwide income. As a result, investors who use offshore entities to evade U.S. federal income tax on capital gains can be prosecuted for tax evasion. Therefore, although the lower corporate expenses of offshore companies can translate into better gains for investors, the IRS maintains that U.S. taxpayers are not to be allowed to evade taxes by shifting their individual tax liability to some foreign entity. (To learn more, see How International Tax Rates Impact Your Investments.)
Asset Protection - Offshore centers are popular locations for restructuring ownership of assets. Through trusts, foundations or through an existing corporation individual wealth ownership can be transferred from people to other legal entities. Many individuals who are concerned about lawsuits, or lenders foreclosing on outstanding debts elect to transfer a portion of their assets from their personal estates to an entity that holds it outside of their home country. By making these on-paper ownership transfers, individuals are no longer susceptible to seizure or other domestic troubles. If the trustor is a U.S. resident, their trustor status allows them to make contributions to their offshore trust free ofincome tax. However, the trustor of an offshore asset-protection fund will still be taxed on the trusts income (the revenue made from investments under the trust entity), even if that income has not been distributed.
Confidentiality - Many offshore jurisdictions offer the complimentary benefit of secrecy legislation. These countries have enacted laws establishing strict corporate and banking confidentiality. If this confidentiality is breached, there are serious consequences for the offending party. An example of a breach of banking confidentiality is divulging customer identities; disclosing shareholders is a breach of corporate confidentiality in some jurisdictions. However, this secrecy doesnt mean that offshore investors are criminals with something to hide. Its also important to note that offshore laws will allow identity disclosure in clear instances of drug trafficking, money laundering or other illegal activities. From the point of view of a high-profile investor, however, keeping information, such as the investors identity, secret while accumulating shares of a public company can offer that investor a significant financial (and legal) advantage. High-profile investors dont like the public at large knowing what stocks theyre investing in. Multi-millionaire investors dont want a bunch of little fish buying the same stocks that they have targeted for large volume share purchases - the little guys run up the prices.
Because nations are not required to accept the laws of a foreign government, offshore jurisdictions are, in most cases, immune to the laws that may apply where the investor resides. U.S. courts can assert jurisdiction over any assets that are located within U.S. borders. Therefore, it is prudent to be sure that the assets an investor is attempting to protect not be held physically in the United States.
Diversification of Investment - In some countries, regulations restrict the international investment opportunities of citizens. Many investors feel that such restriction hinders the establishment of a truly diversified investment portfolio. Offshore accounts are much more flexible, giving investors unlimited access to international markets and to all major exchanges. On top of that, there are many opportunities in developing nations, especially in those that are beginning to privatize sectors that were formerly under government control. Chinas willingness to privatize some industries has investors drooling over the worlds largest consumer market. (To read more, see Investing Beyond Your Borders.)
Disadvantages
Tax Laws are Tightening - Tax agencies like the IRS arent ignorant of offshore strategies. Theyve clamped down on some traditional ways of tax avoidance. There are still loopholes, but most are shrinking more and more every year. In 2004, the IRS amended the Internal Revenue Code (IRC) and began to collect taxes from both American corporations that operate out of another country and American citizens and residents who earn money through offshore investments. (For more information on tax laws that affect offshore investors, see the IRS International Taxpayer - Expatriation Tax.)
Cost - Offshore Accounts are not cheap to set up. Depending on the individuals investment goals and the jurisdiction he or she chooses, an offshore corporation may need to be started. Setting up an offshore corporation may mean steep legal fees, corporate or account registration fees and in some cases investors are even required to own property (a residence) in the country in which they have an offshore account or operate a holding company. Furthermore many offshore accounts require minimum investments of between $100,000 and $1 million. Businesses that make money facilitating offshore investment know that their offerings are in high demand by the very wealthy and they charge accordingly.
How Safe Is Offshore Investing?
Popular offshore countries such as the Bahamas, Bermuda, Cayman Islands and Isle of Man are known to offer fairly secure investment opportunities. More than half of the worlds assets and investments are held in offshore jurisdictions and many well-recognized companies have investment opportunities in offshore locales. Still, like every investment you make, use common sense and choose a reputable investment firm. It is also a good idea to consult with an experienced and reputable investment advisor, accountant, and lawyer who specializes in international investment. If you are looking to protect your assets, or are concerned with estate planning or business succession, it would be prudent to find an attorney (or a team of attorneys) specializing in asset protection, wills or business succession. Of course, these professionals come at a cost. In most cases the benefits of offshore investing are outweighed by the tremendous costs of professional fees, commissions, travel expenses and downside risk. (For more information, see Investment Scams: Prime Banks.)
Conclusion
We are not lawyers, tax accountants or offshore investment experts in any country. Every individuals situation is different. Offshore investment is beyond the means of most investors, and above the risk tolerance of others.
Despite the many pitfalls of offshore investing, it can still pay off to shift some investment assets from one jurisdiction to another. As with even the most insignificant investment, do your research before parting with your money - unless youre prepared to lose it.
Pros And Cons Of Offshore Investing
Offshore investing is often demonized in the media, which paints a picture of investors stashing their money with some illegal company located on an obscure Caribbean island where the tax rate is next to nothing. While its true that there will always be instances of shady offshore deals, the vast majority of offshore investing is perfectly legal. In fact, depending on your situation, offshore investing may offer you many advantages.
Tutorial: Personal Income Tax Guide
What Is Offshore Investing?
Offshore investing refers to a wide range of investment strategies that capitalize on advantages offered outside of an investors home country. We will briefly touch on the advantages and disadvantages of offshore investing. The particulars are far beyond the scope of this introductory article.
There is no shortage of money-market, bond and equity assets offered by reputable offshore companies that are fiscally sound, time-tested and, most importantly, legal.
Advantages
There are several reasons why people invest offshore:
Tax Reduction - Many countries (known as tax havens) offer tax incentives to foreign investors. The favorable tax rates in an offshore country are designed to promote a healthy investment environment that attracts outside wealth. For a tiny country with very few resources and a small population, attracting investors can dramatically increase economic activity. Simply put, offshore investment occurs when offshore investors form a corporation in a foreign country. The corporation acts as a shell for the investors accounts, shielding them from the higher tax burden that would be incurred in their home country. Because the corporation does not engage in local operations, little or no tax is imposed on the offshore corporation. Many foreign companies also enjoy tax-exempt status when they invest in U.S. markets. As such, making investments through foreign corporations can hold a distinct advantage over making investments as an individual. (For additional information, read What is an Emerging Market Economy?)
In recent years, however, the U.S. government has become increasingly aware of the tax revenue lost to offshore investing, and has created more defined and restrictive laws that close tax loopholes. Investment revenue earned through offshore investment is now a focus of regulators and the tax man alike. According to the U.S. Internal Revenue Service (IRS), U.S. citizens and residents are now taxed on their worldwide income. As a result, investors who use offshore entities to evade U.S. federal income tax on capital gains can be prosecuted for tax evasion. Therefore, although the lower corporate expenses of offshore companies can translate into better gains for investors, the IRS maintains that U.S. taxpayers are not to be allowed to evade taxes by shifting their individual tax liability to some foreign entity. (To learn more, see How International Tax Rates Impact Your Investments.)
Asset Protection - Offshore centers are popular locations for restructuring ownership of assets. Through trusts, foundations or through an existing corporation individual wealth ownership can be transferred from people to other legal entities. Many individuals who are concerned about lawsuits, or lenders foreclosing on outstanding debts elect to transfer a portion of their assets from their personal estates to an entity that holds it outside of their home country. By making these on-paper ownership transfers, individuals are no longer susceptible to seizure or other domestic troubles. If the trustor is a U.S. resident, their trustor status allows them to make contributions to their offshore trust free of income tax. However, the trustor of an offshore asset-protection fund will still be taxed on the trusts income (the revenue made from investments under the trust entity), even if that income has not been distributed.
Confidentiality - Many offshore jurisdictions offer the complimentary benefit of secrecy legislation. These countries have enacted laws establishing strict corporate and banking confidentiality. If this confidentiality is breached, there are serious consequences for the offending party. An example of a breach of banking confidentiality is divulging customer identities; disclosing shareholders is a breach of corporate confidentiality in some jurisdictions. However, this secrecy doesnt mean that offshore investors are criminals with something to hide. Its also important to note that offshore laws will allow identity disclosure in clear instances of drug trafficking, money laundering or other illegal activities. From the point of view of a high-profile investor, however, keeping information, such as the investors identity, secret while accumulating shares of a public company can offer that investor a significant financial (and legal) advantage. High-profile investors dont like the public at large knowing what stocks theyre investing in. Multi-millionaire investors dont want a bunch of little fish buying the same stocks that they have targeted for large volume share purchases - the little guys run up the prices.
Because nations are not required to accept the laws of a foreign government, offshore jurisdictions are, in most cases, immune to the laws that may apply where the investor resides. U.S. courts can assert jurisdiction over any assets that are located within U.S. borders. Therefore, it is prudent to be sure that the assets an investor is attempting to protect not be held physically in the United States.
Diversification of Investment - In some countries, regulations restrict the international investment opportunities of citizens. Many investors feel that such restriction hinders the establishment of a truly diversified investment portfolio. Offshore accounts are much more flexible, giving investors unlimited access to international markets and to all major exchanges. On top of that, there are many opportunities in developing nations, especially in those that are beginning to privatize sectors that were formerly under government control. Chinas willingness to privatize some industries has investors drooling over the worlds largest consumer market. (To read more, see Investing Beyond Your Borders.)
Disadvantages
Tax Laws are Tightening - Tax agencies like the IRS arent ignorant of offshore strategies. Theyve clamped down on some traditional ways of tax avoidance. There are still loopholes, but most are shrinking more and more every year. In 2004, the IRS amended the Internal Revenue Code (IRC) and began to collect taxes from both American corporations that operate out of another country and American citizens and residents who earn money through offshore investments. (For more information on tax laws that affect offshore investors, see the IRS International Taxpayer - Expatriation Tax.)
Cost - Offshore Accounts are not cheap to set up. Depending on the individuals investment goals and the jurisdiction he or she chooses, an offshore corporation may need to be started. Setting up an offshore corporation may mean steep legal fees, corporate or account registration fees and in some cases investors are even required to own property (a residence) in the country in which they have an offshore account or operate a holding company. Furthermore many offshore accounts require minimum investments of between $100,000 and $1 million. Businesses that make money facilitating offshore investment know that their offerings are in high demand by the very wealthy and they charge accordingly.
How Safe Is Offshore Investing?
Popular offshore countries such as the Bahamas, Bermuda, Cayman Islands and Isle of Man are known to offer fairly secure investment opportunities. More than half of the worlds assets and investments are held in offshore jurisdictions and many well-recognized companies have investment opportunities in offshore locales. Still, like every investment you make, use common sense and choose a reputable investment firm. It is also a good idea to consult with an experienced and reputable investment advisor, accountant, and lawyer who specializes in international investment. If you are looking to protect your assets, or are concerned with estate planning or business succession, it would be prudent to find an attorney (or a team of attorneys) specializing in asset protection, wills or business succession. Of course, these professionals come at a cost. In most cases the benefits of offshore investing are outweighed by the tremendous costs of professional fees, commissions, travel expenses and downside risk. (For more information, see Investment Scams: Prime Banks.)
Conclusion
We are not lawyers, tax accountants or offshore investment experts in any country. Every individuals situation is different. Offshore investment is beyond the means of most investors, and above the risk tolerance of others.
Despite the many pitfalls of offshore investing, it can still pay off to shift some investment assets from one jurisdiction to another. As with even the most insignificant investment, do your research before parting with your money - unless youre prepared to lose it.
Make Money Trading Earnings Announcements
If you watch the financial news media, youve seen how earnings releases work. Its like the big game on Sunday; it comes with hours, and sometimes days, of endless experts providing their predictions of what the numbers will look like, and other experts providing their strategies of how to invest or trade based on the news. Some would say that it is media overhype at its finest and if you watch the endless flurry of graphics and earnings central music, its hard to argue.
But for the individual investor , is there money to be made in earnings announcements? As with most topics on Wall Street, there are a flurry of opinions, and it will ultimately come down to individual choice, but here are two of those opinions to help you decide for yourself.
SEE: Profit From Earnings Surprises With Straddles And Strangles
Why You Should Try
According to CNBC, the percentage of S
The Basics Of Corporate Structure
CEOs, CFOs, presidents and vice presidents: whats the difference? With the changing corporate horizon, it has become increasingly difficult to keep track of what people do and where they stand on the corporate ladder. Should we be paying more attention to news relating to the CFO or the vice president? What exactly do they do?
Corporate governance is one of the main reasons that these terms exist. The evolution of public ownership has created a separation between ownership and management . Before the 20th century, many companies were small, family owned and family run. Today, many are large international conglomerates that trade publicly on one or many global exchanges.
In an attempt to create a corporation where stockholders interests are looked after, many firms have implemented a two-tier corporate hierarchy. On the first tier is the board of governors or directors: these individuals are elected by the shareholders of the corporation. On the second tier is the upper management: these individuals are hired by the board of directors. Lets begin by taking a closer look at the board of directors and what its members do.
Board of Directors
Elected by the shareholders, the board of directors is made up of two types of representatives. The first type involves individuals chosen from within the company. This can be a CEO , CFO, manager or any other person who works for the company on a daily basis. The other type of representative is chosen externally and is considered to be independent from the company. The role of the board is to monitor the managers of a corporation, acting as an advocate for stockholders. In essence, the board of directors tries to make sure that shareholders interests are well served.
Board members can be divided into three categories:
• Chairman – Technically the leader of the corporation, the chairman of the board is responsible for running the board smoothly and effectively. His or her duties typically include maintaining strong communication with the chief executive officer and high-level executives, formulating the companys business strategy , representing management and the board to the general public and shareholders, and maintaining corporate integrity. A chairman is elected from the board of directors.
• Inside Directors – These directors are responsible for approving high-level budgets prepared by upper management, implementing and monitoring business strategy, and approving core corporate initiatives and projects. Inside directors are either shareholders or high-level management from within the company. Inside directors help provide internal perspectives for other board members. These individuals are also referred to as executive directors if they are part of companys management team.
• Outside Directors – While having the same responsibilities as the inside directors in determining strategic direction and corporate policy, outside directors are different in that they are not directly part of the management team. The purpose of having outside directors is to provide unbiased and impartial perspectives on issues brought to the board.
Management Team
As the other tier of the company, the management team is directly responsible for the day-to-day operations (and profitability) of the company.
• Chief Executive Officer (CEO) – As the top manager, the CEO is typically responsible for the entire operations of the corporation and reports directly to the chairman and board of directors. It is the CEOs responsibility to implement board decisions and initiatives and to maintain the smooth operation of the firm, with the assistance of senior management . Often, the CEO will also be designated as the companys president and therefore also be one of the inside directors on the board (if not the chairman). (To learn about what CEOs sometimes do but shouldnt, see Pages From The Bad CEO Playbook.)
• Chief Operations Officer (COO) – Responsible for the corporations operations, the COO looks after issues related to marketing, sales, production and personnel. More hands-on than the CEO, the COO looks after day-to-day activities while providing feedback to the CEO. The COO is often referred to as a senior vice president.
• Chief Finance Officer (CFO) – Also reporting directly to the CEO, the CFO is responsible for analyzing and reviewing financial data , reporting financial performance, preparing budgets and monitoring expenditures and costs. The CFO is required to present this information to the board of directors at regular intervals and provide this information to shareholders and regulatory bodies such as the Securities and Exchange Commission (SEC). Also usually referred to as a senior vice president, the CFO routinely checks the corporations financial health and integrity.
How Does This Affect Your Investment?
Together, management and the board of governors have the ultimate goal of maximizing shareholder value . In theory, management looks after the day-to-day operations, and the board ensures that shareholders are adequately represented. But the reality is that many boards are made up of management.
When you are researching a company, its always a good idea to see if there is a good balance between internal and external board members. Other good signs are the separation of CEO and chairman roles and a variety of professional expertise on the board from accountants, lawyers and executives. Its not uncommon to see boards that are comprised of the current CEO (who is chairman), the CFO and the COO, along with the retired CEO, family members, etc. This does not necessarily signal that a company is a bad investment, but, as a shareholder, you should question whether such a corporate structure is in your best interests.
Taking The Bite Out Of A Bear Market
A bear market is defined as a decline of 20% in the following three major stock market indexes :
• Dow Jones Industrial Average (DJIA)
• Standard
Five Things To Know About Asset Allocation
With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold - this is referred to as your asset allocation.
What is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors its the best protection against major loss should things ever go amiss in one investment class or sub-class.
The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the sidelines.
We must emphasize that there is no simple formula that can find the right asset allocation for every individual - if there were, we certainly wouldnt be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation:
Risk vs. Return
The risk-return tradeoff is at the core of what asset allocation is all about. Its easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest potential (stocks and derivatives) isnt the answer. The crashes of 1929, 1981, 1987, and the more recent declines of 2000-2002 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. Its time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return. Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you cant keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities. (To learn more about bond investing , see Bond Basics Tutorial.
Dont Rely Solely on Financial Software or Planner Sheets
Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one rule of thumb that many advisors use to determine the proportion a person should allocate to stocks is to subtract the persons age from 100. In other words, if youre 35, you should put 65% of your money into stock and the remaining 35% into bonds, real estate and cash.
But standard worksheets sometimes dont take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that dont capture your financial goals. Remember, financial institutions love to peg you into a standard plan not because its best for you, but because its easy for them. Rules of thumb and planner sheets can give people a rough guideline, but dont get boxed into what they tell you.
Determine your Long and Short-Term Goals
We all have our goals. Whether you aspire to own a yacht or vacation home, to pay for your childs education, or simply to save up for a new car , you should consider it in your asset allocation plan. All of these goals need to be considered when determining the right mix.
For example, if youre planning to own a retirement condo on the beach in 20 years, you need not worry about short-term fluctuations in the stock market . But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments.
Time is your Best Friend
The U.S. Department of Labor has said that for every 10 years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Having time not only allows you to take advantage of compounding and the time value of money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A bad couple of years in the stock market will likely show up as nothing more than an insignificant blip 30 years from now.
Just Do It!
Once youve determined the right mix of stocks, bonds and other investments, its time to implement it. The first step is to find out how your current portfolio breaks down. Its fairly straightforward to see the percentage of assets in stocks vs. bonds, but dont forget to categorize what type of stocks you own (small, mid, or large cap). You should also categorize your bonds according to their maturity (short, mid, long-term). Mutual funds can be more problematic. Fund names dont always tell the entire story. You have to dig deeper in the prospectus to figure out where fund assets are invested.
There is no one standardized solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you dont have, dont worry. Its never too late to get started. Its also never too late to give your existing portfolio a face-lift: asset allocation is not a one-time event, its a life-long process of progression and fine-tuning.
Trust In Utilities
Utilities become desirable, to both novice and seasoned investors, whenever the market or the economy is going through a downturn. Picking individual utility companies to invest in can be time consuming, and if you choose poorly, you will not take part in the benefits that investing in public utilities can provide.
Mutual funds that specialize in utility companies are most often where investors place their money. They offer instant diversification, but that comes at a price – in the form of management fees, which are normally passed along to investors. Utility trusts that operate or invest in public utilities can be a good alternative for many investors. (For more on mutual fund fees, take a look at Stop Paying High Mutual Fund Fees.)
What Are Utility Trusts?
Utility trusts are a type of income trust that are less growth focused than traditional income trusts. An income trust is simply an investment trust that holds income-generating assets; in this case, it would be utilities. The income produced is passed on to the investors (usually called unitholders). These payments are generally higher than a typical stock dividend because, relative to income trusts, non-income trusts use more of their income to fuel more growth instead of paying it out to shareholders.
Income trusts typically aim to pay out a consistent cash flow to their unitholders. It is important to remember that, like dividend-paying stocks, income trusts do not guarantee a dividend, though they strive to pay one. If the underlying business loses money, the trust can reduce or eliminate payouts altogether.
Understanding Utilities
A public utility is a company or organization that operates and maintains the infrastructure for a public service. Public utility companies are subject to state and government regulation, and can either be privately or publicly owned. The biggest difference between the two is that a privately-owned utility may be listed on a stock exchange. Prices charged by public utility companies are regulated by the state or local government. In order for a public utility to charge higher prices, it needs to get approval from a committee. However, these can often take time and have little to no guarantee that the rate increases will be approved. (To learn more about these companies, be sure to check out the Utilities Industry Handbook.)
Advantages of Utility Trusts
Public utility companies are relatively safe and constant when it comes to dividend return. This predictable dividend makes cash flows similar to a bonds cash flow, and therefore they react similarly to changes in interest rates - but not always. Also, like a bond, a higher yield generally means taking on higher risk. The income produced by the underlying utility companies held in a utility trust is easily passed along to the unit holders. The portfolio for a utility trust usually does not change often, which ensures a steady dividend stream if the underlying companies are stable.
The Government Cloud
When it comes to public utility companies, one cannot escape the role the government plays. Each utility company - whether private or public - has to deal with government regulations and red tape. The biggest trend among government in regards to public utilities is deregulation. As of September 2010, 27 states have either passed legislation or are in the process of restructuring the electric power industry (8 of those have suspended their restructuring for now).
Electric utilities have gone through the most dramatic change due to deregulation. Most public utility companies that deal with electricity no longer generate the power. Instead, they service and maintain the grid the power is delivered on. Private companies are now generating the power and selling it to the public utility companies. Investors thinking about public utilities need to be watchful of government regulations and climate when they choose this field. (To learn more about deregulation, read Free Markets: Whats The Cost?)
One concern when it comes to this sector is that, thus far, governments have been hesitant to allow public utilities to raise rates, which makes it challenging to recoup their investment in capital spending and construction of new plants. Government regulations and the restriction on rate increases is what sent the public service of New Hampshire into Chapter 11 for the construction of the Seabrook Nuclear Power Plant. Keeping an eye on the climate in Washington can help an investor looking to put their money into this sector.
When to Invest
When it comes to utilities, there are better times to buy than others, and its important to remember that public utility companies are considered a defensive play. Tough economic times usually benefit utilities, as people still need water, electricity and natural gas to flow uninterrupted, regardless of the economy.
Also, lower interest rates make the steady and high dividend yields offered by utility companies an attractive place to invest. Those interested in capturing income from their investments look to utility companies as a good place to put their money. Keep an eye on a turning market and rising rates, which typically have an inverse effect on the public utilities stock price. (For more defensive investing, read Guard Your Portfolio With Defensive Stocks.)
Green Movement
One of the biggest risks facing public utility companies is the green energy movement, and electric utility companies are feeling the pressure. Whether they create or buy the electricity, governments want the power to be created from renewable sources. This can be costly to upgrade and, with the existing government reluctance to allow public utility companies to recoup their capital expenditure through raising rates, it can hurt the dividend. Any time funds that could otherwise be paid out to shareholders in the form of dividends are instead used for improvement, lower cash flow to the investor in the short term is inevitable. So be careful if your primary interest is on a steady dividend cash flow from utilities, and the utilities are making a lot of capital expenditures instead of paying it out as dividends.
When it comes to investing in utility trusts, one must look at the portfolio and the underlying companies carefully. The risks common to public utility companies should be screened by investors looking to invest their money with a utility trust. So, if there are risks that can affect the future dividend payout of one of these utilities, steer clear of that utility trust.
Summing It All Up
Utility trusts are a great way to invest in the public utility sector. Public utilities are a great place to invest in during tough economic times and tough market conditions. Their inverse relationship with interest rates means you can still make money when the economy is not doing as well. Trusts offer an investor an easy way to quickly diversify within the public utilities sector without having the costs that are associated with mutual funds. Dividends are paid out quickly to trustees, so earning a steady income is possible.
6 Proven Methods For Selling Stocks
Choosing a time to sell a stock can be a very difficult task. It is especially difficult because, for most traders, it is hard to separate their emotions from their trades. The two human emotions that generally affect most traders with regards to selling a stock are greed and fear of regret. The ability to manage these emotions is key to becoming a successful trader.
Rising Profits
For example, many investors dont sell when a stock has risen 10 to 20% because they dont want to miss out on more returns if the stock shoots to the moon. This is due to their greed and the hope that the stock they picked will be a big winner. On the flip side, if the stock fell by 10 to 20%, a good majority of investors still wont sell because of their fear of regret. If they sell and the stock proceeds to rebound significantly, theyll be kicking themselves and regretting their actions.
So when should you sell your stock? This is a fundamental question that investors constantly struggle with. You need to separate out the emotion from your trading decisions. Fortunately, there are some commonly used methods that can help an investor make the process as mechanical as possible. In this article, I will look at six general strategies to help decide when to sell your stock.
Valuation-Level Sell
The first selling category well look at is called the valuation-level sell. In the valuation level sell strategy, the investor will sell a stock once it hits a certain valuation target or range. Numerous valuation metrics can be used as the basis, but some common ones that are used are the price-to-earnings (P/E) ratio, price-to-book (P/B), and price-to-sales (P/S). This approach is popular among value investors who buy stocks that are undervalued. It can be a good signal to sell when a stock becomes overvalued based on certain valuation metrics.
As an illustration of this method, suppose an investor holds stock in Wal-Mart that they bought when the P/E ratio was around 13 times earnings. The trader looks at the historical valuation of Wal-Mart stock and sees that the five-year average P/E is 15.5. From this, the trader could decide upon a valuation sell target of 15.5 time earnings as a fixed sell signal. So the trader has used a reasonable hypothesis to take the emotion out of his decision making. (For more on the P/E, see Profit With The Power Of Price-To-Earnings.)
Opportunity Cost Sell
The next one well look at is called the opportunity cost sell. In this method, the investor owns a portfolio of stocks and would sell a stock when a better opportunity presents itself. This requires a constant monitoring, research and analysis on both your own portfolio and potential new stock additions. Once a better potential investment has been identified, the investor would reduce or eliminate a position in a current holding that isnt expected to do as well as the new stock on a risk-adjusted return basis.
Deteriorating Fundamentals Sell
The deteriorating fundamental sell rule will trigger a stock sale if certain fundamentals in the companys financial statements fall below a certain level. This sell strategy is slightly similar to the opportunity cost in the sense that a stock sold using the previous strategy has likely deteriorated in some way. When basing a sell decision on deteriorating fundamentals, many traders will focus mainly on the balance sheet statement with emphasis on liquidity and coverage ratios. (Learn more about the balance sheet in Breaking Down The Balance Sheet.)
For example, suppose an investor owns the stock of a utilities company that pays a relatively high and consistent dividend. The investor is holding the stock mainly because of its relative safety and dividend yield. Furthermore, when the investor bought the stock, its debt-to-equity ratio was around 1.0 and its current ratio was around 1.4.
In this situation, a trading rule could be established so that the investor would sell the stock if the debt/equity ratio rose over 1.50, or if the current ratio ever fell below 1.0. If the companys fundamentals deteriorated to those levels – thus threatening the dividend and the safety - this strategy would signal the investor to sell the stock.
Down-from-Cost and Up-from-Cost Sell
The down-from cost sell strategy is another rule-based method that triggers a sell based on the amount, in percent, that youre willing to lose. For example, when an investor purchases a stock he may decide that if the stock falls 10% from where he bought it at, he would sell the stock.
Similar to the down-from cost strategy, the up-from cost strategy will trigger a stock sale if the stock rises a certain percentage. Both the down-from-cost and up-from-cost methods are essentially a stop-loss measure that will either protect the investors principal or lock in a specific amount of profit. The key to this approach is selecting an appropriate percentage that triggers the sell by taking into account the stocks historical volatility and the amount you would be willing to lose.
Target Price Sell
If you dont like using percentages, the target price sell method uses a specific stock value to trigger a sell. This is one of the most widely used ways by which investors sell a stock, as seen by the popularity of the stop-loss orders with traders and investors. Common target prices used by investors are typically ones based on valuation model outputs such as the discounted cash flow model. Many traders will base target price sells on arbitrary round numbers or support and resistance levels, but these are less sound than other fundamental based methods.
Bottom Line
Learning to accept a loss on your investment is one of the hardest things to do in investing. Oftentimes, what makes investors successful is not just their ability to choose winning stocks, but also their ability to sell stocks at the right time.
What Are SRI Funds?
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You dont have to check your values at the door when investing in the market. An increasing number of investors are choosing to put their money to work in companies that not only have a profitable future, but also reflect their values, like those committed to environmental sustainability or ones that give back to the community. But this isnt charity, it is Socially or Sustainable and Responsible Investing (SRI), and investors still expect and seek a strong return on their money – just one that balances their values with their investment goals.
The Rise of the SRI Fund
The first SRI fund of its kind started in the early 1990s with very few assets. But at the end of 2010 there were over 250 SRI-focused funds for investors to choose from. Funds earmarked for SRI investments now make up around 12%, or $3 trillion, out of the $25.2 trillion invested in the market today, according to The Forum for Sustainable and Responsible Investment (US SIF), a trade group representing SRI funds. Inside the funds, which are managed by professional money managers, are a collection of companies and investments that comply with a certain SRI cause. They usually follow some sort of environmental, social or corporate governance theme, which are collectively known as ESG issues.
Several of the large money managers offer several SRI products for their clients, ranging from simple passive index funds that track large or small SRI compliant companies, to actively managed funds that invest in companies focused on one of the three main ESG themes. Investors can also put their money in one of a number of exchange traded funds (ETFs) that track SRI compliant companies.
What Does It Mean to Be SRI Compliant?
The large funds may be a bit too broad for many investors, money managers screen and add or eliminate companies that normally do not comply with the general idea of what makes up an SRI company, but peoples values arent usually that simple. In general, money managers choose to avoid adding companies that deal in things that kill (defense
3 Dangers Of Checking Your Stock Portfolio Everyday
The digital age has had a profound impact on global financial markets. Most of the impacts have been advantageous for investors and include the fact that investment information has become readily available and literally right at investor fingertips. This has leveled the investment playing field, with individual investors benefiting as the industry is no longer controlled by a small handful of large banking, brokerage and advisory institutions. Digital information has even revolutionized trading itself as exchange floors are run increasingly by computers, as opposed to physical traders through an open outcry system. (Buying stocks is a careful balance of risk and reward. Learn to identify your risk tolerance and financial goals with these fundamental points. See 4 Key Factors To Building A Profitable Portfolio.)
There are many benefits to vast volumes of data that are readily available to investors, including the ability to check your portfolio in real time via the internet and through the latest smartphone technology. However, the digital age of investing has led to excessive trading, which can be very dangerous to your portfolio. Below is an overview of three of the most serious disadvantages it can place on investors.
Higher Taxes
Checking your stock portfolio everyday and trading too often can increase your tax bill. Taxes on stocks occur only through realized gains, and short-term realized gains are taxed at the same rate as an investors regular income, or namely his or her highest marginal tax rate. Long-term taxable gains are more reasonable at 15%, but this is still much higher than 0, which is what investors pay by holding a stock and locking up appreciation in the form of unrealized gains.
Using options is another shorter term trading strategy that is relatively tax inefficient. Options werent invented as part of the digital age, but the ability to obsess over short-term price fluctuations has made options a more integral part of the trading habits of many investors. As the vast majority of options, including the most common put and call options, are held less than a year, they qualify as short term and are taxed at ordinary income rates. (The option to bolster after-tax stock returns through tax-loss harvesting can reverse investor gloom. check out Tax-Loss Harvesting: Reduce Investment Losses.)
Excessive Trading Costs
Trading stocks often is nearly certain to increase trading costs. Many discount brokers offer equity trades for less than $10 these days, but these trading commissions can still add up for investors that trade excessively. The costs can really add up for day traders as they can rack up hefty trading commissions and must also pay short-term tax rates for realized gains.
Bid and ask spreads are not explicit trading costs, but can greatly affect overall gains in stock portfolios. For liquid securities including blue-chip stocks, the spread is usually not significant. However, for smaller and other illiquid stocks, spreads can be substantial. As the investor must buy at the asking price, or price a seller is willing to offer the security, and sell at the bid price, or price a buyer is willing to pay for the security, a wider spread eats into eventual gains and increases losses should the stock fall in price after purchase. (Discover how investment strategies and expense ratios impact your mutual funds returns. See Stop Paying High Mutual Fund Fees.)
Portfolio Underperformance
Many investment professionals have pointed out that it is extremely difficult to beat the market. The market is usually defined as the Standard
What Are SPDR ETFs?
Standard
Real Estate Vs. Stocks: Which Ones Right For You?
Over the years, we have heard the comparisons as to which is the better investment : real estate or stocks. Both have their advantages and disadvantages, and there are several aspects of each that make them unique investments in their own way. To make money with either investment requires that you understand the positives and negatives of both.
Real Estate
Real estate is something that you can physically touch and feel – its a tangible good and, therefore, for many investors, feels more real. Maybe this partially accounts for the high return on the investment, as from 1978-2004, real estate has had an average return of 8.6%. For many decades this investment has generated consistent wealth and long term appreciation for millions of people.
How it Works
Generally, there are two main types of real estate: commercial and residential. While other types exist (mobile home parks, strip malls, apartment buildings, office buildings, store fronts and single family homes), they generally fall into those two categories. Making money in real estate isnt as cut-and-dry. Some people take the home flipping route – searching for distressed properties, refurbishing them and selling them for a profit at a higher market value . Others look for properties that can be rented in order to generate a consistent income.
Generally, a down payment of up to 20% of the purchase price can be made, and the rest can be financed. This gives you leverage, meaning that you can invest in different types of properties with less money down, helping to build your net worth or income that you could make off the properties. While this can be a positive, if this leverage is used incorrectly, you may owe more on the properties than they are actually worth.
Positives
There are many positive benefits to investing in real estate, including depreciation (writing off wear and tear of a commercial property), tax deductions and finally, you can sell the property through what is know as a 1031 exchange, and will not have to pay capital gains taxes, as long as you invest the money into a similar kind of property type.
Negatives
Like all investments , real estate also has its drawbacks. Most importantly, the investment is illiquid. When you invest in a property, you usually cannot sell it right away. In many cases, you may have to hold the property for several years to realize its true profit potential. Also, the closing cost can add up to thousands of dollars, and include taxes, commissions, and fees. Also, real estate prices have a tendency to fluctuate. While long-term prices generally increase, there are times when prices could go down or stay flat. If you have borrowed too much against the property, you may have trouble making the payment with a property that is worth less money than the amount borrowed on it.
Finally, its often hard to get diversified if investing in real estate. However, diversification is possible in real estate, provided that you do not concentrate on the same community and have a variety of different types of property. That being said, there is an additional way that you can be able to diversify in real estate through real estate investment trusts (REITs), under which you can purchase a trust that is invested in a large portfolio of real estate, and will offer you a dividend as a shareholder. However, in general, stocks offer more diversification because you can own many different industries and areas across the entire economy. (Learn more about REITs in our article Investing In Real Estate.)
Stocks
From 1978-2006, stocks have delivered an average return of 13.4%. They can be more volatile than real estate but over the long run they have provided a much better return than real estates 8.6% average.
How They Work
With a stock , you receive ownership in a company. When times are good, you will profit. During times of economic challenges, you may see diminishing funds as the earnings of the company drop. Taking a long-term approach and being balanced in many areas can help build your net worth at a much greater rate, compared with real estate.
As with real estate, financing in stocks allows you to use margin as leverage to increase the overall amount of shares that you own. The downside is that, if the stock position falls, you could have what is known as margin call. This is where the equity, in relation to amount borrowed, has fallen below a certain level and money must be added to your account to bring that amount back up. If you fail to do this, the brokerage firm can sell the stock to recover the amount loaned to you.
Positives
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account – tax-free - until you start to withdraw the money. As well, many stocks can do considerably better than real estate in one year. Due to the volatility of some stocks, it is not unusual to see companies that are averaging 20% or even 50% growth in one year.
Negatives
Stocks can be very volatile, especially when the economy or the company is facing challenges. Also, stocks are often emotional investments, and your decisions within the market can often be irrational. Finally, bankruptcy is always in the back of the active stock investors mind – as it should be, as your investment will be dissolved in this instance.
Conclusion
In general, stocks may have the advantage in more categories than real estate. However, real estate seems to be better when it comes to stability and tax advantages. A good compromise may be to own a REIT , which combines some of the benefits of stocks with some of the benefits of real estate. While each area has its own benefits and drawbacks, to decide which one would work well for you depends on your overall financial situation and level of comfort.
Do You Understand Investment Risk?
A study conducted by Englands Financial Services Authority (FSA) in 2004 called Consumer Understanding Of Financial Risk has shed some light on how well people understand their investments. Such understanding or, in some cases, the lack of understanding, leads to specific types of behavior. It is important for both investors and providers to be aware of the differences. In this article, well go over this study and what it can teach investors about their own understanding of their personal finances.
Types of Investors
The respondents in the study were divided into three main groups:
• Trusters
were defined as unsophisticated investors who primarily rely on their advisors.
• Partners are those with an intermediate level of sophistication who work together with their advisors to some extent.
• Controllers are sophisticated and often experienced investors who rely on their own understanding and make their own decisions. This simple categorization provides considerable insight into the nature of investors, what they do and expect, and the associated risks and opportunities that exist for both buyers and sellers. (Learn more in What Is Your Risk Tolerance?)
Education and Financial Sophistication Are Not the Same Thing
It is important to note that general or even business education doesnt necessarily translate into specific knowledge about the world of investment. A business graduate is certainly likely to know something about investments, but this knowledge may be very theoretical and, therefore, less applicable to the graduates own experiences. Conversely, a doctor who happens to be very interested in getting the most bang for his buck on his investments may turn out to have a relatively sophisticated understanding of investing. Likewise, retired people with no formal financial education or qualifications may spend hours pouring over the financial pages of the newspaper every day. In this case, they may know more than their advisors about day-to-day developments.
Lets look in more detail at each of the three groups.
Trusters Rely On Others
Not surprisingly, the lower the level of sophistication, the less people understand about the risks to which their money is exposed and the more naive they tend to be about what their advisors or investment companies can really do for them. The FSA study points out that this naiveté can lead to excessive reliance on people in the industry, which can open the door for potential abuse. Alternatively, it may lead nervous and distrusting people to adopt a savings approach, which may be too risk averse to benefit the investor. (For related reading, see Determining Risk And The Risk Pyramid.)
When investors lack understanding of their investments, this often means that they are uninformed about what is meant by high, medium and low risk, the three standard categories prevalent in much of the investment literature. The problem is compounded by the failure of many brokers to present people with clear options with clear risk labels. Investors often think that anything to do with shares is risky, or that fund managers generally buy shares with such astuteness and expertise that there is little risk involved. Generally speaking, the reality is that the greater the value of equities that an investor has in his or her portfolio, the greater the amount of risk the person is taking on compared to leaving that money in a savings account.
While many investors understand the principles of diversification and risk well enough to know it is bad to put all of their eggs in one basket, they do not always know how to avoid this in practice. Trusters, for example, were shown to have a poor understanding of asset classes and very little, if any, awareness of the range of products available in the market. As a result, they tend to delegate most of the responsibility to others, which predictably leads to somewhat mixed results. (For more insight, see Introduction To Diversification and The Importance Of Diversification.)
Partners Make Mutual Decisions
Partners tend to have a medium level of sophistication and often want to be involved in the decision-making process. They generally read newspapers or magazines in and attempt to follow the markets. They also rely on advisors for help, but certainly not for the basic-level financial matters. They are interested in the second opinion that brokers or advisors provide, and also seek professional assistance to ensure that paperwork is completed correctly and that they understand any applicable legal jargon.
The main difficulty with partners is finding the right balance between control and delegation. While some advisors do not welcome client input, and others tend to think customers know more than they really do, it is essential for the investor-advisor roles to be quite clear to both parties. It may be best to have some form of written agreement - even if its an informal one - that highlights the nature of each players respective roles.
Controllers Want to Run the Show
Controllers are sophisticated investors (or at least think they are!) and prefer to take charge of the investing process. They are very interested in the financial sector and have a good understanding of both products and markets. They are aware of and understand the array of products that are available and they know what they want. They also spend a considerable amount of time researching products and markets, and they actively send off for financial statements, buy the latest books, and even attend investment seminars and conferences. This does not necessarily make them risk friendly, but they understand risk and know how to construct an optimal portfolio. Such investors often purchase on execution only, which means that they dont seek an advisors advice.
With respect to controllers who think they are sophisticated, there are certainly those who ought to delegate more of their investing tasks to a professional. Investors who seriously overestimate their knowledge or abilities can get into trouble.
Who Are You and Who Are You Dealing With?
The FSA study reinforces the need for informed financial planning; it also suggests the vulnerability of investors who are either too trusting or not trusting enough. For trusters, and to a lesser extent, partners, ease of understanding is fundamental and checks need to be built into any investment process to ensure that peoples personal and financial circumstances and willingness to take risk are taken into account. If investors are to be served well, what they know and, more importantly, what they do not know, must form a fundamental component of the advisory process. Advisors must take the level of investor knowledge and understanding very seriously.
Economic Indicators For The Do-It-Yourself Investor
Economic indicators are some of the most valuable tools investors can place in their arsenals. Consistent in their release, wide in their scope and range, metrics such as the Consumer Price Index (CPI) and written reports like the beige book are free for all investors to inspect and analyze. Policymakers, most notably those at the Federal Reserve, use indicators to determine not only where the economy is going, but how fast its getting there.
Admittedly, economic indicator reports are often dry and the data is raw. In other words, information needs to be put into context before it can be helpful in making any decisions regarding investments and asset allocation, but there is valuable information in those raw data releases. The various government and non-profit groups that conduct the surveys and release the reports do a very good job of collating and cohesively presenting what would be logistically impossible for any one investor do to on his or her own. Most indicators provide nationwide coverage and many have detailed industry breakdowns, both of which can be very useful to individual investors.
In this article, well touch on the most important aspects of economic indicators and how they relate to individual investors. (For more detailed information, see Economic Indicators To Know.)
What is an economic indicator?
In its simplest form, an indicator could be considered any piece of information that can help an investor decipher what is going on in the economy. The U.S. economy is essentially a living thing; at any given moment, there are billions of moving parts - some acting, others reacting. This simple truth makes predictions extremely difficult - they must always involve a large number of assumptions, no matter what resources are put to the task. But with the help of the wide range of economic indicators, investors are better able to gain a better understanding of various economic conditions.
There are also indexes for coincident indicators and lagging indicators, the components of each are based on whether they tend to rise during or after an economic expansion. (For related reading, see What are leading, lagging and coincident indicators? What are they for?)
Use in Tandem, Use in Context
Once an investor understands how various indicators are calculated and their relative strengths and limitations, several reports can be used in conjunction to make for more thorough decision-making. For example, in the area of employment, consider using data from several releases; by using the hours-worked data (from the Employment Cost Index) along with the Labor Report and non-farm payrolls, investors can get a fairly complete picture of the state of the labor markets. Are increasing retail sales figures being validated by increased personal expenditures? Are new factory orders leading to higher factory shipments and higher durable goods figures? Are higher wages showing up in higher personal income figures? The savvy investor will look up and down the supply chain to find validation of trends before acting on the results of any one indicator release. (For related reading, check out Surveying The Employment Report.)
Personalizing Your Research
Some people may prefer to understand a couple of specific indicators really well and use this expert knowledge to make investment plays based on their analyses. Others may wish to be a jack of all trades, understanding the basics of all the indicators without relying on any one too much. A retired couple living on a combination of pensions and long-term Treasury bonds should be looking for different things than a stock trader who rides the waves of the business cycle. Most investors fall in the middle, hoping for stock market returns to be steady and near long-term historical averages (about 8-10% per year).
Knowing what the expectations are for any individual release is helpful, as well as generally knowing what the macroeconomic forecast is believed to be at become important functions. Forecast numbers can be found at several public websites, such as Yahoo! Finance or MarketWatch. On the day a specific indicator release is made, there will be press releases from news wires such as the Associated Press and Reuters, which will present figures with key pieces highlighted. It is helpful to read a report on one of the newswires, which may parse the indicator data through the filters of analyst expectations, seasonality figures and year-over-year results. For those that use investment advisors, these advisors will probably analyze recently-released indicators in an upcoming newsletter or discuss them during upcoming meetings. (For articles about analyzing and using this data, see Trading On News Releases and A Top-Down Approach To Investing.)
Inflation Indicators - Keeping a Watchful Eye
Many investors, especially those who invest primarily in fixed-income securities, are concerned about inflation. Current inflation, how strong it is, and what it could be in the future are all vital in determining prevailing interest rates and investing strategies.
There are several indicators that focus on inflationary pressure. The most notable in this group are the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI comes out first in any reporting month, so many investors will use the PPI to try and predict the upcoming CPI. There is a proven statistical relationship between the two, as economic theory suggests that if producers of goods are forced to pay more in production, some portion of the price increase will be passed on to consumers. Each index is derived independently, but both are released by theBureau of Labor Statistics. Other key inflationary indicators include the levels and growth rates of the money supply and the Employment Cost Index (ECI). (To learn more, read The Consumer Price Index: A Friend To Investors.)
Economic Output - Stock Investors Inquire Within
The gross domestic product (GDP) may be the most important indicator out there, especially to equity investors who are focused on corporate profit growth. Because GDP represents the sum of what our economy is producing, its growth rate is targeted to be in certain ranges; if the numbers start to fall outside those ranges, fear of inflation or recession will grow in the markets. To get ahead of this fear, many people will follow the monthly indicators that can shed some light on the quarterly GDP report. Capital goods shipments from the Factory Orders Report is used to calculate producers durable equipment orders within the GDP report. Indicators such as retail sales and current account balances are also used in the computations of GDP, so their release helps to complete part of the economic puzzle prior to the quarterly GDP release. (For related reading, see The Importance Of Inflation And GDP and Understanding the Current Account In The Balance Of Payments.)
Other indicators that arent part of the actual calculations for GDP are still valuable for their predictive abilities - metrics such as wholesale inventories, th beige book, the Purchasing Managers Index (PMI) and the Labor Report all shed light on how well our economy is functioning. With the assistance of all this monthly data, GDP estimates will begin to tighten up as the component data slowly gets released throughout the quarter; by the time the actual GDP report is released, there will be a general consensus of the figure. If the actual results deviate much from the estimates, the markets will move, often with high volatility. If the number falls right into the middle of the expected range, then the markets and investors can collectively pat themselves on the back and let prevailing investing trends continue.
Mark Your Calendar
Sometimes indicators take on a more valuable role because they contain very timely data. The Institute of Supply Managements PMI report, for instance, is typically released on the first business day of every month. As such, it is one of the first pieces of aggregate data available for the month just ended. While not as rich in detail as many of the indicators to follow, the category breakdowns are often picked apart for clues to things such as future Labor Report details (from the employment survey results) or wholesale inventories (inventory survey).
The relative order in which the indicators are presented does not change month to month, so investors may want to mark a few days on their monthly calendars to read up on the areas of the economy that might change how they think about their investments or time horizon. Overall, asset allocation decisions can fluctuate over time, and making such changes after a monthly review of macro indicators may be wise.
Conclusion
Benchmark pieces of economic indicator data arrive with no agenda or sales pitch. The data just is - and that is hard to find these days. By becoming knowledgeable about the whats and whys of the major economic indicators, investors can better understand the economy in which their dollars are invested, and be better prepared to revisit an investment thesis when the timing is right.
While there is no one magic indicator that can dictate whether to buy or sell, using economic indicator data in conjunction with standard asset and securities analysis can lead to smarter portfolio management for the do-it-yourself investor.
The Value Investors Handbook
Value investing, and any type of investing for that matter, varies in execution with each person. There are, however, some general principles that are shared by all value investors. These principles have been spelled out by famed investors like Peter Lynch, Kenneth Fisher, Warren Buffet,John Templeton and many others. In this article, we will look at these principles in the form of a value investors handbook.
Buy Businesses
If there is one thing that all value investors can agree on, its that investors should buy businesses, not stocks. This means ignoring trends in stock prices and other market noise. Instead, investors should look at the fundamentals of the company that the stock represents. Investors can make money following trending stocks, but it involves a lot more activity than value investing. Searching for good businesses selling at a good price based on probable future performance requires a larger time commitment for research, but the payoffs include less time spent buying and selling and fewer commission payments. (False signals can drown out underlying trends. Find out how to tone them down and tune them out in Trading Without Noise.)
Love the Business You Buy
You wouldnt pick a spouse based solely on his or her shoes, and you shouldnt pick a stock based on cursory research. You have to love the business you are buying, and that means being passionate about knowing everything about that company. You need to strip the attractive covering from a companys financials and get down to the naked truth. Many companies look far better when you judge them on basic price to earnings (P/E), price to book (P/B) and earnings per share (EPS) ratios than they do when you look into the quality of the numbers that make up those figures.
If you keep your standards high and make sure the companys financials look as good naked as they do dressed up, youre much more likely to keep it in your portfolio for a long time. If things change, youll notice it early. If you like the business you buy, paying attention to its ongoing trials and successes becomes more of a hobby than a chore.
Simple Is Best
If you dont understand what a company does or how, then you probably shouldnt be buying shares. Critics of value investing like to focus on this main limitation. You are stuck looking for businesses that you can easily understand because you have to be able to make an educated guess about the future earnings of the business. The more complex a business is, the more uncertain your projections will necessarily be. This moves the emphasis from educated to guess.
You can buy businesses you like but dont completely understand, but you have to factor in uncertainty as added risk. Any time a value investor has to factor in more risk, he has to look for a larger margin of safety - that is, more of adiscount from the calculated true value of the company. There can be no margin of safety if the company is already trading at many multiples of its earnings, which is a strong sign that, however exciting and new the idea is, the business is not a value play. Simple businesses also have an advantage, as its harder for incompetent management to hurt the company. (For a complete guide to reading the financial reports, check out our Financial Statements Tutorial.)
Look for Owners, Not Managers
Management can make a huge difference in a company. Good management adds value beyond a companys hard assets. Bad management can destroy even the most solid financials. There have been investors who have based their entire investing strategies on finding managers that are honest and able. To quote Buffett, look for three qualities: integrity, intelligence, and energy. And if they dont have the first, the other two will kill you. You can get a sense of managements honesty through reading several years worth of financials. How well did they deliver on past promises? If they failed, did they take responsibility, or gloss it over? (Find out more about Buffetts investing in Warren Buffett: How He Does It.)
Value investors want managers who act like owners. The best managers ignore the market value of the company and focus on growing the business, thus creating long-term shareholder value. Managers who act like employees often focus on short-term earnings in order to secure a bonus or other performance perk, sometimes to the long-term detriment of the company. Again, there are many ways to judge this, but the size and reporting of compensation is often a dead give away. If youre thinking like an owner, you pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus. At the very least, you want a company that expenses its stock options. (Still wondering how to investigate the top brass? Check out Evaluating A Companys Management.)
When You Find a Good Thing, Buy a Lot
One of the areas where value investing runs contrary to commonly accepted investing principles is on the issue of diversification. There are long stretches where a value investor will be idle. This is because of the exacting standards of value investing as well as overall market forces. Toward the end of a bull market, everything gets expensive, even the dogs, so a value investor may have to sit on the sidelines waiting for the inevitable correction. Time, an important factor in compounding, is lost while waiting, so when you do find undervalued stocks, you should buy as much as you can. Be warned, this will lead to a portfolio that is high-risk according to traditional measures like beta. Investors are encouraged to avoid concentrating on only a few stocks, but value investors generally feel that they can only keep proper track of a few stocks at a time.
One obvious exception is Peter Lynch, who kept almost all of his funds in stocks at all times. Lynch broke stocks into categories and then cycled his funds through companies in each category. He also spent upwards of 12 hours every day checking and rechecking the many stocks held by his fund. As an individual value investor with a different day job, however, its better to go with a few stocks for which youve done the homework and feel good about holding long term. (Learn the basic tenets that helped this famous investor earn his fortune in Pick Stocks Like Peter Lynch.)
Measure Against Your Best Investment
Anytime you have more investment capital, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities dont beat what you already have in your portfolio, you may as well buy more of the companies you know and love, or simply wait for better times. During idle times, a value investor can identify the stocks he or she wants and the price at which theyll be worth buying. By keeping a wish list like this, youll be able to make decisions quickly in a correction.
Ignore the Market 99% of the Time
The market only matters when you enter or exit a position; the rest of the time, it should be ignored. If you approach buying stocks like buying a business, youll want to hold onto them as long as the fundamentals are strong. During the time you hold an investment, there will be spots where you could sell for a large profit and others were youre holding an unrealized loss. This is the nature of market volatility.
The reasons for selling a stock are numerous, but a value investor should be as slow to sell as he or she is to buy. When you sell an investment, you expose your portfolio to capital gains and usually have to sell a loser to balance it out. Both of these sales come with transaction coststhat make the loss deeper and the gain smaller. By holding investments with unrealized gains for a long time, you forestall capital gains on your portfolio. The longer you avoid capital gains and transaction costs, the more you benefit from compounding. (Find out how your profits are taxed and what to consider when making investment decisions in Tax Effects On Capital Gains.)
The Bottom Line
Value investing is a strange mix of common sense and contrarian thinking. While most investors can agree that a detailed examination of a company is important, the idea of sitting out on a bull market goes against the grain. Its undeniable that funds held constantly in the market have outperformed cash held outside the market, waiting for a down market. This is a fact, but a deceiving one. The data is derived from following the performance of indexes like the S
The Risks Of Investing In Emerging Markets
Investing is always risky business; corporate scandals regularly surface in the news, corporate bonds are frequently downgraded, accounting fraud is often revealed and market imperfections such as the flash crash continuously bring a level of uncertainty. Even the most stable domestic blue chip companies will face times of tremendous volatility.
Emerging markets offer numerous benefits to investors such as elevated economic growth rates, higher expected returns and diversification benefits. However, there are a number of important risks to consider before investing in regions outside of the developed world. (Emerging markets provide new investment opportunities, but there are risks - both to residents and foreign investors. See What Is An Emerging Market Economy?)
1) Foreign Exchange Rate Risk
Foreign investments in stocks and bonds will typically produce returns in the local currency of the investment. As a result, investors will have to convert this local currency back into their domestic currency. An American who purchases a Brazilian stock in Brazil will have to buy and sell the security using the Brazilian real. Therefore, currency fluctuations can impact the total return of investment. If, for example, the local value of a held stock increased by 5%, but the real depreciated by 10%, the investor will experience a net loss in terms of total returns when selling and converting back to U.S. dollars.
2) Non-Normal Distribution
North American market returns arguably follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be valuated using the same type of mean-variance analysis. Also, because emerging markets are undergoing constant changes, it is almost impossible to utilize historical information in order to draw proper correlations between events and returns.
3) Lax Insider Trading Restrictions
Although most countries claim to enforce strict laws against insider trading, none have proved to be as rigorous as America in terms of prosecuting unfair trading practices. Insider trading and various forms of market manipulation introduce market inefficiencies, whereby equity prices will significantly deviate from their intrinsic value. Such a system can be subject to extreme speculation, and can also be heavily controlled by those holding privileged information.
4) Less Liquidity
Emerging markets are generally less liquid than those found in the developed world. This market imperfection results in higher broker fees and an increased level of price uncertainty. Investors who try to sell stocks in an illiquid market face substantial risks that their orders will not be filled at the current price, and the transactions will only go through at an unfavorable level. Additionally, brokers will charge higher commissions, as they have to make more diligent efforts to find counterparties for trades. Illiquid markets prevent investors realizing the benefits of fast transactions.
5) Difficulty Raising Capital
A poorly developed banking system will prevent firms from having the proper access to financing that is required to grow their businesses. Attained capital will usually be issued at a high required rate of return, increasing the companys weighted average cost of capital (WACC). The major concern with having a high WACC is that fewer projects will produce a high enough return to yield a positive net present value. Therefore, financial systems found in developed nations do not allow companies to undertake a higher variety of profit-generating projects. (This asset class has left much of its unstable past behind. Find out how to invest in it, in Investing In Emerging Market Debt.)
6) Poor Corporate Governance System
A solid corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater voice in the firm than shareholders. Furthermore, when countries have restrictions on corporate takeovers, management does not have the same level of incentive to perform in order to maintain job security. While corporate governance in the emerging markets has a long road to go before being considered fully effective by North American standards, many countries are showing improvements in this area in order to gain access to cheaper international financing.
7) Increased Chance of Bankruptcy
A poor system of checks and balances and weaker accounting audit procedures increase the chance of corporate bankruptcy. Despite that bankruptcy is common in every economy, such risks are most common outside of the developed world. Within emerging markets, firms can more freely cook the book to give an extended picture of profitability. Once the corporation is exposed, it experiences a sudden drop in value. This is not to say that such occurrences do not happen in North America and Europe.
Because emerging markets are viewed as being more risky, they will have to issue bonds that pay higher interest rates. The increased debt burden further increases borrowing costs and strengthens the potential for bankruptcy.
8) Political Risk
Political risk refers to uncertainty regarding adverse political decisions. Developed nations tend to follow a free market discipline of low government intervention, whereas emerging market businesses are often privatized upon demand. Some additional factors that contribute to political risk are: possibility of war, tax increase, loss of subsidy, change of market policy, inability to control inflation and laws regarding resource extraction. Major political instability can also result in civil war and a shutdown of industry, as workers either refuse or are no longer able to do their jobs. (Find out how these worldly offerings can spice up your portfolio. Check out Go International With Foreign Index Funds.)
Conclusion
Investing in emerging markets can produce substantial returns to ones portfolio. However, investors must be aware that all high returns must be judged within the risk and reward framework. The aforementioned risks are some of the most prevalent that must be assessed prior to investing. Unfortunately, however, the premiums associated with these risks can often only be estimated, rather than determined on a concrete basis.
5 Ways To Invest In Travel And Tourism
Most consumers are familiar with the travel and tourism industry from using its services for some needed rest and relaxation during family and related vacations. However, these same activities can be invested in, with many publicly-traded firms offering travel activities for the end benefit of growing the capital of their underlyingshareholders. Listed below are five areas of the travel and tourism market that could prove lucrative from an investing standpoint. It could also help committed travelers better understand the landscape and hunt down some travel deals.
Online Travel Providers
As with many industries, revenue continues to shift to the internet when it comes to providing travel and tourism services. Stock brokers have been replaced in large part with online trading platforms, while traditional travel agents have had to compete with online websites that allow consumers to shop for low prices and convenient schedules.
Leading online travel providers include publicly-traded players such as Orbitz, Priceline and Expedia. In particular, Priceline has been highly successful in driving traffic to its website to book flights and bid for cheap, last minute travel deals. Over the past five years, it has seen sales and profits grow around 20% annually. This growth has fully shown through in its stock price, which is up around 1,000% in the past five years.
Cruising
The cruise line industry has been in existence for more than a century, but still is not that widespread as a travel choice for many consumers. Carnival, the largest cruise line operator in the world, has estimated that only 3.4% of the population in North America has ever been on a cruise. The percentages are even lower in the rest of the world.
Capacity is also growing nicely; Carnival estimates the entire industry has seen average annual capacity growth of roughly 5.6 to 6.9% over the past five years.
Hotels
The hotel industry is dominated by a couple of leading international players. This includes publicly-traded firms Marriott and Starwood Hotels, as well as privately owned Hilton. These companies have largely blanketed their home United States market and are now growing internationally. In Starwoods case, 84% of its new hotel pipeline was international. These chains have also pursued the managing of properties for hotel owners, as well as timeshares where they sell the rights for consumers to use their properties for a week, or more, during each calendar year. (For additional reading, see Timeshares: Dream Vacation Or Money Pit?)
Maga-resorts
Large resort operators combine the development of hotels with other entertainment and related amenities. Publicly-traded operators in this space include Gaylord Entertainment, which owns the Opryland resort in Nashville and other properties in Texas, Florida and Maryland. It specializes in massive resorts that allow big travel groups to host conventions and other giant gatherings.
Vail Resorts owns some of the best-known ski resorts in Colorado and surrounding areas. This includes Vail Mountain, Breckenridge and Beaver Creek Resort. Of course, Walt Disney specializes in kid-friendly theme parks, hotels and entertainment complexes, such as Disney World in Florida and Disneyland in California.
Casinos
Las Vegas-style gambling is growing rapidly across Asia. Macao has grown into the largest gambling market in the world and has seen the building of massive casino resorts from Las Vegas-based firms such as Wynn Resorts and Las Vegas Sands. Both are publicly traded companies. This growth is expanding to other parts of Asia, including Singapore, and potentially Vietnam and Japan.
The Bottom Line
These are just some of the many opportunities to invest in the travel and tourism industries across the world. Overseas growth, especially in emerging market economies, should continue to outpace that in more developed markets in North America and Europe. However, as with the online travel space, there will always be pockets that are picking up market share in every part of the world. (To learn more, read An Evaluation Of Emerging Markets.)
The 3 Biggest Risks Faced By International Investors
Investing internationally has often been the advice given to investors looking to increase the diversification and total return of their portfolio. The diversification benefits are achieved through the addition of low correlation assets of international markets that serve to reduce the overall risk of the portfolio. However, although the benefits of investing internationally are widely accepted theories, many investors are still hesitant to invest abroad. In this article, well discuss the reasons why this may be the case and help highlight key concerns for investors so they can make a more informed decision.
Transaction Costs
Likely the biggest barriers to investing in international markets are the transaction costs. Although we live in a relatively globalized and connected world, transactions costs can still vary greatly depending on which foreign market you are investing in. Brokerage commissions are almost always higher in international markets compared to domestic rates. In addition, on top of the higher brokerage commissions, there are frequently additional charges that are piled on top that are specific to the local market, which can include stamp duties, levies, taxes, clearing fees and exchange fees.
As an example, here is a general breakdown of what a single purchase of stock in Hong Kong by a U.S. investor could look like on a per trade basis:
Fee Type Fee
Brokerage Commission HK$299
Stamp Duty
0.1%
Trading Fees 0.005%
Transaction Levy 0.003%
TOTAL HK$299 0.108%
In addition, if you are investing through a fund manager or professional manager, you will also see a higher fee structure. To become knowledgeable about a foreign market to the point where the manager can generate good returns, the process involves spending significant amounts of time money on research and analysis. These costs will often include the hiring of analysts and researchers who are familiar with the market, accounting expertise for foreign financial statements, data collection, and other administrative services. For investors, these fees altogether usually end up showing up in the management expense ratio.
One way to minimize transaction costs on buying foreign stock is through the use of American Depository Receipts (ADRs). ADRs trade on local U.S. exchanges and can typically be bought with the same transaction costs as other stocks listed on U.S. exchanges. It should be noted however, that although ADRs are denominated in U.S. dollars, they are still exposed to fluctuations in exchange rates that can significantly affect its value. A depreciating foreign currency relative to the USD will cause the value of the ADR to go down, so some caution is warranted in ADRs. (For more, see An Introduction To Depository Receipts.)
Currency Risks
The next area of concern for retail investors is in the area of currency volatility. When investing directly in a foreign market (and not through ADRs), you have to exchange your domestic currency (USD for U.S. investors) into a foreign currency at the current exchange rate in order to purchase the foreign stock. If you then hold the foreign stock for a year and sell it, you will have to convert the foreign currency back into USD at the prevailing exchange rate one year later. It is the uncertainty of what the future exchange rate will be that scares many investors. Also, since a significant part of your foreign stock return will be affected by the currency return, investors investing internationally should eliminate this risk.
The solution to mitigating this currency risk, as any financial professional will likely tell you, is to simply hedge your currency exposure. However, not many retail investors know how to hedge currency risk and which products to use. There are tools such as currency futures, options, and forwards that can be used to hedge this risk, but these instruments are usually too complex for a normal investor. Alternatively, one tool to hedge currency exposure that may be more user-friendly for the average investor is the currency ETF. This is due to their good liquidity, accessibility and relative simplicity. (If you want to learn the mechanics of hedging with a currency ETF, see Hedge Against Exchange Rate Risk With Currency ETFs.)
Liquidity Risks
Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered. In the previous discussion on currency risk we described how currency risks can be eliminated, however there is typically no way for the average investor to protect themselves from liquidity risk. Therefore, investors should pay particular attention to foreign investments that are, or can become, illiquid by the time they want to close their position.
Further, there are some common ways to evaluate the liquidity of an asset before purchase. One method is to simply observe the bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity. Altogether, these basic measures can help you create a picture of an assets liquidity.
Bottom Line
Investing in international stocks is often a great way to diversify your portfolio and get potentially higher returns. However, for the average investor, navigating the international markets can be a difficult task that can be fraught with challenges. By understanding some of the main risks and barriers faced in international markets, an investor can position themselves to minimize these risks. Lastly, investors face more than just these three risks when investing abroad, but knowing these key ones will start you off on a strong footing.
Conglomerates: Cash Cows Or Corporate Chaos?
Conglomerates are companies that either partially or fully own a number of other companies. Not long ago, sprawling conglomerates were a prominent feature of the corporate landscape. Vast empires, such as General Electric (NYSE:GE) and Berkshire Hathaway (NYSE:BRK.A), were built up over many years with interests ranging from jet engine technology to jewelry. Corporate hodgepodges like these pride themselves on their ability to avoid bumpy markets. In some cases, they have produced impressive long-term shareholder returns - but this doesnt mean that corporate conglomerates are always a good thing for investors. If youre interested in investing in these behemoths, there are a few things you should know. Here we explain what conglomerates are and give you an overview of the pros and cons of investing in them.
The Case for Conglomerates
The case for conglomerates can be summed up in one word: diversification. According to financial theory, because the business cycle affects industries in different ways, diversification results in a reduction of investment risk. A downturn suffered by one subsidiary, for instance, can be counterbalanced by stability, or even expansion, in another venture. In other words, if Berkshire Hathaways brick-making division has a bad year, the loss might be offset by a good year in its insurance business.
At the same time, a successful conglomerate can show consistent earnings growth by acquiring companies whose shares are more lowly rated than its own. In fact, GE and Berkshire Hathaway have both promised - and delivered - double-digit earnings growth by applying this investment growth strategy.
The Case Against Conglomerates
However, the prominent success of conglomerates such as GE and Berkshire Hathaway is hardly proof that conglomeration is always a good idea. There are plenty of reasons to think twice about investing in these stocks , particularly in 2009, when both GE and Berkshire suffered as a result of the economic downturn, proving that size does not make a company infallible.
Investment guru Peter Lynch uses the phrase diworsification to describe companies that diversify into areas beyond their core competencies. A conglomerate can often be an inefficient, jumbled affair. No matter how good the management team, its energies and resources will be split over numerous businesses, which may or may not be synergistic.
For investors, conglomerates can be awfully hard to understand, and it can be a challenge to pigeonhole these companies into one category or investment theme. This means that even managers often have a hard time explaining their investment philosophy to shareholders. Furthermore, a conglomerates accounting can leave a lot to be desired and can obscure the performance of the conglomerates separate divisions. Investors inability to understand a conglomerates philosophy, direction, goals and performance can eventually lead to share underperformance.
While the counter-cyclical argument holds, there is also the risk that management will keep hold of businesses with poor performance, hoping to ride the cycle. Ultimately, lower-valued businesses prevent the value of higher-valued businesses from being fully realized in the share price . (For further reading, see The Ups And Downs Of Investing In Cyclical Stocks.)
Whats more, conglomerates do not always offer investors an advantage in terms of diversification. If investors want to diversity risk, they can do so by themselves, by investing in a few focused companies rather than putting all of their money into a single conglomerate. Investors can do this far more cheaply and efficiently than even the most acquisitive conglomerate can.
The Conglomerate Discount
The case against conglomerates is a strong one. Consequently, the market usually applies a haircut to the piecewise, or sum-of-parts, value - that is, it frequently values conglomerates at a discount to more focused companies. This is known as the conglomerate discount. According to a 2001 article in CFO Magazine, academic studies have suggested in the past that this discount could be as much as 10-12%, but more recent academic inquiries have concluded that the discount is closer to 5%. Of course, there are some conglomerates that command a premium but, in general, the market ascribes a discount.
The conglomerate discount gives investors a good idea of how the market values the conglomerate as compared to the sum value of its various parts. A deep discount signals that shareholders would benefit if the company were dismantled and its divisions left to run as separate stocks.
Lets take a shot at calculating the conglomerate discount using a simple example. Well use a fictional conglomerate called DiversiCo, which consists of two unrelated businesses: a beverage division and a biotechnology division.
DiversiCo has a stock market valuation of $2 billion and total debt of $0.75 billion. Its beverage division has balance sheet assets of $1 billion, while its biotechnology division has $0.75 billion worth of assets. Focused companies in the beverage industry have median market-to-book values of 2.5, while pure play biotech firms have market-to-book values of 2. DiversiCos divisions are fairly typical companies in their industries. From this information, we can calculate the conglomerate discount:
Example - Calculating the Conglomerate Discount
Total Market Value DiversiCo:
= Equity Debt
= $2 billion $0.75 billion
= $2.75 billion
Estimated Value Sum of the Parts:
= Value of Biotech Division Value of Beverage Division
= ($0.75 billion X 2) ($1 billion X 2.5)
= $1.5 billion $2.5 billion
= $4.0 billion
So, the conglomerate discount amounts to:
= ($4.0 billion - $2.75 billion)/$4.0 billion
= 31.25%
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DiversiCos conglomerate discount of 31.25% seems unusually deep. Its share price does not reflect the true value of its separate divisions. It becomes clear that this multibusiness company could be worth significantly more if it were broken up into individual businesses. Consequently, investors may push for divesting or spinning off its beverage and biotech divisions to create more value. If that were to happen, Diversico might be worth closer examination as a buying opportunity.
What to Look For
The big question is whether investing in conglomerates makes sense. The conglomerate discount suggests it does not. But there may be a silver lining. If you invest in conglomerates that break up into individual pieces through divestitures and spinoffs, you could capture an increase in value as the conglomerate discount disappears. As a general rule, you stand to get greater returns when conglomerates break up than when they are built.
That said, some conglomerates do command a valuation premium - or at least a slim conglomerate discount. These are extremely well-run companies. They are managed aggressively, with clear targets set for divisions. Underperforming companies are quickly sold, or divested. More importantly, successful conglomerates have financial rather than strategic or operating objectives, adopting strict approaches to portfolio management .
If you choose to invest in conglomerates, look for ones with financial discipline, rigorous analysis and valuation, a refusal to overpay for acquisitions and a willingness to sell off existing businesses. As with any investment decision , think before you buy and dont assume that big companies always come with big returns.
The Merger - What To Do When Companies Converge
You may hear about it in the financial news - the merger. Its often a situation cloaked in mystery and confusion. Do you know what to do when a company youve invested in plans to merge with another company? In this article, well show you how to invest around mergers and the ups and downs involved in the process.
SEE: Cashing In On Corporate Restructuring
How It Works
A merger occurs when a company finds a benefit in combining business operations with another company, in a way that will contribute to increased shareholder value. It is similar in many ways to an acquisition, which is why the two actions are so often grouped together as mergers and acquisitions (M
Understanding Financial Liquidity
Do you know how much easily accessible money you have in the form of cash and equivalents? This is a measure of your liquidity. As youll see, this concept plays a role in your financial and investing lives and those of the companies you buy and sell. Starting from a definition of liquidity with examples of different types, well move on to a discussion of how banks play a role in keeping liquidity available. Well then look at liquidity from an investors viewpoint in terms of the stock market. Finally, well end off with a brief look at a couple of financial ratios that can be used to evaluate a companys liquidity.
Tutorial: Basic Financial Concepts
What Is Liquidity?
Liquidity is the term used to describe how easy it is to convert assets to cash. The most liquid asset, and what everything else is compared to, is cash. This is because it can always be used easily and immediately.
Certificates of deposit are slightly less liquid, because there is usually a penalty for converting them to cash before their maturity date. Savings bonds are also quite liquid, since they can be sold at a bank fairly easily. Finally, shares of stock, bonds, options and commodities are considered fairly liquid, because they can usually be sold readily and you can receive the cash within a few days. Each of the above can be considered as cash or cash equivalents because they can be converted to cash with little effort, although sometimes with a slight penalty. (For related reading, see The Money Market.)
Moving down the scale, we run into assets that take a bit more effort or time before they can be realized as cash. One example would be preferred or restricted shares, which usually have covenants dictating how and when they might be sold. Other examples are items like coins, stamps, art and other collectibles. If you were to sell to another collector, you might get full value but it could take a while, even with the internet easing the way. If you go to a dealer instead, you could get cash more quickly, but you may receive less of it. (For further reading, see Contemplating Collectible Investments and A Primer On Preferred Stocks.)
The least liquid asset is usually considered to be real estate because that can take weeks or months to sell.
When we invest in any assets, we need to keep their liquidity levels in mind because it can be difficult or time consuming to convert certain assets back into cash.
Other than selling an asset, cash can be obtained by borrowing against it. While this may be done privately between two people, it is more often done through a bank. A bank has the cash from many depositors pooled together and can more easily meet the needs of any borrower.
Furthermore, if a depositor needs cash right away, that person can just withdraw it from the bank rather than going to the borrower and demanding payment of the entire note. Thus, banks act as financial intermediaries between lenders and borrowers, allowing for a smooth flow of money and meeting the needs of each side of a loan.
Liquidity and the Stock Market
In the market, liquidity has a slightly different meaning, although still tied to how easily assets, in this case shares of stock, can be converted to cash. The market for a stock is said to be liquid if the shares can be rapidly sold and the act of selling has little impact on the stocks price. Generally, this translates to where the shares are traded and the level of interest that investors have in the company. Company stock traded on the major exchanges can usually be considered liquid. Often, approximately 1% of the float trades hands daily, indicating a high degree of interest in the stock. On the other hand, company stock traded on the pink sheets or over the counter are often non-liquid, with very few, even zero, shares traded daily.
Another way to judge liquidity in a companys stock is to look at the bid/ask spread. For liquid stocks, such as Microsoft or General Electric, the spread is often just a few pennies - much less than 1% of the price. For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price. (For more insight, see Why The Bid-Ask Spread Is So Important.)
One thing to note as an investor when placing an order, is the liquidity of the stock. During normal market hours on the major exchanges, placing a limit order will get you the price you are looking for. This is particularly true for companies that are non-liquid, or during after-hours trading when fewer traders are active; at these times, it is better to place a limit order because the lower liquidity may lead to a price you would not be willing to pay. (To learn more, see The Basics Of Order Entry.)
Liquidity and Companies
One last understanding of liquidity is especially important for investors: the liquidity of companies that we may wish to invest in.
Cash is a companys lifeblood. In other words, a company can sell lots of widgets and have good net earnings, but if it cant collect the actual cash from its customers on a timely basis, it will soon fold up, unable to pay its own obligations. (To read more, check out The Essentials Of Cash Flow and Spotting Cash Cows.)
Several ratios look at how easily a company can meet its current obligations. One of these is the current ratio, which compares the level of current assets to current liabilities. Remember that in this context, current means collectible or payable within one year. Depending on the industry, companies with good liquidity will usually have a current ratio of more than two. This shows that a company has the resources on hand to meet its obligations and is less likely to borrow money or enter bankruptcy.
A more stringent measure is the quick ratio, sometimes called the acid test ratio. This uses current assets (excluding inventory) and compares them to current liabilities. Inventory is removed because, of the various current assets such as cash, short-term investments or accounts receivable, this is the most difficult to convert into cash. A value of greater than one is usually considered good from a liquidity viewpoint, but this is industry dependent. (To read more, see The Dynamic Current Ratio and Analyze Investments Quickly With Ratios.)
One last ratio of note is the debt/equity ratio, usually defined as total liabilities divided by stockholders equity. While this does not measure a companys liquidity directly, it is related. Generally, companies with a higher debt/equity ratio will be less liquid, as more of their available cash must be used to service and reduce the debt. This leaves less cash for other purposes.
Bottom Line
Liquidity is important for both individuals and companies. While a person may be rich in terms of total value of assets owned, that person may also end up in trouble if he or she is unable to convert those assets into cash. The same holds true for companies. Without cash coming in the door, they can quickly get into trouble with their creditors. Banks are important for both groups, providing financial intermediation between those who need cash and those who can offer it, thus keeping the cash flowing. An understanding of the liquidity of a companys stock within the market helps investors judge when to buy or sell shares. Finally, an understanding of a companys own liquidity helps investors avoid those that might run into trouble in the near future.
Finding The Right Trading Coach
If you have ever thought about getting a trading coach or trading program, or bought a book about trading, this topic may have crossed your mind. If the coach knows so much about trading, why is he or she teaching others? This is an interesting question and relates to the old adage: Those that cant ... teach. Meaning those who were unsuccessful at an endeavor move to the teaching realm to coach others. Many people dont like the idea that a trader who cant make big money should be teaching others. But does your coachs personal success really matter? In other words, is a full-time trader in a better position to help you than someone who no longer trades or has never traded? When we break down the pros and cons you may realize you werent giving some people the credibility they deserve, and were possibly giving too much credit to others. (For general investment information refer to Top 10 Commandments Of Investing.) Arguments for Both Sides
A coach who is a trader will claim to have definite advantage over someone who doesnt trade. This may be true if the coach has the track record to back this claim up, but just because a person is successful at trading does not mean he or she can effectively relay that skill to someone else.
On the other hand, a coach who no longer trades can still provide great benefit if he or she is an effective teacher . A non-trader coach may have been successful as a trader in the past, but has chosen to give up trading. The reasons for this are numerous: some traders prefer coaching to trading, have found trading too stressful, want to help others or have already succeeded and want a new challenge, to list but a few potential reasons. However, it may also be that the trader has failed miserably. At first it may seem that this person would not be a good coach, but this is not necessarily true; we can learn a lot from other peoples failures. In addition, even though someone was unable not implement a certain system themselves due to lack of discipline, psychological or physiological reasons, this does not mean that a different person cant be successful using the same method.
Both sides can likely agree on the fact that in order to coach someone else, a teacher needs to have experience in what students will go through. Essentially, coaches must have market experience in some form or another. The coach needs to know what hurdles students will have to go over, and be able to help them navigate through those obstacles. This does not mean they need to have traded personally, but they will at least have to have been in an environment where they witnessed others trading. Observation can be a great teacher that can lead to the teaching of others.
A Deeper Look
On both sides of the argument there are examples of traders being great and horrible coaches, as well as coaches who no longer trade (or never did) that are fantastic. Think for a moment about a sport. The athletes who play professional sports are the best athletes in the world, and yet they are often coached by someone who has inferior skill. This is OK, because the coach is there to help hone another persons skills. Just because coaches dont have the qualities of a peak performance athlete does not mean they cant pick out and elevate those qualities in others. On the flip side, we have had some amazing talents who could not and cannot effectively pass on whatever it was that made them great athletes.
When we look at trading, or investing , much worth is placed in those who dont actually trade the markets professionally. Market analysts gauge the market using varying tools and methods and relay that information to others. While many analysts may not be traders, some are often very accurate in their market analysis. Having a birds eye view of the unfolding situation allows them to make predictions without an investment in the outcome. These insights are helpful to many traders, even though the information comes from someone who may have never placed a trade.
Never having placed a trade does pose a problem for the trader. The market is constantly moving, and while an analyst may be able to anticipate the direction and magnitude of a move, the gyrations along the way can have the power to wipe a trader out if he or she executes a move at the wrong time. In this case, a student trader would benefit from having the information constructed into something tradeable by a trading coach.
How to Find a Good Coach
With arguments on both sides, there is no hard-and-fast rule when it comes to which is better. The bottom line is whether someone gets you the knowledge and skills that you want. If the coach is teaching you in a way you understand and you feel you are getting your moneys worth, that is what counts.
Trading and coaching is a business. Coaches need to recruit students - this is how they make money . Therefore, sales pitches abound across media sources. When seeking to improve your trading, this can be overwhelming. That said, you can often narrow your search down quite quickly by following a few simple guidelines.
1. Dont Focus on a Coachs Personal Results
Dont worry about whether a potential coach was a trader, is a trader or what his or her personal track record is. Personal trading results dont matter; what matters is how a given coachs students are doing. Look for reviews by students about a coach or training program , and if possible contact a few students directly to ask them about their experience.
2. Avoid Getting Emotional
Sales pages are meant for the hard sell. Therefore, sift through sales pages with an analytical mind, not an emotional one. Is there any substantiation to an advertisers claims? People who know the markets know that no one is right all the time, so skip past coaches and programs that promise outlandish results.
3. Consider Your Personality and Style
If you have some experience already, look for someone who meshes with your personality and style. Do you understand the language the coach uses? Does his or her method seem simple and easy to understand? Complex methods can be hard to implement and may not be easily passed from one person to another. Also, if you cant understand what someone else is saying when you are first introduced to their work, it is likely only going to get harder to understand down the road.
Conclusion
Good information, coaching and training programs can be found, but in order to hit on the best possible program, traders need to do some research. This includes finding reviews of any product or service being considered, and touching base with those companies or individuals to see what they have to offer. We can also discard any offers that promise outlandish results or are hard to understand. Trading can be difficult, but learning about it should be much easier - especially if you take the time to seek out the best possible sources.
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.
An Inside Look At ETF Construction
Some people are happy to simply use a range of devices like wrist watches and computers and trust that things will work out. Others want to know the inner workings of the technology they use, and understand how it was built. If you fall into the latter category and as an investor have an interest in the benefits that exchange-traded funds (ETFs) offer, youll definitely be interested in the story behind their construction.
How an ETF Is Created
The creation and redemption process for ETF shares is almost the exact opposite of that of mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which then uses that cash to purchase securities and in turn issue additional shares of the fund. When investors wish to redeem their mutual fund shares, the shares are returned to the mutual fund company in exchange for cash. The creation of an ETF, however, does not involve cash.
The process begins when a prospective ETF manager (known as a sponsor) files a plan with the SEC to create an ETF. Once the plan is approved, the sponsor forms an agreement with an authorized participant, generally a market maker, specialist or large institutional investor, who is empowered to create or redeem ETF shares. (In some cases, the authorized participant and the sponsor are the same).
The authorized participant borrows shares of stock, often from a pension fund, places those shares in a trust, and uses them to form creation units of the ETF. Creation units are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares is whats commonly designated as one creation unit of a given ETF. Then, the trust provides shares of the ETF - which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units) - to the authorized participant. Because this transaction is an in-kind trade - that is, securities are traded for securities - there are no tax implications. Once the authorized participant receives the ETF shares, they are then sold to the public on the open market just like shares of stock.
When ETF shares are bought and sold on the open market, the underlying securities that were borrowed to form the creation units remain in the trust account. The trust generally has little activity beyond paying dividends from the stock held in the trust to the ETF owners and providing administrative oversight because the creation units are not impacted by the transactions that take place on the market when ETF shares are bought and sold.
Redeeming an ETF
When investors want to sell their ETF holdings, they can do so by one of two methods. The first is to sell the shares on the open market. This is generally the option chosen by most individual investors. The second option is to gather enough shares of the ETF to form a creation unit and then exchange the creation unit for the underlying securities. This option is generally only available to institutional investors due to the large number of shares required to form a creation unit. When these investors redeem their shares, the creation unit is destroyed and the securities are turned over to the redeemer. The beauty of this option is in its tax implications for the portfolio.
We can see these tax implications best by comparing the ETF redemption to that of a mutual fund redemption. When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by the tax burden. This is because to redeem the shares, the mutual fund may have to sell the securities it holds, realizing the capital gain, which is subject to tax. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis. Therefore, even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains.
ETFs minimize this scenario by paying large redemptions with shares of stock. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer. This increases the cost basis of the ETFs overall holdings, minimizing its capital gains. It doesnt matter to the redeemer that the shares it receives have the lowest cost basis because the redeemers tax liability is based on the purchase price it paid for the ETF shares, not the funds cost basis. When the redeemer sells the shares of stock on the open market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios.
The Role of Arbitrage
Critics of ETFs often cite the potential for ETFs to trade at a share price that is not aligned with the value of the underlying securities. To help us understand this concern, a simple representative example best tells the story.
Assume an ETF is made up of only two underlying securities:
• Security A, which is worth $1 per share
• Security B, which is also worth $1 per share
In this example, most investors would expect one share of the ETF to trade at $2 per share (the equivalent worth of Security A and Security B). While this is a reasonable expectation, it is not always the case. It is possible for the ETF to trade at $2.02 per share or $1.98 per share or some other value.
If the ETF is trading at $2.02, investors buying shares of the ETF are paying more for the shares than the underlying securities are worth. This would seem to be a dangerous scenario for the average investor, but in reality, it isnt a major problem because of arbitrage trading.
Heres how arbitrage sets the ETF back into equilibrium. The trading price of an ETF is established at the close of business each day, just like any other mutual fund. ETF sponsors also announce the value of the underlying shares on a daily basis. When the price of the ETF deviates from the value of the underlying shares, the arbitragers spring into action. If the underlying securities are trading at a lower price than the ETF shares, arbitragers buy the underlying securities, redeem them for creation units, and then sell the ETF shares on the open market for a profit. If underlying securities are trading at higher values than the ETF shares, arbitragers buy ETF shares on the open market, form creations units, redeem the creation units in order to get the underlying securities, and then sell the securities on the open market for a profit. The actions of the arbitrageurs set the supply and demand of the ETFs back into equilibrium to match the value of the underlying shares.
Because ETFs were used by institutional investors long before they were discovered by the investing public, active arbitrage among institutional investors has served to keep ETF shares trading at a range that is close to the value of the underlying securities.
The Bottom Line
In a sense, ETFs have a lot in common with wrist watches. Everybody wants their watch to tell the correct time, but they dont need to know how the watch was built in order to benefit from it. With ETFs, investors can enjoy the benefits associated with this unique and attractive investment product, without even being aware of the complicated series of events that make it work. But, of course, knowing how those events work makes you a more educated investor, which is the key to being a better investor.
3 Essential Rules For New Investors
The investing landscape can be extremely volatile, and changes year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, and the nature of the industry, it is not that simple to be simple, but it can certainly be done. First, we will take a look at the potential difficulties of understanding investments, and then well look at how new investors can invest safely, suitably and sensibly.
How Much Do We Really Understand?
One could argue that the only asset that is fully understandable is cash in the bank, or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment.
Moving a bit up the risk ladder, we get to bonds. Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they dont pay much. Municipal bonds pay a little more and are usually tax exempt, but are not going to satisfy the average investors retirement needs. So to really earn anything, you need a variety of bonds, probably some corporate ones, plus, arguably some foreign ones. Yet, these start to become complex and more risky, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues. (Learn more in the Bond Basics Tutorial.)
The same applies to stocks, mutual funds and so on. Even real estate funds have proven to be less reliable and straightforward than many people might think. Direct real estate purchases are more understandable in one sense – what you see is what you get. But then again, there can be unknowns relating to the market, taxation, the location, disclosure by the seller and so on.
Similarly, alternative investments, like hedge funds, can be extremely complex. Infrastructure, too, is without doubt a great idea in principle, but the nitty-gritty of investing in it is not such a sure thing. No matter how sound the principle of a particular investment, there is almost always someone or something out there that can make it go wrong. And as for certificates of deposit (CD), they are probably the hardest type of investment to understand. Given yield curves, expectations and potential early withdraw penalties, they may be the easiest to missell. (Analyzing a hedge fund will help you determine whether its a good investment - and a good fit. Read Hedge Fund Due Diligence, for more.)
Tracker funds, on the other hand, are relatively simple to understand – you are indeed just buying the market, but the markets themselves are not so easy to deal with and understand. Furthermore, the tracker market is becoming more sophisticated and complex. This all sounds very daunting. But in fact, one can still invest simply and understandably, at low cost and with a good, diversified portfolio that is likely to perform well over time.
How Can We Invest Sensibly, Suitably and Simply?
The above section certainly implies that we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. One can really invest in a straightforward manner, and understand what one is doing.
Many veteran investors have simple diversified portfolios, and look more at asset allocation. Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg, of Kiplinger, has said in his Value Added Web Column that: Most people wish they didnt have to be investors, and that they lead busy enough lives without having to worry about stocks, bonds and mutual funds. Goldberg therefore recommends sticking with index funds that simply mirror the market and only attempt to be average. He even argues that one only needs three index funds, one covering the U.S. equity market, another with international equities and the third tracking a bond index. (Use these rules to guide you on the road to financial freedom, check out The 10 Commandments Of Investing.)
Trackers are sometimes better than actively managed funds. Lower fees, low turnover and a combination of available investor education makes index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of good managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.
A good piece of advice is to start searching through Investopedia.coms tutorial section, namely to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.
It is interesting to note the book title, How Buffett Does It: 24 Simple Investing Strategies from the Worlds Greatest Value Investor (James Pardoe, McGraw-Hill, 2005), about the worlds greatest pro. Buffett himself comments that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But one does not have to fall for this.
Conclusions
The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not even understand in principle. A small number of index funds seems a very good solution. (You might want to check out Getting Started In Stocks.)
Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in some mixed fund which has served them well, there is a better chance that it will continue to do so. On the other hand, if you get a phone call from someone who you met in a pub last week and who wants to give you a hot tip as a big favor, be more skeptical.
Likewise, there are many independent financial advisors around who get paid only for their time and not on commission. Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes, but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand after all, the losses are not so disastrous. Always bear in mind that too many bits and pieces also create complexity which can lead to errors.
The Changing Role Of Equity Research
Actually, the title of this article is a bit misleading, because the role of research hasnt changed since the first trade occurred under the buttonwood tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.
Research and the Stock Market
The role of research is to provide information to the market. A lack of information creates inefficiencies that result in stocks being misrepresented (over- or under-valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and its peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.
Research in Bull and Bear Markets
If the role of research has always been so noble, why is it in such a state of ill-repute? There are two reasons: firstly, the current bear market gives us a new perspective to evaluate the excesses of the last bull market; secondly, investors need to blame somebody.
In every bull market, there are excesses that become apparent only in the bear market that follows. Whether it is tulips or transistors, each age has its mania that distorts the normal functioning of the market. In the rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the hot sector(s). This herd mentality is the reason why bull markets have funded so many me-too ideas throughout history.
Research is a function of the market and is influenced by these swings. In a bull market, investment bankers, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain rational practitioners are ignored and their research reports go unread. During the late 1990s, the business media catered to the audiences demands and gave the spotlight to the famous talking heads that are now under investigation.
Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s and the 1970s, and its occurring today. Some of the criticisms are deserved, but the need to provide information has not changed.
Research in Todays Market
To discuss the role of research in todays market, we need to differentiate between Wall Street research and other research. Wall Street research is provided by the major brokerage firms, both on and off Wall Street. Other research is produced by independent research firms and small boutique brokerage firms.
This differentiation is important. First, Wall Street research has become focused on big cap, very liquid stocks and ignores the majority (over 60% based on research) of publicly-traded stocks. This myopic focus on a small number of stocks is the result of deregulation and industry consolidation. In order to remain profitable, Wall Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trade profits.
Those companies that are likely to provide the research firms with sizable investment banking deals are the stocks that are determined worthy of being followed by the market. The stocks long-term investment potential is secondary. The second reason to distinguish Wall Street from other research is that most of the blame for the excesses of the last bull market is rightfully placed on Wall Street.
Other research is filling the information gap created by Wall Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Wall Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their research by opening an account and paying higher commissions.
This means that independent research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for research, because they dont really know what they are paying for until well after the purchase. Unfortunately, not all research is worth buying. I have purchased reports from reputable sources only to find them inaccurate and misleading. (For more reasons to do your research read: What Is The Impact Of Research On Stock Prices?)
Who Pays for Research? Big Investors Do!
The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research in order to gain and keep clients. Investors just had to ask their brokers for a report and retained it at no charge. What seems to have gone unrealized is that the commissions pay for that research.
A good indicator of the value of research is the amount institutional investors are willing to pay for it. Institutional investors hire their own analysts to gain a competitive edge over other investors. They also pay (often handsomely) independent research firms for additional research. Institutions also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute). All this amounts to big money, but the institutions realize that research is integral to making successful investment decisions. (For more read The Impact of Sell-Side Research.)
If investors are unwilling to buy research how will the market correct the imbalance caused by the lack of coverage? The solution may be found by looking at the issue a slightly different way.
The Growing Role of Fee-Based Research
Fee-based research increases market efficiency and bridges the gap between investors who want research (without paying) and companies who realize that Wall Street is not likely to provide research on their stock. This research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research.
It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based research is analogous to the role of your physician. You pay a physician not to tell you that you feel good, but to give you his or her professional and truthful opinion of your condition.
Legitimate fee-based research is a professional and objective analysis and opinion of a companys investment potential. Promotional research is short on analysis and full of hype. One example of this is the fax and email reports about the penny stocks that will supposedly triple in a short time.
Legitimate fee-based research firms have the following characteristics:
1. They provide analytical, not promotional services.
2. They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest.
3. They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity.
Companies who engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency. Such a company is making the following important statements:
1. That it believes its shares are undervalued because investors are not aware of the company.
2. That it is aware that Wall Street is no longer an option.
3. That it believes that its investment potential can withstand objective analysis.
The National Investor Relations Institute (NIRI) was probably the first group to recognize the need for fee-based research. In January 2002, NIRI issued a letter emphasizing the need for small-cap companies to find alternatives to Wall Street research in order to get their information to investors. More recently, the NIRI is conducting a survey on research alternatives and will possibly have a session on this topic at their national conference this year. (For more information on fee-based research read Fee-Based Research: The Good, The Bad And The Ugly.)
The Bottom Line
The reputation and credibility of a company and the research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with disreputable research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential.
Understanding Stocks, Mutual Funds And ETFs
There are a lot of investment products available and a lot are difficult to understand, for the consumer with little investment knowledge. Three common products, mutual funds, exchange traded funds and equities are similar, but function very differently in a portfolio.
Mutual Funds
Other than stocks, taking a close second in any investment popularity contest is the mutual fund. Anybody with a company or government sponsored retirement portfolio has most of their money invested in these funds. Mutual funds may be popular, but theyre not well understood.
Think of a mutual fund as a collection; the collection could be stocks, bonds or nearly any product. Any fund that is actively managed has a team of managers and advisors, who attempt to beat the overall performance of the market. For the person who has little or no investment experience, mutual funds offer a professionally managed product that should make money for you, without having to monitor a complicated portfolio.
The problem with mutual funds is that after fees, a majority of stock funds underperform the stock market and this isnt new. Back to the 1960s, stock mutual fund performance has lagged the market by an average of 2%. Although many stock funds underperform the market, passively managed index funds have lower costs and closely track the performance of the market. (For additional reading, check out: Is Your Mutual Fund Safe?)
Exchange Traded Funds (ETFs)
Similar to mutual funds, exchange traded funds are often a basket of stocks, bonds or other investment products, but unlike mutual funds, ETFs are traded on the stock exchanges. More importantly, ETFs dont try to beat the market like stock mutual funds, but instead reflect the performance of an index, sector or other product. The SPDR S
The Value Line Investment Survey
Have you ever opened the statement that your mutual fund company sent to you, then looked at the returns and thought, I could do better than that?
Its an increasingly common feeling, as the returns generated by many equity mutual funds often leave investors frustrated. If you want to try your hand at picking stocks but dont know where to start, the Value Line Investment Survey can help.
The Survey
The Value Line Investment Survey consists of professional research and recommendations on approximately 1,700 stocks. According to Value Line, this represents … approximately 95% of the trading volume of all stocks traded in U.S. markets … The Survey also provides weekly updates on the financial markets, recommended portfolios, developments involving covered securities and special topical reports. For would-be stock pickers, Value Line provides an easy way to start your research.
How to Get Started
Bearing in mind that conducting your own stock research is a time-consuming task, the first step in getting familiar with the tools Value Line offers is to set aside a few hours of reading time. You will need to study the materials closely in order to understand how to use them before you will be ready to invest any cash.
Prior to delving into the literally thousands of pages of stock research at your fingertips, start by reviewing The Complete Guide to Using The Value Line Investment Survey. In roughly 40 pages, this slim volume explains Value Lines ranking system (stocks are rated from one to five in a variety of categories) provides line-by-line explanations for the information provided in each of the research reports. At the back of the booklet is a detailed glossary of investment terms that includes definitions for terms ranging from bond ratings to unit labor costs.
Next, youll want to read, A Quick Study Guide. This guide explains the information included in the two binders that serve as primary research tools for investors using the hard copy version of Value Line. (An online service is also available.) The first binder contains the Summary and Indexand Ratings and Reports. The second binder contains Selection and Opinion. The Quick Study Guide also explains how to use the research to choose stocks for your portfolio.
Binder 1: Summary and Index
Starting with the first binder, the Summary and Index provides an overview of the stock screens Value Line provides, including lists of stocks with the lowest price-to-earnings ratio, the highest dividend yields, the highest annual total revenues and a host of other choices. These screens help investors identify stocks that align well with theirpersonal investment goals. For example, investors seeking income may look for stocks that offer high dividend payments, while investors seeking growth may seek stocks that have the highest appreciation potential. If this is your first effort at picking stocks, this portion of the Survey could be of particular interest to you. In addition, the Summary and Index catalogs all of the covered stocks and provides the page number where the research reports can be found.
It also provides key statistics for the universe of covered stocks, including price-to-earnings ratio, dividend yields and appreciation potential. These statistics provide information about the universe and the direction it has been moving in, as well as providing a baseline for comparing an individual stock against the universe.
The Ratings and Reports section provides stock research on approximately 1,700 companies. The research includes an analysts report that provides a brief overview of the company, a review of its financial health and a recommendation regarding its attractiveness to investors. The data portion of the report provides a detailed statistical analysis, including a price target, transactions by company officials (buying/selling), transactions by institutions, chart of historical returns, sales figures, earnings data and much more. Perhaps the best thing about the research section, particularly if you are a novice, is its ranking system.
Every stock in the survey is ranked on a scale of one to five in three different areas: timeliness, safety and technical. A rank of one denotes stocks that are expected to outperform the rest of the Value Line universe. Timeliness refers to performance expectations for the next six to twelve months. Safety compares the securitys price stability against its peers, and the Technical ranking compares 10 price trends to provide price return potential for a three to six month period. An alphabetical listing of all covered stocks, including key statistics and the ranking numbers, is particularly convenient for investors seeking a specific rating in one or more categories.
Binder 2: Weekly Selection and Opinion
The second binder contains the Weekly Selection and Opinionsection, which includes an economic outlook, market commentary and research on selected topics. Additionally, it includes evaluations of four model portfolios, one targeting short-term growth, one for long-term growth, one for income and, lastly, one for both growth and income. The evaluations highlight both successful selections and failures, which serves as an important reminder.
While the Value Line Investment Survey is a convenient, easy-to-use tool that is particularly helpful to novice investors, investing is not an endeavor that comes with any guarantees. The information you read in the Survey is well researched and impressively packaged, but there is no guarantee that it is correct. Like any other stock research, the insight provided by Value Line does not mean that you cant lose money on an investment that you make using the research. As with all security purchases, let the buyer beware
Using the Data
Taken as a whole, the Value Line Investment survey provides all the tools an investor needs to develop a picture of the current economic landscape, learn about stock analysis and identify securities that are appropriate for a variety of investment objectives. By matching the results of the research with your personal investment needs, you should be able to put together enough information to choose a stock or build an entire portfolio.
How to Get It
The Value Line Investment Survey is available by subscription. A one-year subscription is just over $500 for the online version and just under $600 for the print version. For an additional fee, the firm also offers research on mutual funds, exchange traded funds, convertible securities and more. You can get them all for just under $1,000.
Interestingly, many large libraries receive the print version of the Value Line Investment Survey and provide it to patrons for free. This provides an opportunity to learn about, use and thoroughly evaluate the materials before plunking down the cash for a personal subscription conveniently delivered to your house.
Next Steps
The Value Line Investment Survey is not the only professional research that you can easily access. In fact, it is just the first in a long list of tools. After you have read, researched and mastered the Value Line tool set, you can expand your repertoire of investment tools by using the research reports provided through websites associated with online brokerage accounts. These sites provide access to research reports similar to those offered by Value Line. It is worth noting that reports from various research providers often contradict each other.
The Bottom Line
While these contradictions may be frustrating, think of research as data gathering. You can take in data from as many sources as possible and use that data to formulate your own opinion. Relying on any single source of data is unlikely to be a wise decision, as there are no guarantees that the researchers behind your data source will always make the right call. Of course, if reading these research reports is too time consuming, too scary or too frustrating, you can always buy a mutual fund or hire a professional financial advisor to provide investment recommendations.
Warren Buffetts Bear Market Maneuvers
In times of economic decline, many investors ask themselves, What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target? The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices. In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy. (For more on Warren Buffett and his current holdings, sign up for our Coattail Investor newsletter.)
The Buffett Investment Philosophy
Buffett has a set of definitive assumptions about what constitutes a good investment. These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price. (For further reading, see Warren Buffett: The Road To Riches and What Is Warren Buffetts Investing Style?)
Buffett looks for businesses with a durable competitive advantage. What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source. (For more insight, see Competitive Advantage Counts, 3 Secrets Of Successful Companies and Economic Moats Keep Competitors At Bay.)
Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.
In addition, he assumes the following points to be true:
• The global economy is complex and unpredictable.
• The economy and the stock market do not move in sync.
• The market discount mechanism moves instantly to incorporate news into the share price.
• The returns of long-term equities cannot be matched anywhere else.
Buffett Investment Activity
Berkshire Hathaway investment industries over the years have included:
• Insurance
• Soft drinks
• Private jet aircraft
• Chocolates
• Shoes
• Jewelry
• Publishing
• Furniture
• Steel
• Energy
• Home building
The industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?
Buffett Investment Criteria
Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions . While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:
1. The candidate company has to be in a good and growing economy or industry.
2. It must enjoy a consumer monopoly or have a loyalty-commanding brand.
3. It cannot be vulnerable to competition from anyone with abundant resources.
4. Its earnings have to be on an upward trend with good and consistent profit margins.
5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio.
6. It must have high and consistent returns on invested capital.
7. The company must have a history of retaining earnings for growth.
8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow.
9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments.
10. The company must be free to adjust prices for inflation.
The Buffett Investment Strategy
Buffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices. Buffett does not buy tech shares because he doesnt understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadnt been around long enough to provide sufficient performance history for his purposes.
And even in a bear market , although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.
Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown. (To learn about the disadvantage of being confined to blue chip stocks , read Why Warren Buffett Envies You.)
Buffetts selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low. And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.
Conclusion
Buffetts strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices. Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made. Buffett also benefits from a huge cash war chest that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.