Fortune Watch

If you are a crook, unethical or a scam artist then there’s easy money to be made investing in the stock market.

When the stock market is strong, it invites the purveyors of schemes designed to make you poor and them rich to push their wares even harder.

People who know nothing of investing get tempted in a strong stock market, but want to get in on the action and there are always crooks willing to help them invest in the latest hot stock.

Unfortunately, the deals sound so great that many unsuspecting novices to investing in the stock market fall prey to the schemes.

Fear and greed are the two most powerful emotional motivators. Both drive investors to make decisions that are foolish.

When the market is in one of its down cycles, fear drives investors out of the market as prices are dropping. When the market rebounds they buy back in at prices often higher than what the got as they exited the market. Thus the famous sell low, buy high strategy – not a winner.

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 “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”- Warren Buffet.

The right time to get back in the market may be just around the corner. With global economies sinking, sometimes dramatically, it can be a scary thought to put your hard-earned money on the line. However, a smart investor will realise that golden opportunities are appearing if proper research is done.

It has not dropped dramatically since the financial collapse of 2008-2009, but it is still in familiar territory. It may take another another year or more for a large upswing in the markets, but at least we hope that the Dow will not drop below previous lows. That may bring hope and some peace of mind about starting to invest again.

For investors, the operative question is simple, albeit very broad: In the midst of this crisis, what do we do?

A good rule of thumb: If a stock you are considering for investment depends upon a speedy return to normal, you should be looking elsewhere. Warren Buffett has often said that you should invest in businesses that you wouldn’t mind owning if the stock market were closed for an extended period.

Dollar Cost Averaging

The concept of Dollar Cost Averaging comes to mind in the current market situation. It is the process of buying stocks or similar investments on a regular basis, such as once a month, using a fixed amount of money. When prices are low, you are able to buy more shares. When prices are high, you buy fewer. In this way, you are able to take advantage of temporary low prices. This is especially helpful for long-term investments, such as retirement accounts. It may go against human nature to buy stocks when everything is falling and red but in fact it can lead to a bigger payoff if done correctly.
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A rally is a beautiful thing, particularly when the correction preceding it was embraced enthusiastically. This is the time to harvest your profits — pipe dreams of great wealth and inflated ego aside — jump on those profits before they erode before your disbelieving eyes. If you over think the environment or over cook the research, you’ll absolutely miss the party.

Unlike many things in life, stock market realities need to be dealt with quickly, decisively, and with zero hindsight — and this market reality? No rally in financial market history has ever escaped the ensuing correction. In the real world of investing, most unrealized profits eventually hit the tax return as realized losses

Here’s a list of ten things to do and to think about right now to protect yourself better than you did the last time a correction blindsided you:

1. Your present asset allocation should have been tuned in to your goals and objectives. Resist the urge to increase your equity allocation because you expect a further rise in stock prices. That would be an attempt to time the market, which is, rather obviously, impossible.

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Fascinating, isn’t it, this stock market of ours, with its unpredictability, promise, and unscripted daily drama. But individual investors are even more interesting. We’ve become the product of a media driven culture that must have reasons, predictability, blame, scapegoats, and even that four-letter word, certainty.

We are a culture of investors where hindsight is rapidly replacing the reality-based foresight that once was flowing in our now real-time veins — just like in basketball, golf, and football.

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What works in investing? I don’t mean that question the obvious way-that it’s a place where people buy and sell stocks through brokers. What I mean is how you think stock prices are really set. What is your mental model of how prices are decided?

A flawed mental model can lead to some interesting conclusions. For example, in the early days of email, a friend of a mine believed that if you reduced the font size in an email message, then the message would become smaller and therefore easier to send. It was a flawed mental model, or rather, was the fax mental model being applied to email.

I believe one of the fundamental reasons why so many people have trouble investing in the stock markets is that they have severely flawed mental models of what determines a stock price. While there are many mental models of how the stock markets work, some are more common than others.

This is the most widespread one: ‘There are people who know when a stock’s price is about to rise. If one of them tells me, then I can make money.’ This is the ‘tip’ model of the stock markets. It isn’t so much a mental model as the lack of one. Unfortunately, this is a very common one. There seem to be a lot of people who believe that someone out there knows which way things will move and everything depends on somehow getting to know these secrets.

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This is a fairly long read, most of you will leave before you reach halfway and say “I know the ropes, I know the game and I know the rules, what the heck is this guy talking about?” If you think this is a load of crap and you are a master, get off my site and go invest all your money, I know jolly well that you know nothing. Oh yeah! before you go make sure to bookmark this page, you will need to read it when the damage is done. Ask 8 out of 10 people why they invested in a particular stock, the answers will be like “Its a great stock and besides most of my friends have invested too.” The truth is they don’t have a clue. If you do happen to read till the end, I’d love to hear from you.  Assuming I have your attention and interest, please read on.

It is important to be independent in our decisions to invest, and be able to evaluate and understand the companies that we are considering for potential investment. In this article, I want to share with you some of the things that I look at when deciding if a stock is a good investment or not.

Revenue
To pick out a stock that will create good long-term value for its shareholders, investors need to look at the sales figure to see if it is growing at a healthy rate long-term.

Investors should, however, make sure that the company is not over-aggressive in its expansion and taking on too much debt; spreading itself too thin. Investors should also make sure that the company is not in the habit of regularly issuing new stock to fund its growth, as this kind of activities will dilute the holdings of shareholders. The best companies are usually the ones that can mostly or fully fund their expansion from internally generated funds.

Investors also shouldn’t overpay for stocks with high growth rates, as this will put investors in a situation where they find themselves with big losses because a high-growth company they bought shares in missed earnings estimates by 0.1% or something.

It is important to figure out if the growth rate of the company is sustainable by reading the annual report for information on growth and looking at the industry the company is in, as well as the size of the company in relation to the size of its largest competitors. A company doing $8 billion dollars in sales in a mature industry where its biggest competitor is only doing $10 billion dollars in sales generally can’t grow much and shouldn’t have too high a rate of growth.
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Most people enter the investment arena thinking that “Risk” is a board game they played in college. Today, I would guess that the majority of investors have never owned an individual share of common stock or a Municipal Bond.

The popularity of investment products has heightened the risk for all investors and has indirectly led to many of the policy errors that threaten both capitalism and the economic fabric of America. Market prices are increasingly and inappropriately influenced by decision-making based only on the derivatives that contain them.

Few people consider the investment risk associated with public policy decisions. Product investors and derivative speculators participate in less personal markets, where it is more difficult to connect the dots between their personal financial interests and their political alignments.

So in a very real sense, investors have to deal with public policy risk every bit as much as they need to analyze the risks associated with the securities and other financial products they hold in their portfolios — complicated, but it is doable.

Apart from these important peripheral considerations, the risk of loss in any equity investment is generally greater than the risk of loss in any debt related instrument. The potential reward from each type is just the opposite, and that’s where all the excitement begins.

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Boaters run aground by not paying attention to tides, charts, navigation tools and their GPSes. Investors get swamped with information, media noise, breaking news, politicians, gurus, and derivatives — so much so that they can’t see the oncoming fog banks and tsunamis of cyclical change.

Most investment mistakes are caused by basic misunderstandings of the securities markets and by invalid performance expectations. Losing money on an investment may not be the result of an investment sandbar and not all mistakes in judgment result in broken propellers.

Errors occur most frequently when judgment is rocked out of the boat by emotion, hindsight, and misconceptions about how securities react to waves of varying economic, political, and hysterical circumstances. You are the commander of your investment fleet. Use these ten risk-minimizers as lifeboats:

1. Identify realistic goals that include time, risk-tolerance, and future income requirements — chart your course before you leave the pier. A well thought out plan will minimize tacking maneuvers. A well-captained plan will not need trendy hardware or exotic rigging.

2. Learn to distinguish between asset allocation and diversification. Asset allocation divides the portfolio between equity and income securities. Diversification limits the size of individual holdings in several ways. Both hedge against the risk of loss. Both are done best using a cost based approach.

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Rising markets require GREED CONTROL just as surely as falling markets demand protection against FEAR — the two heads of the “ole” Uncertainty Monster!

While the media and your buddies drool or cringe, respectively, your Working Capital focus keeps you on target, looking for higher yielding, quality, income securities and/or quality equities that have fallen from grace with the Market. Remember that Smart Cash is only “smart” if it doesn’t burn a hole in your Asset Allocation.

Knowing that excessive cash is the result of profit taking should encourage investors to avoid the purchase of high priced old favorites, hot new issues, and the best performing funds. When the FEAR head is talking to you, The Working Capital Model will be whispering in your other ear to get that Equity Allocation back where it belongs with lower priced quality issues — possibly the same ones you recently sold for profits.

I know of no other Investment Manager anywhere (other than those who have contacted me and obtained my consent), private or public, that uses The Working Capital Model to direct individual investor portfolios — certainly none of the major operators, who are dependent for their survival upon the whim of even larger “others”.
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The Asset Allocation formula is the mission statement that defines the long term structure and nature of the portfolio. By simply stating, for example, that the portfolio is to be 70% invested in equities and 30% in fixed income, an investor has proven that: (1) he has analyzed his personal situation carefully and, (2) determined that this structure is most likely to achieve his long term goals.

Asset Allocation is often misused and abused in an effort to superimpose a valid investment planning tool on speculation strategies that have no real merits of their own. For example, “annual portfolio repositioning”, “market timing adjustments”, and shifting between Mutual Funds. To be effective, Asset Allocation must be implemented as an on-going process that is to be tended to with every investment decision.

The Asset Allocation Formula itself is sacred, and if constructed properly, should never be altered in any respect due to conditions in either equity or income markets. Changes in the personal situation, goals, and objectives of the investor are the only issues that can be allowed into the Asset Allocation decision making process. It operates above the whims and cycles of the markets — Income or Equity.

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