Fortune Watch

They’re boring and passive. They are run on autopilot by hands off managers. Instead of making decisions about the best course of action, the managers merely try to match the overall market’s performance. They strive to be average. But an investing strategy built on these funds will soon bring higher returns than chasing after the best actively managed mutual fund.

A portfolio manager actively manages the traditional equity fund. They buy and sell stock frequently in attempts to “outperform the market,” usually defined by a broad measure.. Index funds are passively managed. Their manager’s buy and hold only the stocks contained in their chosen benchmark. Their aim is to imitate returns, whether the market goes up or down.

They sell only when an investor redeems his investment or if a stock is kicked out of the Index. This passive investment saves money on research, salaries, and other overhead, and it avoids the emotional traps of buying at the top and selling at the bottom that torment active managers. The biggest saving for Index funds is the brokerage and other trading costs which active manager incur on their hyper active trading. In theory, this all leads to higher returns.

Which of the two is better? Let’s look at the odds. But with their growing numbers, it is difficult to guess how many will beat the benchmark in the long-term. And as the number of fund increase, it will get tough to pick the winners. And you will have to work to pick the right ones. But it takes little effort to pick an index fund that delivers almost the same return. You certainly won’t beat “the market,” but you’ll beat almost everyone working hard to make a choice.

Besides, index funds give you the diversity with discipline. You don’t run the risk of building large position in a small, illiquid company that concentrates you in one industry. Index funds give you a healthy dose of large companies that represent many industries, and the shares of these funds are easily bought and sold.

Which index fund should you pick? Every thing being equal the least expensive fund will be a winner. And recurring fund expense is a function of a funds size. The larger the fund, lower the expenses.

Besides, as an Index fund investor, you’re not getting any extra value. After all, the fund is merely trying to match the index. As you don’t need an advice to buy an Index fund, so you should never pay a sales charge on an index fund. But every Index fund (barring the tax saver) available today charges a load as they pay the fund sales man to sell the concept.

Stocks not Best Investment for Quick Returns

Did you buy a stock to turn $20,000 into the $60,000 you need for Junior’s next year in college? If so, you’re not investing, you’re gambling, and, unless you are incredibly lucky, you will not meet your goal. The expectation of a high return in a short time frame is not realistic. Do stocks ever shoot up like rockets?

Yes, some do. However, you must understand that the market works on a rigid risk-reward basis. If there is little risk to the investor, there will be a lower potential reward. Investments that offer an extremely high potential reward invariably come with a high level of risk.

For the investor, this means if you are after the big returns, you must be prepared to suffer more losses than rewards. As an investment choice, stocks have historically returned 11 to 14 percent.

This does that mean that every stock should return in that range? Not at all – that is simply an average. You need to assess the risk of investing in a particular stock before deciding what an acceptable return is.

An investment in a young high tech company should have a higher potential payout than putting your money in a “blue chip” company that posts modest growth and pays a regular dividend.

What would be the risk factor for a stock that could potentially triple in price over a short period? The answer is very high – in fact, so high that the odds of it succeeding would be very slim. There is no safe (or legal) way to earn a very high return on your money over a short period.

Investing in stocks is best done as a long-term effort, which allows your money to grow and permits time for course corrections and adjustments.

In financial terms, leverage is reinvesting debt in an effort to earn greater return than the cost of interest. When a firm uses a considerable proportion of debt to finance its investments, it is considered highly leveraged. In this situation, both gains and losses are amplified. Margin is a form of debt or borrowed money that is used to invest in other financial instruments. It is often used as collateral to the holder of a position in securities, options or futures contracts to cover the credit risk of his or her counterparts. The concept of leverage and margin are interconnected because you can use a margin to create leverage.

Leverage allows a firm to invest in assets that have the potential to generate high returns. Unfortunately, a leveraged firm brings about additional risk because if the investment does not provide the returns expected, the firm still has to pay back the debt and interest. When a firm is leveraged it ultimately means that it depends somewhat on debt to finance its investments.

A leveraged firm does have its advantages, however. For example, it can increase shareholders’ return on investment by giving the company the ability to take on more high return yielding projects and there is also a tax advantage that is related with borrowing.

A margin is collateral such as cash or securities that are deposited into an account to cover credit risk that the other investor must take on when they have a position in a security, option or futures contract. The margin account is used to cushion any losses that may occur from fluctuations in prices.

It helps to decrease default risk because it constantly monitors and ensures that the investors are able to honor the contract. A margin is also considered borrowed money that is used to buy securities. This can be a practical way of obtaining funds in order to invest in a profitable investment.

A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options or futures contracts in the anticipation of receiving substantially high returns. Some stocks or securities are not permitted to be margined – this is usually due to their volatility and the desire of brokers to refrain from lending out money when there is a high potential for default. It is important when deciding to borrow money that a thorough investigation be done to make certain that the investment is reliable and not excessively risky. This is because an inability to pay back the principal and interest of a loan could result in bankruptcy.

One of my friends writes some interesting stuff that is being written nowadays about investing, is fond of using the word fool. But he doesn’t do it the normal way – the way, say, a school teacher does. For example, I remember him once saying that banks were the default suppliers of foolishness in the markets. This idea of foolishness in this special sense makes it easier to understand why markets behave the way they do. What exactly is this foolishness? I think it’s best defined as what is not.

We’ve all heard of the Efficient Market Hypothesis, which says that financial markets are ‘efficient’, meaning that the prices of stocks (or other securities) reflect all known information and therefore incorporate the collective beliefs of all investors about the future. For the hypothesis to be correct, people must have equal access to all information and have rational expectations.

I think the kind of foolishness we are talking about is everything that is the opposite of all those factors that make the market efficient. It’s a bit like heat and cold in physics. You could say that the flow of knowledge and rational expectations keep the markets efficient or you could say that it’s the flow of foolishness that keeps the markets inefficient. Isn’t that a problem? No, it isn’t, most certainly not. Inefficiency is what keeps the stock market interesting and profitable. If the markets were as efficient as the hypothesis says, then those who can identify and mark out foolishness would make less money.

Therefore, a steady and limitless supply of foolishness is the greatest of assets. Foolishness is the life blood of the stock market. Without foolishness, we would be nowhere. Instead of worrying about how well companies are doing and how much the economy is growing, smart stock investors should instead worry about whether an adequate supply of foolishness will be maintained. I’m happy to inform readers that if present trends continue, they have nothing to fear.

Read (more…)

In years of answering people’s questions about investing, I’ve come to classify two major sources of problems: One, investing without thinking enough, and two, thinking too much about investments. We all know at least a few hypochondriacs who continuously suspect themselves to be suffering from dangerous illnesses and require frequent visits to specialists and get exotic medical tests done to allay their fears.

Similarly, there are a vast number of investment hypochondriacs who suspect their asset portfolios to be suffering from some dangerous disease. Generally, they believe that this disease can only be diagnosed by having a specialist examine the portfolio and test it by applying exotic formulae that will perform some magical analysis. Somewhat like its medical version, investment hypochondria, too, is encouraged by these specialists who claim to detect and cure exotic diseases suffered by investment portfolios.

One of the most popular type of diseases in this field is a faulty asset allocation. Many people are worried sick about whether their investment portfolios have the correct amount of money allocated to debt and equity. Periodically, I get asked about what the formula for calculating asset allocation is and sometimes I’m actually asked this not by a patient but by a budding specialist.

The problem, of course, is that there is no formula, nor can there ever be. Asset allocation is just a fancy term for investing according to your needs. Try to get anyone like this to plan your investments and they’ll start by putting up a charade whose purpose is to convince you that finding out correct asset allocation is a complex process that requires proprietary formulae being churned up in complex looking spreadsheets invented by teams of MBAs.

By this process, deciding on an asset allocation starts by figuring out how risk-averse you are and how much risk you are willing to take to get the returns you want. This sounds so logical and systematic but is actually completely useless. Professional investors who are investing other people’s money may be able to find out their location on a risk-vs-return continuum, but at the back of their mind, everyone else wants zero risk. And guess what, zero risk is effectively possible if you do asset allocation the right way.

The key to really figuring out asset allocation is simply to make a rough time table of the future, one where you try and lay down when you will need how much money. Now, what you need to understand is that over some time horizon, most asset types turn zero risk, or as least as close to it as humanly possible. What you need to do is to match your investment time horizon (and not some theoretical risk level) to the asset type. Assets like bank Fixed Deposits and cash mutual funds are always zero risk, short-term income funds are zero risk after six months, and a good stock portfolio like a well-chosen set of diversified equity funds are close to zero risk after maybe seven years.

I‘ll admit this is a slightly simplified view but what I’m trying to do here is to demonstrate the principal on which individuals should base their asset allocation. There is no formula for asset allocation. The right way to do this is to figure out what you plan to do with your money in the future.

In simple economics, there is little distinction between savings and investments. One saves by reducing present consumption, while he invests in the hope of increasing future consumption.Therefore, a fisherman who spares a fish for the next catch reduces his present consumption in the hope of increasing it in the future.

Most of the people probably have savings accounts with ATMs to access their hard-earned cash and be able to store away any extra cash in a place a little safer than a mattress. A few of you may even have some stocks or bonds.

Let me explain why while a savings account in the bank may seem like a safer place than the mattress to store your money, in the long-term it is a losing proposition! If you open a savings account at the bank, they will pay you interest on your savings. So you think that your savings are guaranteed to grow and that makes you feel extremely good! But wait until you see what inflation will do to your investment in the long-term!

The bank may pay you 5 percent interest a year on your money, if inflation is at 4 percent though; your investment is only growing at a mere 1 percent annually.

Saving and investing are often used interchangeably, but they are quite different! Saving is storing money safely, such as in a bank or money market account, for short-term needs such as upcoming expenses or emergencies.

Typically, you earn a low, fixed rate of return and can withdraw your money easily.
Investing is taking a risk with a portion of your savings such as by buying stocks or bonds, in hopes of realizing higher long-term returns.

Unlike bank savings, stocks and bonds over the long term have returned enough to outpace inflation, but they also decline in value from time to time.The rate of returns and risk for savings are often lower than for other forms of investment.

Return is the income from an investment. Risk is the uncertainty that you will receive an expected return and preservation of capital. Savings are also usually more liquid. That is, you may quickly and easily convert your investment to cash.

The decision about which investment to choose is influenced by factors such as yield, risk, and liquidity. Investments may produce current income while you own the investment through the payment of interest, dividends or rent payments.

When you sell an investment for more than its purchase price, the profit is known as a capital gain, also called growth or capital appreciation.

Too much money in the Stock Market.

When there is too much money in the stock market, it can be a warning sign that things are about to change.

New money coming into the market could means investors who have been holding cash investments (CDs, bonds, and so on) are jumping into equities.

Individually, this may be a good decision, depending on where investors place their money.
Better Stock Return Unfortunately, what often happens is inexperienced investors watch a bull market run and want to get in on the better returns the stock market offers.

They may not choose their investments wisely and push the prices of hot stocks even higher. Because they are inexperienced, they buy stocks they hear about on television or from friends.

Rather than do their own research, money pours into the market and pushes up certain stocks beyond reasonable expectations.

If you have been a stock investor for at least 10 years, this scenario may sound like the tech bubble of the late 1990s.Stock Market Bubble. Huge amounts of cash poured into the market creating a demand for something to buy. During that period, it was any stock that had to do with the Internet.

Like any market where there are more buyers than sellers, prices shot up until professional investors began pulling their money out of the market and values crashed.

This doesn’t mean you should stay out of a market where there is lots of enthusiasm. However, be careful about what stocks you buy and even more careful about what you pay for them.

Don’t rely on the market to keep its enthusiasm forever.

On Tuesday, February 27 this year, the Dow Jones Industrial Average dropped 416 points—the markets sharpest drop in three years. Two emotions—fear and greed—can lead to bad investment decisions.

Investing can be dangerous yet profitable endeavor. Many people have been burnt and decide not to ever invest again. This is the primary fear for investing in anything. They may give you excuse such as ‘I don’t have enough money’ or ‘I don’t know where to invest’. But the number one fear is always the fear of losing money. If a novice investor knows that he won’t lose money, he must have used all means necessary (such as loan) to buy as much investment opportunity possible.

Investing here can mean a lot of things from buying gold coin to real estate. There are several ways of how to reduce your fear of investing in common stock.

Get Educated. When you know more about something, you are more certain of your outcome. When you know how to calculate the fair value of a common stock, you will know your expected return of investment. Remember that the less uncertainty you have, the less risk you undertake. You will also know more about the downside risk of your investment. If a common stock has $ 3 per share of positive net cash, is profitable and is currently trading at $ 5 per share, then you know that it won’t trade at below $ 3 per share for a long period of time. Your maximum possible risk here is 40% of your original investment.

Start Small. When you begin your investing journey, you have a lot of unknowns. Less education means more unknown which means greater risk. How small should you start? As much money that you can afford to lose. If you still have no idea, then how about $ 1 a day? One dollar a day will give you $ 500,000 after fifty years of investing with 10.5 % return. Even if you have $ 500,000 right now, it is better for you to start small if you are a novice investor.

Pay Yourself First: means that you find investment that can pay you first as investors. What investment can pay you first? One thing that comes to mind is buying a common stock that historically has steady or increasing dividends. There is one more way to pay yourself first by selling covered call options. For novice investors, however, I suggest we put this subject of selling covered call options off until you get really really comfortable with investing in common stock.

Learn From Your Mistake. Once you begin investing, the fear of losing money is always there. The best ways to learn is from your own mistake, but do not to hasten your learning curve.

Will you be fear-free after reading this column? The answer is no. Fear is always there because of uncertainty. Successful investing is about predicting the future which is uncertain. Even investing in your money-market account is uncertain. It involves some small risk. The risk might be inflation being higher than the interest rate offered. There is also uncertainty regarding the direction of interest rate. Interest rate used to be in the high single digits during the 1980s. Look where it is now.

We live in uncertain world. Instead of hiding behind the wall, we need to embrace it and educate ourselves to reduce the uncertainty. Doing this will in effect increase our investment return beyond the rate of inflation.

Investing in the stock market sometimes boils down to one essential element, namely good choices.

No matter how well we do our research, how often we buy and sell, or how much we pay experts for their tips and advice, without choosing stocks that represent value, we won’t succeed.

Although some are good at predicting the direction of the market and timing the ups and downs, if they don’t purchase the right stocks, they will still meet with difficulties when trying to reap profits.

For that reason, some of the best paid people on Wall Street are known primarily for their talent at picking stocks. Financial advisors give talks and write books and newsletters about how to choose stocks that will outperform the market, and most experts echo the same sentiment and agree that one of the best ways to judge a stock is from the point of view of a consumer. By using instincts we have already honed as ordinary shoppers, we can often ferret out information that even the most skilled and software-savvy market watchers miss. While they study analytical charts, earnings reports, and the stock exchange ticker tape, folks just like you actually do business with the companies they invest in, because their experience as a customer speaks volumes about the value of the company and its products and services.

Here are the kinds of things to look for as indicators of a company’s worth.

How popular is their product or service? If everyone you know uses it, and is satisfied with such things as price, customer service, and reliability, the company is probably well situated among the competition. Are the employees satisfied? One of the best ways to judge a company is by talking to employees. Many companies put on a good façade, but underneath the fancy marketing is plenty of discontent. But if employees like a company – especially if they like it enough to buy stock in it – that’s a very good sign.

How well known are they? You may find a great startup company with all the trappings of success, but discover that it is lesser known. Many small or regional companies are popular in their own back yards, but the rest of the world may not yet know about them. Buying such unknowns can be a great way to invest in the next hot stock. If the fundamentals look good, sometimes being lesser known is a good thing for investors getting in on the ground floor.

If they went out of business, where would you go for similar products and services? If you can’t think of a convenient alternative, the company is probably in a niche market that enjoys customer loyalty and repeat business.

Shop around, and notice what you see and how each business makes you feel. Then trust your intuition. Make a list of companies that get your attention, and then call their shareholder relations department and ask for more details. By starting your list with companies you already have a first hand experience of, you raise the chances considerably that you will make smart choices.

Most, but not all, stocks move with the overall trend of the market. I’m not talking necessarily about one-day bumps, but general upward and downward trends – bull markets and bear markets. For this reason, it’s important to have an idea what the general trend of the market seems to be and what the market is telling us about future trends.

For this reason, it’s important to have an idea what the general trend of the market seems to be and what the market is telling us about future trends.

You can get a good idea of where the market is headed with just two pieces of information: Price and volume. When you put these two together, you get a picture that tells whether there are more sellers in the market or buyers. Volume tells you whether there is movement in the market and price tells you which direction.

The volume indicator comes from the daily sales volume. Both of these indicators are available online from many different sites. If the market has a high-volume day and prices (of the indexes) are up, you are probably looking at mutual funds and institutional investors buying, which is a sign of an up market trend.

On the other hand, a high-volume day with lower prices could mean a downward trend with the big players backing out of the market. You need to use some common sense when watching these indicators. For example, if you have three or four days of high volume and rising prices, it is not unusual to hit a high-volume day where the prices fall off.

You’ll usually hear the talking heads on television refer to this as “profit taking.” If you begin to see the down days too frequently in a market that has been moving up, it may be a sign that it is about to reverse course or stall.

Mutual funds and institutional investors are the volume buyers and sellers that move the market. When they began moving in a direction, that’s where the market goes and you can see it in the price and volume numbers. A market that shows sharp price movements in either direction without corresponding volume increases is sending false messages that should be watched carefully.

What does this mean to you? Don’t swim upstream. The obvious forces of supply and demand (except when something extraordinary occurs) drive the market. When there are more buyers (higher prices on higher volume) than sellers, the market is trending up.

When there are more sellers (lower prices on higher volume) than buyers, the market is trending down.

Watch for signs that the market is changing course (different price and volume than the prevailing trend), if you see more than a few of these, prepare for a change.