true adventures in money hacking

Saturday, October 17, 2009

Stocks: Owning Part of a Company

Buying stock makes you a partial owner of that company. You're basically betting that the company will be successful. This can be exciting, especially if you're really interested in what the company does. But the most common, and best, advice about buying stocks is that you can't put all your eggs in one basket. In other words, do not, no matter how great the company is, put all your money into that one stock. The risk is just too much. It's generally advisable to diversity your portfolio, which means investing in many different companies and industries. To diversify a portfolio, an investor should own at least ten different stocks in different industries.

Unless you have loads of cash and are able to buy millions of dollars of diversified stocks, by nature owning stock directly carries a higher risk than investing in a mutual fund. The advantages are in the lack of management fees (because you do it yourself) and direct control over your investments.

How they work
When you buy stock, you become a part owner of the company and are known as a stockholder, or shareholder. Stockholders can make money in two ways--receiving dividend payments and selling stock that has appreciated. A dividend is an income distribution by a corporation to its shareholders, usually made quarterly. Stock appreciation is an increase in the value of stock in the company, generally based on its ability to make money and pay a dividend. However, if the company doesn't perform as expected, the stock's value may go down. There is no guarantee you will make money as a stockholder. In purchasing shares of stock, you take a risk on the company making a profit and paying a dividend or seeing the value of its stock go up.

Day-trading and other short-term stock holding techniques make for some very risky investments. The best way to minimize risk and maximize potential is to become a long-term investor. Plan on holding your stocks for years--at least five and preferably many more. The idea is that if you choose the right companies, over the years they will grow and continue to be successful and their stock will appreciate. The longer the investment term, the more the risk decreases since you're allowing time for any spikes in performance to even out to a slow growth.

Why Some Investments Make Money and Others Don't
You can potentially make money in an investment if:

The company performs better than its competitors.
Other investors recognize it's a good company, so that when it comes time to sell your investment, others want to buy it.
The company makes profits, meaning they make enough money to pay you interest for your bond, or maybe dividends on your stock.

You can lose money if:

The company's competitors are better than it is.
Consumers don't want to buy the company’s products or services.
The company's officers fail at managing the business well, they spend too much money, and their expenses are larger than their profits.
Other investors that you would need to sell to think the company's stock is too expensive given its performance and future outlook.
The people running the company are dishonest. They use your money to buy homes, clothes, and vacations, instead of using your money on the business.
They lie about any aspect of the business: claim past or future profits that do not exist, claim it has contracts to sell its products when it doesn't, or make up fake numbers on their finances to dupe investors.
The brokers who sell the company's stock manipulate the price so that it doesn't reflect the true value of the company. After they pump up the price, these brokers dump the stock, the price falls, and investors lose their money.
For whatever reason, you have to sell your investment when the market is down.

Buying Stock: How to Pick 'Em
Before investing in a company, learn about its past financial performance, management, products, and how the stock has been valued in the past. Learn what the experts say about the company and the relationship of its financial performance and stock price. Successful investors are well informed.

Where do you find all that information? You could go to the company's website and try to find its financial statements and annual reports, then visit a bunch of financial news sites or get a free subscription to Investor's Business Daily. But if you're short on time, websites like Morningstar, TDAmeritrade, Scottrade, and Yahoo! Finance make the basic information you'll need easier to find. Each of these sites let you search stocks by ticker symbol and access profiles of that company and its stock. Most include of these sites include in each company's profile organized financial stats, analyst commentary, relevant news, and helpful charts. If you don't have a certain company in mind, all of the above sites have free customizable stock screeners which let you search stocks by various criteria.

No set of criteria will guarantee you a winning stock, but here are some tips:

Look for companies with high cash to debt ratios. Then look for mid-level payout ratios; too high could be dangerous because it could mean that the company is overreaching. You don’t want a company that pays out more than it can afford. A good average is around 40%.
Also avoid stocks with high dividend yields (for the market at the time). By nature of its definition, a stock's dividend yield falls when its price goes up, and vice versa. A yield above 6% could mean that share price is plummeting. Furthermore, high yields tend to indicate mature companies with little opportunity for growth.
This one might seem obvious, but it's important so it's getting listed anyway: profits. Look for companies with high profits, and more specifically high profits relative to revenues. If Company A and Company B both have 1-year profits of, say, $2 million, but Company A's revenue is lower, all else being equal, Company A's stock would be more desirable. Why? Because a higher percentage of the money it brings in directly benefits its shareholders by increasing the company's net worth.
Look for a high P/E (above 30). This tends to indicate a better growth rate and expectation of future profits. Particularly avoid stocks with low price-to-earnings ratios (below 15) because they tend towards slower growth and lower profit expectations.

Once you've found some stocks you're interested in, you can create a watchlist for them. A watchlist allows you to monitor stock prices, company news, etc. See the bottom of this page for step-by-step instructions on creating a free watchlist at Morningstar.com. Some of the above websites also let you set alerts to notify you when a stock price reaches or falls to a specified amount.

If you're serious about learning the details about a company, it's time to check out their financial statements and reports. Most of these you can access from the company's website and/or from the monitor/broker sites listed above.

Your first stop: the income statement. The income statement contains the following information:

Revenue: how much money the company has earned
Expenses: how much money the company has spent
Gross profit: how much money the company has left after sales to pay its operating expenses (revenue − cost of sales)
Net income: how much money is left after all expenses are paid, i.e. actual profit. Also called earnings, profit, "bottom line."
Earnings per share (EPS): net income ÷ number of shares outstanding
Equity aka stockholder's equity aka net assets aka net worth: how much more the company owns than it owes
Market capitalization: a company's market value (stock price × shares outstanding)
Gross margin: gross profits ÷ revenues
Operating margin: operating profits ÷ revenues
Net margin: net profits ÷ revenues
Price to earnings ratio (P/E): very roughly, how expensive or cheap a stock is at the moment (stock price ÷ earnings per share). One way to gauge how a stock is valued relative to the market is to compare its P/E with the average S&P 500 P/E.
Return on equity (ROE): net income ÷ equity
Dividend Yield: annual dividends per share ÷ stock price

How to set up a free watch list on Morningstar:
(from the Morningstar.com website)

Go to Morningstar.com and click on the tab labeled "Portfolio."
In the Portfolio Manager window, under "Create a Portfolio," click "New Portfolio."
You'll see a box labeled "Step 1." It's automatically set up to build a watch list, so click "Continue."
Pick a name for your portfolio, or just call it "watch list." Then, plug in the ticker symbols of the companies you want to watch. Click "Done."
In the following window, you'll see a list of updates, alerts, and tips that Morningstar will send you daily for the companies in your watch list. Click "Done" again.
Now you have a watch list that you can visit anytime by clicking the Portfolio tab on Morningstar.com.

Friday, October 16, 2009

Investments Primer

An investment is anything you acquire for future income or other financial benefit. Investments increase by generating income (interest or dividends) and/or by growing (appreciating) in value.

It's important that you go into any investment in stocks, bonds, annuities, or mutual funds with a full understanding that you could lose some or all of your money in any one investment.

As you can see in the chart below, different kinds of investments generally provide different rates of return (as well as different risks—highest to lowest in the chart below). Note that average rates of return are not guaranteed; they only show what has happened historically.

Asset Class	Rate of Return*
Stocks of smaller companies	14%-16%
Common stocks	10%-13%
Long term corporate bonds	6.5%-8%
Long term US government bonds	5%-7.5%
Short term US Treasury bills	3.5%-5%

*Average rate of return since 1926, Ibbotson and Associates

When choosing an investment type (stocks, bonds, annuities, funds, etc.), start by figuring out how much risk you want to take. Yes, yes, obviously we all want low risk, but low risk generally means low returns, so in some cases it's worth the added risk to earn the added cash. Here are some questions to ask yourself to determine the amount of risk you should take:

Do you have a specific financial goal? An amount you need to accumulate over a given period? If not, ask yourself how much you'd like (realistically) to have in ten years, twenty years, forty years, etc. If you're hell-bent on becoming a millionaire (and good luck!), you might decide to opt for higher risk, higher return investments. Also, if you're saving for retirement and it's a ways away, you have more freedom to go with higher risk investments because you have longer to recoup your losses if things don't go your way.
When are you going to need money the most? In other words, how long can you leave your savings tied up in investments before you start needing to spend it? Are saving for your first house in a few years or are you planning on leaving your investments grow to support you in your retirement? Generally, the longer time horizon you have, the more risk you can tolerate because investments tend to have more even growth over long period of time.
How financial stable are you? Can you afford to lose some of your investment or will that leave you completely destitute? If you absolutely cannot take the chance of losing any of your money even if it means the chance of gaining more (yes, it's a gamble that way), choose lower risk investments.

Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called diversification, can be neatly summed up as, "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929--or recently) by following a consistent pattern of adding new money to their investments over long periods of time.

Monitoring Your Investments
Some people like to look at the stock quotations every day to see how their investments have done. That's probably too often. You may get too caught up in the ups and downs of the "trading" value of your investment, and sell when its value goes down temporarily--even though the performance of the company is still stellar. Remember, you're in for the long haul. Check monthly or quarterly instead.

Keep in mind, though, that it's not enough to simply check an investment's performance. You should compare that performance against an index of similar investments over the same period of time to see if you are getting the proper returns for the amount of risk that you are assuming. You should also compare the fees and commissions that you're paying to what other investment professionals charge. Look for a low expense ratio (below 1%).

Invest Wisely / Don't be stupid (adapted from SEC's "Invest Wisely")
Never:

Send money to purchase an investment based simply on a telephone sales pitch.
Make a check out to a sales representative personally.
Send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.
Allow your transaction confirmations and account statements to be delivered or mailed to your sales representative as a substitute for receiving them yourself. These documents are your official record of the date, time, amount, and price of each security purchased or sold. When you receive them you should verify that the information in these statements is correct and file them away safely.
Trust anyone who tells you, "Invest quickly or you will miss out on a once in a lifetime opportunity!"or otherwise puts pressure on you to make an investment quickly.

If your sales representative asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.

Certain activities may indicate problems in the handling of your account and, possibly, violations of state and federal securities laws, such as:

Recommendations from a sales representative based on "inside" or "confidential information," an "upcoming favorable research report," a "prospective merger or acquisition," or the announcement of a "dynamic new product."
Representations of spectacular or specific profit, such as, "Your money will double in six months." Remember, if it sounds too good to be true, it probably is!
"Guarantees" that you will not lose money on a particular securities transaction, or agreements by a sales representative to share in any losses in your account.
An excessive number of transactions in your account. Such activity generates additional commissions for your sales representative, but may provide no better investment opportunities for you.
A recommendation from your sales representative that you make a dramatic change in your investment strategy, such as moving from low risk investments to speculative securities, or concentrating your investments exclusively in a single product.
Switching your investment in a mutual fund to a different fund with the same or similar investment objectives. Unless there is a legitimate investment purpose, a switch recommended by your sales representative may simply be an attempt to generate additional commissions for the sales representative.
Pressure to trade the account in a manner that is inconsistent with your investment goals and the risk you want or can afford to take.
Assurances from your sales representative that an error in your account is due solely to computer or clerical error. Insist that the branch manager or compliance officer promptly send you a written explanation. Verify that the problem has been corrected on your next account statement.

If You Have a Problem (adapted from SEC's "Invest Wisely")
If you have a problem with your sales representative or your account, promptly talk to the sales representative's manager or the firm's compliance officer. Confirm your complaint to the firm in writing. Keep written records of all conversations. Ask for written explanations.

If the problem is not resolved to your satisfaction, contact the appropriate regulators listed at the end of this document. Investor complaint information assists these regulators in identifying violations of the securities laws and prosecuting violators. However, none of these organizations is authorized to provide legal representation to individual investors or to get your money back for you.

Obtain information on using arbitration to resolve your dispute by contacting FINRA, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, or the Chicago Board Options Exchange. Each of these organizations operates a forum to resolve disputes between brokerage firms and their customers. You may also wish to consult an attorney knowledgeable about securities laws. Your local bar association can assist you in locating a securities attorney.

Securities Regulators to Contact:

U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Office of Investor Education and Advocacy
Online Complaint Form

North American Securities Administrators Association, Inc.
Suite 710
10 G Street, NE
Washington, DC 20002
(202) 737-0900
Web site