Who Should Invest in Mutual Finds?

Anyone who has money they won’t need to touch for several years needs to invest in equities (stocks) to prevent the loss of their savings due to inflation.  Likewise, anyone who wishes to become wealthy should consider stock investing as a way to magnify their earning ability.  By investing, one can gain income in exchange for allowing others to use their capital and by doing so grow net worth at a rate that is much greater than most people can earn through simply working.

There are two ways that investors can participate in the stock market – by buying stocks directly and through mutual funds.  Deciding which way is appropriate for you depends on several factors including your time available to research investments, your tolerance for volatility, your investment objectives, and your interest and ability to pick stocks.

Buying individual stocks means selecting from the thousands of choices available the small basket of stocks one would like to own.  It also means deciding when to buy, and probably more importantly, when to sell.  Buying individual stocks means being able to control one’s emotions and determining the best choices for a position while prices are moving up 100% or down 50% in a single year or even a period of a few weeks.  It also requires more study to learn the mechanics of putting in trades, the nuances of things like ex-dividend dates, and more bookkeeping when it comes to income taxes.

By buying stocks directly, one can outperform the market.  Instead of buying all ten of the stocks in a market sector, you can pick just the top one.  If you have a talent for sorting out the good businesses from the bad, you can do much better than the market return.  You also have the advantage that you don’t need all of your picks to be good, just one or two to be great.

There are certainly advantages to mutual funds as well, however.  In buying a mutual fund, one is pooling her money with that of thousands of other investors.  That pool of money is then used to buy 100, 200, 500, or even 1000 different stocks or more.  Buying mutual funds gives automatic diversification, which will reduce the chance of losses and generally reduce the amount of volatility so that the value of your portfolio will be more stable.  While there are years when the market will move up or down 40%, most years will result in swings of 20% or less.  Also, while buying mutual funds guarantees only matching the market, minus fees and expenses, mutual funds are easily bought, and once purchases require almost no maintenance at all.

Given the choice between individual stocks or mutual funds, one should buy mutual funds if most of the following are true:

1.  You tend to be worried by large fluctuations in your portfolio value.  If a drop of 20% would cause you to sell and hide under a rock, individual stocks aren’t for you.  If you would take advantage of the lower prices to buy more shares, you have the right psychology.

2.  You don’t have the desire to learn about the markets or do the research needed to find good stocks.  Many people have other things that they would rather be doing than reading the Wall Street Journal and Money Magazine.  If this is true of you, maybe mutual funds would be a better choice.

3.  You don’t have time to do the research to find good stocks.  Because mutual funds are the market, finding good mutual funds requires a lot less time than finding good stocks.  Granted, once you have found a basket of good stocks the time required to maintain the portfolio drops dramatically, so long as you are investing for the long-term, but it does take an initial investment of time.

4.  You have a lot of money.  The more money you have, the more important it is to have the proper diversification to reduce the chances of a large loss.  A person who has $2000 to invest can well afford the loss of the $2000 in a single stock, provided he is raising money from his salary and investing regularly.  A person with $1 million cannot afford a loss of the whole $1 million from large positions in a few stocks.  A good portion of that money, say 50%, should be in mutual funds.  Another portion, say 30%, should be in several large, solid, dividend paying stocks and bonds. The remainder can be in larger position in individual growth stocks, if desired.  As one’s wealth grows, a portion should be diverted into mutual funds.  That portion should grow with the value of the portfolio.

5.  You can’t leave things alone.  People who are constantly trading will never make money in individual stocks.  If you find yourself constantly watching CNBC, unable to stick to a position for long periods of time, you would be better off buying mutual funds and using some of the proceeds each year to fund a trip to Vegas.  At least that way you’ll get a change of scenery and drinks will be included.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How Can I Predict the Market Price for a Stock?

Ask SmallIvy

 

Dear SmallIvy,

How can I determine the market price for a stock?

Trevor

Dear Trevor,

The market price for a stock is actually made up of three prices, the Bid, the Ask, and the Last Trade.  The Bid price is what someone who wants to buy the stock is willing to pay.  The Ask price is what a person who is selling a stock is wanting for their shares.  The difference between the Bid and the Ask price is called the spread.  The Last Trade is the price at which the last set of shares changed hands.  Usually when stock prices are reported, the Last Trade is reported, although it would give a better picture if all of the prices were reported.  All three of these numbers can be found at Yahoo and other sites that provide stock quotes.

When you enter a market order to buy, your broker will buy shares at whatever the current Ask price is.  Note that if you are buying a lot of shares this can get a little more complex because actually your broker will buy as many shares as he can at the current Ask price, and once sellers at that price are gone, will start buying at higher Ask prices until the order is filled.  In fact, if there are other people in line in front of you, you may actually not get any shares at the current ask price, resulting in your purchasing shares at a higher price entirely.

One way to avoid the above issue is to order a Limit order.  A limit order says that you are willing to pay only a certain price.  The order will not be filled unless the ask price drops to the level of the limit.  For example, if you entered an order to buy 500 shares of XLNX at $50 per share and the current Ask price was $51, you would not buy any shares until the ask price dropped to $50 or lower.  Orders are normally good for only one day.  You can extend the time period (particularly for limit orders) to 30 days by making the order GTC, or Good ‘Til Cancelled.

I hope this answers your question.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

A Correction vs. a Bear Market

Please allow me to address a pet peeve of mine today.  That is the correct definition of a correction and a bear market.  It wouldn’t bother me so much if just the nightly newscasts got this wrong, but I hear people who should know better such as the Wall Street Journal getting it wrong as well.  Please refer your friends to this post and distribute it far and wide for I’d like to stop hearing people incorrectly using these terms.

First of all, the incorrect definitions.

Often on a newscast during a market downturn someone – either the anchor or the person they are interviewing – will say we’re having a correction, but have not yet entered a bear market.  They then will present the usual, incorrect definition that a correction is when the market has gone down 10%, and a bear market is when it has gone down 20%.  While it is true that the market will tend to decline more during a bear market than during a correction, the correct definition has nothing to do with percentages.  (This is like the old joke that a recession is when people are out of work, but a depression is when you’re out of work!)

To understand the correct definition, one must understand a little about charting, trends and Dow Theory.  For some basic definitions see the past post on charting: http://smallivy.wordpress.com/category/charting/ .  Corrections and bear markets have to do with what kind of trend the market is in. Specifically the long-term trend, which is found using a chart with intervals of a week making up each point in the chart.  Normally a Open-High-Low-Close chart would be used in which the opening price, high price, low price, and closing price for the week would be plotted for each point.  For an example, see the chart for Harley-Davidson during the last year:

http://finance.yahoo.com/q/bc?s=HOG&t=6m&l=on&z=m&q=b&c=

A stock is in an up-trend if the stock is making higher highs and higher lows, such that a straight edge can be laid on the chart and a line drawn from low to low and the stock does not cross this line.  This is known as the trend line.  Harley was in an up-trend from mid-February to mid-May of 2010, and as one can see the lows followed the trend line pretty well, such that each time the stock’s price fell to the trend line it bounced off of it and moved higher.  A down-trend is just the opposite, where the stock sees lower lows and lower highs, such that a straight edge could be used to connect the highs in a descending trend line.  A stock will be in an up-trend, a down-trend, or drawing lines (bouncing between two prices and going nowhere) at any given time.

In order for the trend to change, three things need to happen.  For an up-trend:  1) The stock’s price must break the trend line.  2) The stock must fall below the previous low, and 3) The stock must not reach the previous high.  For Harley the trend line was broken in early May, the low was broken in mid-May, and the stock failed to reach the previous high later in mid-may, so the stock has reversed from an up-trend to a down-trend (like much of the market right now).  One could now form a down-trend by connecting the high reached in early May to the lower high reached in mid-May.

Dow Theory looks at the Industrials (the DJIA) and the transportations (the DJ Transportation Index).  Each time both of these move down in price (one of the regular downward movements as was seen in the Harley chart) while they are in an up-trend — a Bull Market — it is called a correction.  If they both actually change from an up-trend to a down-trend, we are in a bear market.  For Harley, it was in a bull trend from February until May, with corrections about once or twice a month.  In late May it entered a bear trend.   

I’ve heard that the incorrect definition came from someone one of the shows was interviewing who didn’t want to go into Dow theory, so he just gave the 10%, 20% definitions, probably in a statement like, “If it is just a correction, we may see a decline of 10% or so.  If it is a bear market it may go down 20% or more.”  Because a correction only requires one down-leg before the stock climbs to a new high, while a bear market by definition requires at least two down-legs, most bear markets will result in a decline of about twice that seen during most corrections.  Likewise, a correction of less than about 10% probably would be barely noticed, so the trader was probably just trying to get the relative magnitudes across, not knowing that his rules-of-thumb would become gospel.

Corrections can be much larger, however.  An extreme example is the crash of 1987. 

http://finance.yahoo.com/echarts?s=%5EDJI#symbol=%5EDJI;range=my;compare=

In that stunning crash the Dow Jones Industrials went from 2596 to 1938 in one day — a decline of more than 20%!  Looking at the chart, however, you’ll note there was only one leg down, the trend was never broken, and the spectacular bull market that started back in the early ’80′s under Reagan continued clear until the early 2000′s when it was finally ended by the dot-com bust.  Since that time we have been drawing lines.

So, you now know the correct definitions, so please stop spreading the incorrect ones.  Also, forward a link to this post to all of your friends to correct the mis-information.  I’ll know my quest is done when I see USA Today with the correct definition.

Did you find this info useful?  Refer a friend: http://smallivy.wordpress.com 

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Short Selling

The term “short sale” has come more into the popular vernacular lately in reference to the real estate transaction in which the lender allows the borrower to sell a house for less than is owed for the property.  In stocks and other securities a short sale is something entirely different.  Today I will discuss short sales as they relate to securities.

In securities, a short sale goes as follows – An investor (or speculator) calls her broker and says that she wants to sell 100 shares of company XYZ short at $50 per share.  Her broker goes out and borrows the shares (usually from someone who has a margin account who is currently on margin) and then sells the shares for $50.  The broker deposits the proceeds, less commissions, in the investor’s account.  At some later date, to close the transaction, the investor must purchase the shares, replacing those that were borrowed.  (Note that this person will probably not know that the shares were every borrowed, and if he decides to sell his shares during the period shares from another person must be found and used for the sale.)  If the company pays a dividend while the short seller still has the position open she must pay the dividend to the person from whom the shares were borrowed (who again doesn’t know they are gone).

If the investor who did the short sale is able to buy the shares back at a lower price, say $40 per share, she will make the difference in price ($50-$40)x100 = $1000, minus commissions and any dividends she had to pay.  If the stock rises above the price she sold them for and she closes the position, she will lose money.  Obviously, stocks are sold short when an investor thinks it will decline in price.  Because stocks naturally tend to increase in price (because of inflation if nothing else), selling short is not a long-term strategy.

Now that I’ve explained the basics, I’ll discuss some fo the strategies of short selling in a later post.

Refer a friend – link to this page: http://smallivy.wordpress.com

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Taking the Big First Step

All right, so you’ve read a bit.  You’ve saved up some money.  You are ready to invest, but don’t know how to take the first big step.  Investing is a craft, just like wood working.  Eventually, having prepared and made a plan, you need to start cutting wood.

Start out by picking a stock, using some of the tips I’ve given in previous posts.  We’re looking for a stock that has had a long history of growth, and continues to have good prospects.  This should not be a stock tip from a friend or something out of a magazine.  This should be a company whose charts and history you have studied.

Next, just step in and buy your first 100 shares.  You may not get the best price.  The stock may decline a bit after buying it.   Just remember that the general direction of the type of stocks you are picking is up, so time is your friend.

Continue to save up and invest, buying more shares until you have a significant position.  Then find another stock and do the same.

You’ll need to accept that you will not be perfect at timing the market.  Also, sometimes you’ll be wrong about a stock and will have to sell at a loss.  The point is to learn from your mistakes.  Study why the stock did not work out as you had hoped and look for the same signs in the future.

If you are persistent, some of your stocks will do well.  Let your winners ride, paring them down here or there if the positions become too large.  If you have a winner, look for other stocks in similar situations.  Also, start to look at the various factors that influence the price of stocks so you will understand why the markets behave as they do.

The secret is to keep at it, consistently buying more, letting winners grow and admitting it when you are wrong and selling the losers.

Refer a friend – link to this page: http://smallivy.wordpress.com

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.