Rules to Avoid Behavioural Traps
(Continuing the investing story of Dave and his Investment Counselor)
Dave: I don't feel secure enough to trade again soon. I just want to master investing. How can one get over these behavioural traps and be a successful long-term investor?
IC: Dave, I'm glad you are not trading, since trading is right for only a very small fraction of my clients.
Researchers have found that you must set up rules and incentives to keep your investments on track - this is called PRECOMMITMENT. Set an ASSET ALLOCATION RULE and then stick to it. If you have enough knowledge, you can do this alone or else with an investment advisor. Do not try to second guess your rule. Remeber that the basic factors generating returns change from less than we think as we watch the day-to-day ups and downs of the market. A disciplined investment strategy is almost always a winning strategy. Furthermore, you need to get rid of the temptation to trade stocks. One way to do this is by closing all your trading and online accounts. If you have to pay higher commissions, you are less likely to trade more frequently.
If you do buy stocks for a short-term trade, set a stop-loss order to minimize your losses. You do not want to let your losses mount, rationalizing that the stock will eventually come back. If you are tempted to sell a stock that has a gain, think of the taxes you will have to pay, and if you are reluctant to sell a stock that has a loss, think of the tax savings you will realize. Finally, do not tell your friends about your trades. Living up to their expectations will make you even more reluctant to take a loss and admit that you were wrong.
Dave: I'll have to admit that I sometimes enjoyed trading.
IC: If you really enjoy trading, establish a rule that every year you are going to establish a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account. Consider the money you put into the account lost, because most likely it will wither to nothing, being consumed by transaction costs and trading losses. And you should never consider exceeding the rigid limit you place on how much money you put into that account.
If that does not work, or if you feel nervous about the market and have a compulsion to trade, seek help. There are some reformed traders establishing Traders' Anonymous (TA) programs designed to help people who cannot resist the temptations of trading too frequently.
Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)
Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327
Sunday 24 May 2009
Behavioural Traps (2)
Behavioural Traps (2)
(The investing story of Dave, Jennifer and the investment counselor)
Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.
The Technology Boom, 1999 -2001
TIME: October 1999
Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.
Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?
Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.
Fads, Social Dynamics, and Stock Bubbles
[IC: When everyone is excited about the market, you should be extremely cautious. Stock prices are based not just on economic values but also on psychological factors that influence the mood of the market. Fad and social dynamics play a large role in the determination of asset prices. Stock prices have been far too volatile to be explained by fluctuations in economic factors such as dividends or earnings. Much of the extra volatility can be explained by fads and fashions that have a great impact on investor decisions.]
[IC: Note how others influenced your decision, against your better judgment. Psychologist have long know how hard it is to remain separate from a crowd. It was not social pressure that led the subjects to act against their own best judgment but rather their disbelief that a large group of people could be wrong.]
[IC: The Internet and technology bubble is a perfect example of social pressures influencing stock prices. The conversations around the office, the newspaper headlines, the analysts' predictions - they all fed the craze to invest in these stock. Psychologists call this penchant to follow the crowd the HERDING INSTINCT, the tendency of individuals to adapt their thinking to the prevailing opinion.]
[IC: "We find that whole communities suddenly fix their minds upon one subject, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion and run after it... Sober nations have all at once become desperte gamblers, and risked most their existence upon the turn of a piece of paper... Men, it has been well said, think in herds... they go mad in herds, while they only recover their senses slowly and one by one." This happens again and again through history. Dave was convinced that "this time is different." The propensity of investors to follow the crowd is a permanent fixture of financial history. And following the crowd is not always irrational, although it may lead to some very bad results. Individuals have a feeling that "someone knows something" and that they shouldn't miss out. Sometimes that's right, but very often that is wrong. Economists call this decision-making process an INFORMATION CASCADE.]
TIME: March 2000
Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.
Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!
Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.
TIME: July 2000
Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?
Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.
I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.
Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.
Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.
Excessive Trading, Overconfidence and the Representative Bias
[IC: From examining your trading records, I see that you were an extremely active trader. Let me tell you something. Trading does nothing for you but cause extra anxiety and losses. A couple of economists examined the records of tens of thousands of traders, and they showed that the returns of the heaviest traders were 7.1% below those who traded infrequently.]
[IC: It is extraordinarily difficult to be a successful trader. Even bright people who devote their entire energies to trading stocks rarely make superior returns. The problem is that most people are simply OVERCONFIDENT in their own abilities. To put it another way, research has confirmed that the averge individual - be he or she a student, a trader, a driver, or whatever - believes that he or she is better than average, which of course is statistically impossible.}
[IC: What causes this overconfidence? Overconfidence comes from several sources.
First, there is what we call a SELF-ATTRIBUTION BIAS that causes one to take credit for a favourable turn of events when credit is not due. Remember in March 2000 bragging to your wife about how smart you were to have bought those Internet stocks? Your early success fed your overconfidence. You and your friends attributed your stock gains to skillful investing, even though those outcomes were frequently the result of chance.
Another source of overconfidence comes from the tendency to see too many parallels between events that seem the same but are remarkably different. This is called the REPRESENTATIVE BIAS. This bias actually arises because of the human learning process. When we see something that looks familiar, we form a representative heuristic to help us learn. However, the parallels we see are often not valid, and our conclusions are misguided.
[IC: You mentioned your investment newsletters say that every time that such and such an event occurred in the past, the market has moved in a certain direction, implying that it is bound to do so again, but when you try to use that advice, it never works. This is finding patterns in the data when in fact there are none. Searching past data for patterns is called DATA MINING, and it is easier than ever to do with inexpensive computer programs. Throw in a load of variables to explain stock price movements, and you are sure to find some spectacular fits.
Psychologically, human beings are not designed to accept all the randomness that is out there. It is very discomforting for many to learn that most movements in the market are random and do not have any identifiable cause or reason. Individuals possess this deep psychological need to know WHY something happens. This is where the reporters and so-called experts come in. They are more than happy to fill the holes in our knowledge with explanations that are wrong more often than not.]
[IC: Before you bought the technology stocks in July of 2000, your broker compared these companies to the suppliers providing the gear for the gold rushers of the 1850s. It seemed like an insightful comparison at the time, but in fact the situations were very different. This is an obvious representative bias. It is interesting that you mentioned your broker, who is supposed to be the expert, is subject to the same overconfidence that you are. There is actually evidence that experts are even more subject to overconfidence than the layperson. These so called experts have been trained to analyze the world in a particular way, and selling their advice depends on finding supporting, not contradictory evidence.
Recall the failure of the analysts to change their earnings forecasts of the technology sector despite being bombarded with bad news that suggested that something was seriously wrong with their view of the whole industry. After being fed great news by the corporations for years, supported by 20 to 30 % earnings growth rates, they had no idea how to handle downbeat news, so most just ignored it.
The propensity to shut out bad news was even more pronounced among analysts in the Internet sector. Many were so convinced that these stocks were the wave of the future that despite the flood of ghastly news, many only downgraded these stocks AFTER they had fallen 80 or 90%!
The predisposition to disregard news that does not correspond to your worldview arises from what psychologists called COGNITIVE DISSONANCE. Cognitive dissonance is the discomfort we encounter when we confront evidence that conflicts with our view or suggests that our abilities or actions are not as good as we thought. We all display a natural tendency to minimise this discomfort, which makes it difficult for us to recognize our overconfidence.]
TIME: November 2000
Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.
Prospect Theory, Loss Aversion, and Holding onto Losing Trades
[IC: Let me explain why you end up holding so many losers in your portfolio? A key finding of Kahneman and Tversky Prospect Theory was that individuals form a REFERENC POINT from which they judge their performance. They found that from that reference point individuals are much more upset about losing a given amount of money than they are from gaining the same amount. They called this behaviour LOSS AVERSION and suggested that the decision to hold or sell an investment will be dramatically influenced by whether your stock has gone up or down, in other words, whether you have a gain or a loss.]
[IC: When you buy a stock, how do you track its performance? Exactly, you calculate how much the stock has gone up or down since you bought it. Often the reference point is the purchase price that investors pay for the stock. Investors become fixated on this reference point to the exclusion of any other information. This investor behaviour is referred to as MENTAL ACCOUNTING.
When you buy a stock, you open a mental account with the purchase price as the reference point. Similarly, when you buy a group of stocks together, you will either think of the stocks individually or you may aggregate the accounts together. Whether your stocks are showing a gain or a loss will influence your decision to hold or sell the stock. Moreover, in accounts with multiple losses, you are likely to aggregae individual losses together because thinking about one big loss is an easier pill for you to swalllow than thinking of many smaller losses. Avoiding the realisation of losses becomes the primary goal of many investors.]
[IC: Dave, you mentioned that the thought of realizing the losses on your technology stocks petrified you. That is a completely natural reaction. Your pride is one of the main reasons why you avoided selling at a loss. Every investment involves an emotional as well as a financial commitment that makes it hard to evaluate objectively. You felt good that you sold out of your Internet stocks with a small gain, but the networking stocks you subsequently bought never showed a gain. Even as prospects dimmed, not only did you hang onto those stocks, but you also bought more, hoping against hope that they would recover.
Prospect theory predicts that many investors will do as you did - increase your position, and consequently your risk, in an attempt to get even. ]
[IC: You thought that buying more stock would increase your chances of recouping your losses. Millions of other investors think likewise. In 1982, Leroy Gross wrote a manual for stockbrokers and called this phenomenon the "GET-EVEN-ITIS" disease. He claimed "get-even-itis" probably has caused more destruction to portfolios than any other mistake.
It is hard for us to admit that we have made a bad investment and it is even harder for us to admit that mistake to others. To be a successful investor, however, you have no choice but to do so. Decisions on your portfolio must be made on a FORWARD-LOOKING basis. What has happened in the past cannot be changed. It is a "SUNK COST," as economist say. When prospects do not look good, sell the stock whether or not you have a loss. ]
[IC: You bought more shares because you thought the stocks were cheap, as many were down 50 % or more from their highs. Cheap relative to what? Cheap relative to their past price or their future prospects? You thought that a price of 40 for a stock that had been 80 made the stock cheap, yet you never considered the fact that maybe 40 was still too high. This demonstrates another one of Kahneman and Tvrsky's behavioural findings: ANCHORING, or the tendency of people facing complex decisions to use an anchor, or a suggested number, to form their judgement. Figuring out the correct stock price is such a complex task that it is natural to use the recently remembered stock price as an anchor and then judge the current price a bargain. ]
[IC: You are concern that following my advice and selling your losers whenever prospects are dim will register a lot more losses on your trades. Good! Most investors do exactly the opposite and realize poor returns. Research has shown that investors sell stocks for a gain 50% more frequently than they sell stocks for a loss. This means that stocks that are above their purchase price are 50% more likely to be sold than stocks that are in the red. Traders do this even though it is a horrible strategy from the point of view of paying taxes.
Let me tell you of one short-term trader I successfully counseled. He showed me that 80 percent of his trades made money, but he was down overall because he lost so much money on his losing trades that they drowned out his winners.
After I counseled him, he became a successful trader. Now he says that only one-third of his trades make money but that overall he is way ahead. When things do not work out as he planned, he gets rid of losing trades quickly while holding onto his winners. There is an old adage on Wall Street that sums up successful trading: "Cut your losers short, and let yours winner ride." ]
TIME: August 2001
Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.
Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.
Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...
Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.
Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.
Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)
Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327
(The investing story of Dave, Jennifer and the investment counselor)
Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.
The Technology Boom, 1999 -2001
TIME: October 1999
Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.
Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?
Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.
Fads, Social Dynamics, and Stock Bubbles
[IC: When everyone is excited about the market, you should be extremely cautious. Stock prices are based not just on economic values but also on psychological factors that influence the mood of the market. Fad and social dynamics play a large role in the determination of asset prices. Stock prices have been far too volatile to be explained by fluctuations in economic factors such as dividends or earnings. Much of the extra volatility can be explained by fads and fashions that have a great impact on investor decisions.]
[IC: Note how others influenced your decision, against your better judgment. Psychologist have long know how hard it is to remain separate from a crowd. It was not social pressure that led the subjects to act against their own best judgment but rather their disbelief that a large group of people could be wrong.]
[IC: The Internet and technology bubble is a perfect example of social pressures influencing stock prices. The conversations around the office, the newspaper headlines, the analysts' predictions - they all fed the craze to invest in these stock. Psychologists call this penchant to follow the crowd the HERDING INSTINCT, the tendency of individuals to adapt their thinking to the prevailing opinion.]
[IC: "We find that whole communities suddenly fix their minds upon one subject, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion and run after it... Sober nations have all at once become desperte gamblers, and risked most their existence upon the turn of a piece of paper... Men, it has been well said, think in herds... they go mad in herds, while they only recover their senses slowly and one by one." This happens again and again through history. Dave was convinced that "this time is different." The propensity of investors to follow the crowd is a permanent fixture of financial history. And following the crowd is not always irrational, although it may lead to some very bad results. Individuals have a feeling that "someone knows something" and that they shouldn't miss out. Sometimes that's right, but very often that is wrong. Economists call this decision-making process an INFORMATION CASCADE.]
TIME: March 2000
Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.
Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!
Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.
TIME: July 2000
Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?
Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.
I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.
Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.
Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.
Excessive Trading, Overconfidence and the Representative Bias
[IC: From examining your trading records, I see that you were an extremely active trader. Let me tell you something. Trading does nothing for you but cause extra anxiety and losses. A couple of economists examined the records of tens of thousands of traders, and they showed that the returns of the heaviest traders were 7.1% below those who traded infrequently.]
[IC: It is extraordinarily difficult to be a successful trader. Even bright people who devote their entire energies to trading stocks rarely make superior returns. The problem is that most people are simply OVERCONFIDENT in their own abilities. To put it another way, research has confirmed that the averge individual - be he or she a student, a trader, a driver, or whatever - believes that he or she is better than average, which of course is statistically impossible.}
[IC: What causes this overconfidence? Overconfidence comes from several sources.
First, there is what we call a SELF-ATTRIBUTION BIAS that causes one to take credit for a favourable turn of events when credit is not due. Remember in March 2000 bragging to your wife about how smart you were to have bought those Internet stocks? Your early success fed your overconfidence. You and your friends attributed your stock gains to skillful investing, even though those outcomes were frequently the result of chance.
Another source of overconfidence comes from the tendency to see too many parallels between events that seem the same but are remarkably different. This is called the REPRESENTATIVE BIAS. This bias actually arises because of the human learning process. When we see something that looks familiar, we form a representative heuristic to help us learn. However, the parallels we see are often not valid, and our conclusions are misguided.
[IC: You mentioned your investment newsletters say that every time that such and such an event occurred in the past, the market has moved in a certain direction, implying that it is bound to do so again, but when you try to use that advice, it never works. This is finding patterns in the data when in fact there are none. Searching past data for patterns is called DATA MINING, and it is easier than ever to do with inexpensive computer programs. Throw in a load of variables to explain stock price movements, and you are sure to find some spectacular fits.
Psychologically, human beings are not designed to accept all the randomness that is out there. It is very discomforting for many to learn that most movements in the market are random and do not have any identifiable cause or reason. Individuals possess this deep psychological need to know WHY something happens. This is where the reporters and so-called experts come in. They are more than happy to fill the holes in our knowledge with explanations that are wrong more often than not.]
[IC: Before you bought the technology stocks in July of 2000, your broker compared these companies to the suppliers providing the gear for the gold rushers of the 1850s. It seemed like an insightful comparison at the time, but in fact the situations were very different. This is an obvious representative bias. It is interesting that you mentioned your broker, who is supposed to be the expert, is subject to the same overconfidence that you are. There is actually evidence that experts are even more subject to overconfidence than the layperson. These so called experts have been trained to analyze the world in a particular way, and selling their advice depends on finding supporting, not contradictory evidence.
Recall the failure of the analysts to change their earnings forecasts of the technology sector despite being bombarded with bad news that suggested that something was seriously wrong with their view of the whole industry. After being fed great news by the corporations for years, supported by 20 to 30 % earnings growth rates, they had no idea how to handle downbeat news, so most just ignored it.
The propensity to shut out bad news was even more pronounced among analysts in the Internet sector. Many were so convinced that these stocks were the wave of the future that despite the flood of ghastly news, many only downgraded these stocks AFTER they had fallen 80 or 90%!
The predisposition to disregard news that does not correspond to your worldview arises from what psychologists called COGNITIVE DISSONANCE. Cognitive dissonance is the discomfort we encounter when we confront evidence that conflicts with our view or suggests that our abilities or actions are not as good as we thought. We all display a natural tendency to minimise this discomfort, which makes it difficult for us to recognize our overconfidence.]
TIME: November 2000
Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.
Prospect Theory, Loss Aversion, and Holding onto Losing Trades
[IC: Let me explain why you end up holding so many losers in your portfolio? A key finding of Kahneman and Tversky Prospect Theory was that individuals form a REFERENC POINT from which they judge their performance. They found that from that reference point individuals are much more upset about losing a given amount of money than they are from gaining the same amount. They called this behaviour LOSS AVERSION and suggested that the decision to hold or sell an investment will be dramatically influenced by whether your stock has gone up or down, in other words, whether you have a gain or a loss.]
[IC: When you buy a stock, how do you track its performance? Exactly, you calculate how much the stock has gone up or down since you bought it. Often the reference point is the purchase price that investors pay for the stock. Investors become fixated on this reference point to the exclusion of any other information. This investor behaviour is referred to as MENTAL ACCOUNTING.
When you buy a stock, you open a mental account with the purchase price as the reference point. Similarly, when you buy a group of stocks together, you will either think of the stocks individually or you may aggregate the accounts together. Whether your stocks are showing a gain or a loss will influence your decision to hold or sell the stock. Moreover, in accounts with multiple losses, you are likely to aggregae individual losses together because thinking about one big loss is an easier pill for you to swalllow than thinking of many smaller losses. Avoiding the realisation of losses becomes the primary goal of many investors.]
[IC: Dave, you mentioned that the thought of realizing the losses on your technology stocks petrified you. That is a completely natural reaction. Your pride is one of the main reasons why you avoided selling at a loss. Every investment involves an emotional as well as a financial commitment that makes it hard to evaluate objectively. You felt good that you sold out of your Internet stocks with a small gain, but the networking stocks you subsequently bought never showed a gain. Even as prospects dimmed, not only did you hang onto those stocks, but you also bought more, hoping against hope that they would recover.
Prospect theory predicts that many investors will do as you did - increase your position, and consequently your risk, in an attempt to get even. ]
[IC: You thought that buying more stock would increase your chances of recouping your losses. Millions of other investors think likewise. In 1982, Leroy Gross wrote a manual for stockbrokers and called this phenomenon the "GET-EVEN-ITIS" disease. He claimed "get-even-itis" probably has caused more destruction to portfolios than any other mistake.
It is hard for us to admit that we have made a bad investment and it is even harder for us to admit that mistake to others. To be a successful investor, however, you have no choice but to do so. Decisions on your portfolio must be made on a FORWARD-LOOKING basis. What has happened in the past cannot be changed. It is a "SUNK COST," as economist say. When prospects do not look good, sell the stock whether or not you have a loss. ]
[IC: You bought more shares because you thought the stocks were cheap, as many were down 50 % or more from their highs. Cheap relative to what? Cheap relative to their past price or their future prospects? You thought that a price of 40 for a stock that had been 80 made the stock cheap, yet you never considered the fact that maybe 40 was still too high. This demonstrates another one of Kahneman and Tvrsky's behavioural findings: ANCHORING, or the tendency of people facing complex decisions to use an anchor, or a suggested number, to form their judgement. Figuring out the correct stock price is such a complex task that it is natural to use the recently remembered stock price as an anchor and then judge the current price a bargain. ]
[IC: You are concern that following my advice and selling your losers whenever prospects are dim will register a lot more losses on your trades. Good! Most investors do exactly the opposite and realize poor returns. Research has shown that investors sell stocks for a gain 50% more frequently than they sell stocks for a loss. This means that stocks that are above their purchase price are 50% more likely to be sold than stocks that are in the red. Traders do this even though it is a horrible strategy from the point of view of paying taxes.
Let me tell you of one short-term trader I successfully counseled. He showed me that 80 percent of his trades made money, but he was down overall because he lost so much money on his losing trades that they drowned out his winners.
After I counseled him, he became a successful trader. Now he says that only one-third of his trades make money but that overall he is way ahead. When things do not work out as he planned, he gets rid of losing trades quickly while holding onto his winners. There is an old adage on Wall Street that sums up successful trading: "Cut your losers short, and let yours winner ride." ]
TIME: August 2001
Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.
Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.
Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...
Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.
Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.
Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)
Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327
Behavioural Traps (1)
Behavioural Traps (1)
(The investing story of Dave and Jennifer)
Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.
The Technology Boom, 1999 -2001
TIME: October 1999
Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.
Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?
Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.
TIME: March 2000
Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.
Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!
Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.
TIME: July 2000
Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?
Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.
I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.
Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.
Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.
TIME: November 2000
Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.
TIME: August 2001
Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.
Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.
Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...
Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.
Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.
Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)
Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327
(The investing story of Dave and Jennifer)
Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.
The Technology Boom, 1999 -2001
TIME: October 1999
Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.
Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?
Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.
TIME: March 2000
Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.
Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!
Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.
TIME: July 2000
Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?
Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.
I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.
Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.
Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.
TIME: November 2000
Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.
TIME: August 2001
Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.
Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.
Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...
Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.
Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.
Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)
Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327
The lure of short-term gains
The lure of short-term gains
There are many strategies employed in the market. During a given period, any strategy may give a negative return, despite having delivered good positive returns in the past or over the long term. The investor maybe tempted to change a proven strategy.
An investor changed from fundamental investing, to technical investing, to warrants investing, to options investing and to investing in U.S. equities. These techniques spoke loudly the resourcefulness of the investor, but the success must await an honest revelation of the total returns. This was certainly bewildering to those who are less savy. Yet, it was both interesting and intriguing to follow the investing adventure of this investor.
Sometimes, the lure of short-run gains, the attraction of a new paradigm, and the relentless pressure to keep pace with hot sectors and hot stocks caused some/many investors to abandon their long-term principles. The long-term moderate rate of return is too slow for many who tasted the spectacular gains made in the bull market.
However, by accepting a modest return of 7 or 8% per year (doubling wealth every 10 years), there are many stocks giving such a return with low or no risk. Patience must be exercised by long-term investors. Stocks remain the best investment for all those seeking steady, long-term gains.
There are many strategies employed in the market. During a given period, any strategy may give a negative return, despite having delivered good positive returns in the past or over the long term. The investor maybe tempted to change a proven strategy.
An investor changed from fundamental investing, to technical investing, to warrants investing, to options investing and to investing in U.S. equities. These techniques spoke loudly the resourcefulness of the investor, but the success must await an honest revelation of the total returns. This was certainly bewildering to those who are less savy. Yet, it was both interesting and intriguing to follow the investing adventure of this investor.
Sometimes, the lure of short-run gains, the attraction of a new paradigm, and the relentless pressure to keep pace with hot sectors and hot stocks caused some/many investors to abandon their long-term principles. The long-term moderate rate of return is too slow for many who tasted the spectacular gains made in the bull market.
However, by accepting a modest return of 7 or 8% per year (doubling wealth every 10 years), there are many stocks giving such a return with low or no risk. Patience must be exercised by long-term investors. Stocks remain the best investment for all those seeking steady, long-term gains.
Are CDs Good Protection For The Bear Market?
Are CDs Good Protection For The Bear Market?
by Ana Gonzalez Ribeiro (Contact Author Biography)
A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and on the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out. (For basic background on CDs, read Are certificates of deposit a kind of bond?)
What Is a CD?
A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs. (Learn about investing over the short or long term in Five Things To Know About Asset Allocation.)
CDs are considered time deposits because the purchaser agrees at the time of purchase to leave his or her deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back the deposit before maturity, he or she will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)
One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.
Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)
CDs Vs. Stocks
Stocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)
For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses (and gains) for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps. Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)
Guaranteed Protection
CDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit for up to $100,000 for individual accounts at its insured banks. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.
If you have a joint account with your spouse, you can be covered for up to $250,000 (which was increased temporarily from $200,000 by the FDIC on October 3, 2008) at each institution, but if you set up your accounts under a different set of provisions (for example, as a trust), you might be covered up to an even higher amount. Check with your bank first. Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)
When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.
In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction - it is buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)
CD Laddering
CD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates.
Here's how it works:
When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account. Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:
a one-year CD at 3% interest
a two-year CD at 3.5% interest
a three-year CD at 3.7% interest
a four-year CD at 3.9% interest
a five-year CD at 4.1% interest
When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs. Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)
Tax Consequences
Interest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service (IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.
Conclusion
CDs are a comparatively safe investment. If they are managed properly, they can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future.
Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.
For more advice for surviving a bear market with your assets intact, read Adapt To A Bear Market and Has Your Fund Manager Been Through A Bear Market?
by Ana Gonzalez Ribeiro, (Contact Author Biography)
Ana Gonzalez Ribeiro holds an MBA with honors in Finance and works as an Account Administrator and Freelance Writer. She has published articles in The Hispanic Outlook on Higher Education, New Mexico Woman, Spotlight on Recovery Magazine and The Loop Newsletter for College Forward. She is also a regular contributing writer specializing in business-related issues for Alaska Business Monthly. She worked for The Volunteer Center of United Way Westchester as a writer for the Youth Volunteer Guidebook 2008-2009 and served as Treasurer for the Society for Hispanic MBAs. During her spare time, she enjoys collecting stamps, reading biographies, staying up to date on business-related trends and working as a Notary Public and signing agent.
http://www.investopedia.com/articles/bonds/08/CD-certificate-of-deposit-recession-bear-market.asp
http://www.investopedia.com/university/certificate-of-deposit-cd/
by Ana Gonzalez Ribeiro (Contact Author Biography)
A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and on the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out. (For basic background on CDs, read Are certificates of deposit a kind of bond?)
What Is a CD?
A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs. (Learn about investing over the short or long term in Five Things To Know About Asset Allocation.)
CDs are considered time deposits because the purchaser agrees at the time of purchase to leave his or her deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back the deposit before maturity, he or she will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)
One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.
Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)
CDs Vs. Stocks
Stocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)
For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses (and gains) for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps. Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)
Guaranteed Protection
CDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit for up to $100,000 for individual accounts at its insured banks. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.
If you have a joint account with your spouse, you can be covered for up to $250,000 (which was increased temporarily from $200,000 by the FDIC on October 3, 2008) at each institution, but if you set up your accounts under a different set of provisions (for example, as a trust), you might be covered up to an even higher amount. Check with your bank first. Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)
When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.
In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction - it is buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)
CD Laddering
CD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates.
Here's how it works:
When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account. Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:
a one-year CD at 3% interest
a two-year CD at 3.5% interest
a three-year CD at 3.7% interest
a four-year CD at 3.9% interest
a five-year CD at 4.1% interest
When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs. Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)
Tax Consequences
Interest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service (IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.
Conclusion
CDs are a comparatively safe investment. If they are managed properly, they can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future.
Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.
For more advice for surviving a bear market with your assets intact, read Adapt To A Bear Market and Has Your Fund Manager Been Through A Bear Market?
by Ana Gonzalez Ribeiro, (Contact Author Biography)
Ana Gonzalez Ribeiro holds an MBA with honors in Finance and works as an Account Administrator and Freelance Writer. She has published articles in The Hispanic Outlook on Higher Education, New Mexico Woman, Spotlight on Recovery Magazine and The Loop Newsletter for College Forward. She is also a regular contributing writer specializing in business-related issues for Alaska Business Monthly. She worked for The Volunteer Center of United Way Westchester as a writer for the Youth Volunteer Guidebook 2008-2009 and served as Treasurer for the Society for Hispanic MBAs. During her spare time, she enjoys collecting stamps, reading biographies, staying up to date on business-related trends and working as a Notary Public and signing agent.
http://www.investopedia.com/articles/bonds/08/CD-certificate-of-deposit-recession-bear-market.asp
http://www.investopedia.com/university/certificate-of-deposit-cd/
Short-term Investment Options
Investment question:
I have a short period of time (1 year or less) during which I will have money to invest. What are my investment options?
Answer:
If you only have a short period of time in which to invest your money (i.e. less than one year), there are several investment options you should consider outside of the typical checking and savings accounts, which pay very little or no interest. These alternative short-term investments are known as money market securities.
For example, you might want to consider a Treasury bill (T-bill), a U.S. government debt security with a maturity of less than one year. T-bills ares one of the most marketable securities around the world, and their popularity is mainly due to their simplicity. The maturity for a T-bill is either three, six or 12 months, and new ones are typically issued on a weekly basis. The constant issue of new T-bills and the competitive bidding process mean that T-bills can be easily cashed in at any time.
Furthermore, banks and brokerages traditionally charge a very low commission on trading T-bills. You can purchase Treasury bills in the U.S. through any of the 12 Federal Reserve banks or 25 branch offices.
Commercial paper is another investment you might want to consider. It is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount to reflect current market interest rates. Maturities usually range no longer than nine months and, because of their slightly higher risk, they usually offer a higher rate of return than a T-bill.
Certificates of deposits (CDs) are time deposits at banks. These time deposits may not be withdrawn on demand like with a checking account and are generally issued by commercial banks, although they can also be bought through brokerages. They carry a specific maturity date (three months to five years), a specific interest rate that is slightly higher than T-Bills and can be issued in any denomination. However, the amount of interest you can earn depends on the amount and length of the investment, the current interest rate environment and the specific bank. While nearly every bank offers CDs, rates can vary widely, so it's important to shop around.
Banker's acceptance (BA) are short-term credit investments created by non-financial companies and guaranteed by a bank. They are traded at a discount to face value in the secondary market. For corporations, a BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the creditworthiness of a foreign trade partner is unknown. The advantage of BAs is that they do not need to be held to maturity and can be sold off in the secondary markets where they are constantly traded. (For further reading on these subjects, check out Money Market Tutorial.)
http://www.investopedia.com/ask/answers/109.asp
I have a short period of time (1 year or less) during which I will have money to invest. What are my investment options?
Answer:
If you only have a short period of time in which to invest your money (i.e. less than one year), there are several investment options you should consider outside of the typical checking and savings accounts, which pay very little or no interest. These alternative short-term investments are known as money market securities.
For example, you might want to consider a Treasury bill (T-bill), a U.S. government debt security with a maturity of less than one year. T-bills ares one of the most marketable securities around the world, and their popularity is mainly due to their simplicity. The maturity for a T-bill is either three, six or 12 months, and new ones are typically issued on a weekly basis. The constant issue of new T-bills and the competitive bidding process mean that T-bills can be easily cashed in at any time.
Furthermore, banks and brokerages traditionally charge a very low commission on trading T-bills. You can purchase Treasury bills in the U.S. through any of the 12 Federal Reserve banks or 25 branch offices.
Commercial paper is another investment you might want to consider. It is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount to reflect current market interest rates. Maturities usually range no longer than nine months and, because of their slightly higher risk, they usually offer a higher rate of return than a T-bill.
Certificates of deposits (CDs) are time deposits at banks. These time deposits may not be withdrawn on demand like with a checking account and are generally issued by commercial banks, although they can also be bought through brokerages. They carry a specific maturity date (three months to five years), a specific interest rate that is slightly higher than T-Bills and can be issued in any denomination. However, the amount of interest you can earn depends on the amount and length of the investment, the current interest rate environment and the specific bank. While nearly every bank offers CDs, rates can vary widely, so it's important to shop around.
Banker's acceptance (BA) are short-term credit investments created by non-financial companies and guaranteed by a bank. They are traded at a discount to face value in the secondary market. For corporations, a BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the creditworthiness of a foreign trade partner is unknown. The advantage of BAs is that they do not need to be held to maturity and can be sold off in the secondary markets where they are constantly traded. (For further reading on these subjects, check out Money Market Tutorial.)
http://www.investopedia.com/ask/answers/109.asp
Spotting A Market Bottom
Spotting A Market Bottom
by Chris Seabury (Contact Author Biography)
Stock market bottoms can be challenging to spot. And many times, investors think that they have found this point, only for the major averages to head even lower. The big question many have is: just how do you know when a market bottom has taken place? This requires the tools and indicators that have identified major market bottoms in the past, and an understanding of what they are, how they work and that each indicator must correlate a similar reading.
Stock Market Bottoms
Since the end of World War II, stock prices have generally bottomed six months into a recession. Once it becomes official that the country is in a recession, it is generally a rearview mirror indicator meaning that there have already been two or more quarters of negative GDP growth. On the other hand, when we are emerging out of a recession, we will not know until many months later. This is one of the reasons that it can be so confusing for investors to spot major bottoms taking place. (Learn more about taking advantage of an unstable market, read Profiting From Panic Selling.)
Things to Watch for
Just imagine how wonderful it would have been to buy stocks at bargain prices before major upward moves, such as January, 1975, August, 1982, or even March, 2003. All of those periods share some common patterns that should be observed in order to determine if the market is bottoming.
The Double Bottom Pattern
The double bottom pattern is considered to be one of the most reliable of all the technical patterns. In this pattern, the major market averages will hit a low on heavy volume, then bounce back up and then retest the previous low on light volume.
The key is to watch and see how the averages trade when approaching that second low point. If the averages have a sizable break below the previous low, it is advisable to watch and see what happens. However, if the averages test that low point and then have some type of reversal, this could be a sign that a double bottom pattern is forming.
A second area to watch is volume. This is the total amount of buying and selling that is occurring. Generally, heavy volume on up or down moves shows strong conviction from either the buyers or sellers. When you see the volume lighten up on the downward moves and increase substantially on the upward moves, there is a large amount of buying taking place. After a major market bottom has occurred, you will see this heavy volume accompanied by a strong upward move in the major market averages.
Economic Numbers
Generally, the stock market will bottom and start moving higher before you see it represented in economic numbers or headlines. In many cases, the more negative economic news headlines you see, the better. When the press represents the psychology of the moment, and we start to see consistent headlines showing how bad the economy is, it suggests that the sentiment of the crowd has become so negative that the vast majority have already moved out of their positions.
A second number to pay attention to is the consumer confidence index. During and after market bottoms have occurred, you will see consumer spending and consumer confidence increase. When this happens, consumers are spending more money and corporate earnings are starting to rise.
A third economic number to watch is purchasing managers' index, which measures the economic health of the manufacturing sector. When these two numbers have bottomed, then started to consistently rise for more than three months in a row, the manufacturing and service sectors are on the road to expansion once again. (For further reading, see Economic Indicators For The Do-It-Yourself Investor.)
High Yield Bonds
Another indicator to watch is the high yield bond spread. High yield bonds are the bonds issued by companies who have a high possibility of default. To be able to attract investors to loan them money, they have to offer a higher interest rate. When lending standards are becoming easier, you will see the amount of interest or the spreads on these bonds drop. When this happens, it is a sign that investors and banks are becoming more willing to take risk. This would signal that economic conditions are starting to improve. (For more, see Top 6 Uses For Bonds.)
Copper Prices
Copper prices are a good indicator as to how strong or weak the global economy is. This metal is used in economic expansion in products such as pipes, radiators, air conditioners, electronics and computers, to name a few. Watching to see if the price of copper has bottomed or has room to fall further will help determine the overall worldwide demand for the metal. When demand has increased, you will start to see prices rise; when demand is falling, prices will follow.
Look for copper prices to finish declining and start to move in a similar upward pattern with the financial markets. This would be a real-time signal that manufacturers and home builders are seeing their businesses pick up. To keep up with the increases in demand, they have to use more copper, causing the price to rise. (For more, see Guard Your Portfolio With Defensive Stocks.)
The Bottom Line
Market bottoms are accompanied by a variety of factors, such as:
- high amounts of fear,
- a decrease in the volume on downward moves,
- a large increase in the volume on upward moves,
- double bottom patterns,
- improving economic numbers,
- the spread on high yield bonds narrowing and
- an increase in copper prices.
However, it is important to remember that the financial markets look forward at least six months prior to any real improvement in the economic numbers. By using all of the indicators together, you have the key to spotting a market bottom. (For more, see Market Bottom: Are We There Yet?)
by Chris Seabury, (Contact Author Biography)
http://www.investopedia.com/articles/economics/09/spotting-a-market-bottom.asp
Saturday 23 May 2009
Financial genius in a rising market
It is good to have friends who are smart intelligent investors. These people are fun to meet. They share precious personal knowledge and experience. On many occasions, you can coattail on their hardwork profitably. At times, they prevented you from committing an obvious investing mistake.
How to spot these smart intelligent investors? Yes, they maybe of any ages. The younger investor maybe smart, but it does take time to build up an experience. Seek out those in their 50s or older with a good track record. There are many who invest in the market; a record they do have but not that of the truly committed smart intelligent investor.
The truly smart intelligent investors are those with a record of good total return accumulated over MANY years of investing. They are passionate, hardworking and perhaps well-networked. They have a philosophy and strategy. They may even sound boring as they are so predictable. They are not many but not rare. Make friends with them. Rub shoulders with them. There is little to lose and a lot more to gain.
Of course, beware the financial genius in a rising market. As the saying goes, when the tide recedes, many of them are found swimming naked.
How to spot these smart intelligent investors? Yes, they maybe of any ages. The younger investor maybe smart, but it does take time to build up an experience. Seek out those in their 50s or older with a good track record. There are many who invest in the market; a record they do have but not that of the truly committed smart intelligent investor.
The truly smart intelligent investors are those with a record of good total return accumulated over MANY years of investing. They are passionate, hardworking and perhaps well-networked. They have a philosophy and strategy. They may even sound boring as they are so predictable. They are not many but not rare. Make friends with them. Rub shoulders with them. There is little to lose and a lot more to gain.
Of course, beware the financial genius in a rising market. As the saying goes, when the tide recedes, many of them are found swimming naked.
Bear Trap(s)
Bear Trap(s)
There is an interesting post on this topic here: http://ssinvesting.blogspot.com/2008/05/how-to-define-bear-trap-if-public-bank.html
One of the challenges in investing for the long term is to have a personal strategy in handling volatility of stock prices.
You can choose to avoid such volatilities by investing in stalwarts like Nestle. This stock has long term revenue and profit growth. Its share price is trending upwards in keeping with its business performance. The consistency and predictably attracts certain types of investors. Yet, there are others who feel investing in this stock is not for them. Too slow and the returns are at best moderate!
Then, there are stocks with high volatilities or Beta. Their prices swing greatly, often based on rumours. Long term investors will be better off ignoring these fluctuations and monitor the quarterly reported results instead.
A good safety strategy in investing is to assume the attitude that all shares in the market are overpriced. This will prevent you from making big mistakes and forces you to carry out the appropriate valuation to counter this belief before putting good money to work.
What to do when the price of a good stock suddenly dropped drastically?
Instead of looking at price, follow PE. PE fluctuations up or down 20% are quite normal. You can usually ignore these, assuming you know the business of your investments well.
However, do not ignore the big fall in the PE of more than 20%. Check the news. What might be causing this sudden fall in price? Is there any fundamental deterioration in the business of the company? Will this be a temporary or permanent situation? You may have to decide to hold or sell quickly depending on your assessment.
Should you be buying more? If yes, when?
Let's review some recent events in the market.
Transmile: When news first broke a few years ago, that the auditor was unwilling to approve the accounts without qualification, the shares got sold down. This was a good learning experience. Some thought this was a buying opportunity. With the benefit of hindsight, cutting loss by selling at $9 to $11 was definitely better than the below $1 price the stock is trading at present. Wonder why related Kuok's company bought the shares during the particular period? The objectives of the majority or significant shareholders may not be in congruent with those of the minority shareholders. It was more to inspire some confidence in investors in Transmile.
PBB: Public Bank too was sold down since last year. Another drop occurred in Feb and March 09. Generally, the banking industry is going into a tough period. The price of the stock will reflect this. Is this a sell or a buy? Is this a temporary or a permanent setback to PBB core business?
Selling or buying into Transmile and PBB when their stock prices sunk are 2 entirely different operations. Which is a bear trap? Which is an opportunity or investment?
Usually the price will remain low for sometime after a bad news was known. You have time to pick these stocks. The important thing is to do the homework, check out and follow the news as this unfold. What is its impact on the long term durability of the business of the company? If you have done the homework, the analysis, the assessment of the impact of the news, the risks, and you understand the business and issues, be courageous. Make your own decision based on your own analysis. Don't be swayed by the crowd, or follow the crowd or look for affirmation by others.
The link: http://ssinvesting.blogspot.com/2008/05/how-to-define-bear-trap-if-public-bank.html rightly pointed out that the bear trap need only be applied to lousy companies with no prospect of recovery in their business. Those investing in good high quality companies need not fear the "bear traps" situations. Thanks for sharing this point. Instead the best opportunity to buy good quality companies is when they are being sold at low prices on some temporary bad news, assuming that these companies are within your circle of competence.
There is an interesting post on this topic here: http://ssinvesting.blogspot.com/2008/05/how-to-define-bear-trap-if-public-bank.html
One of the challenges in investing for the long term is to have a personal strategy in handling volatility of stock prices.
You can choose to avoid such volatilities by investing in stalwarts like Nestle. This stock has long term revenue and profit growth. Its share price is trending upwards in keeping with its business performance. The consistency and predictably attracts certain types of investors. Yet, there are others who feel investing in this stock is not for them. Too slow and the returns are at best moderate!
Then, there are stocks with high volatilities or Beta. Their prices swing greatly, often based on rumours. Long term investors will be better off ignoring these fluctuations and monitor the quarterly reported results instead.
A good safety strategy in investing is to assume the attitude that all shares in the market are overpriced. This will prevent you from making big mistakes and forces you to carry out the appropriate valuation to counter this belief before putting good money to work.
What to do when the price of a good stock suddenly dropped drastically?
Instead of looking at price, follow PE. PE fluctuations up or down 20% are quite normal. You can usually ignore these, assuming you know the business of your investments well.
However, do not ignore the big fall in the PE of more than 20%. Check the news. What might be causing this sudden fall in price? Is there any fundamental deterioration in the business of the company? Will this be a temporary or permanent situation? You may have to decide to hold or sell quickly depending on your assessment.
Should you be buying more? If yes, when?
Let's review some recent events in the market.
Transmile: When news first broke a few years ago, that the auditor was unwilling to approve the accounts without qualification, the shares got sold down. This was a good learning experience. Some thought this was a buying opportunity. With the benefit of hindsight, cutting loss by selling at $9 to $11 was definitely better than the below $1 price the stock is trading at present. Wonder why related Kuok's company bought the shares during the particular period? The objectives of the majority or significant shareholders may not be in congruent with those of the minority shareholders. It was more to inspire some confidence in investors in Transmile.
PBB: Public Bank too was sold down since last year. Another drop occurred in Feb and March 09. Generally, the banking industry is going into a tough period. The price of the stock will reflect this. Is this a sell or a buy? Is this a temporary or a permanent setback to PBB core business?
Selling or buying into Transmile and PBB when their stock prices sunk are 2 entirely different operations. Which is a bear trap? Which is an opportunity or investment?
Usually the price will remain low for sometime after a bad news was known. You have time to pick these stocks. The important thing is to do the homework, check out and follow the news as this unfold. What is its impact on the long term durability of the business of the company? If you have done the homework, the analysis, the assessment of the impact of the news, the risks, and you understand the business and issues, be courageous. Make your own decision based on your own analysis. Don't be swayed by the crowd, or follow the crowd or look for affirmation by others.
The link: http://ssinvesting.blogspot.com/2008/05/how-to-define-bear-trap-if-public-bank.html rightly pointed out that the bear trap need only be applied to lousy companies with no prospect of recovery in their business. Those investing in good high quality companies need not fear the "bear traps" situations. Thanks for sharing this point. Instead the best opportunity to buy good quality companies is when they are being sold at low prices on some temporary bad news, assuming that these companies are within your circle of competence.
Friday 22 May 2009
Keep Investing Simple and Safe (KISS)
Keep Investing Simple and Safe
When is the best time to buy share?
Anytime really. You should track a list of high quality stocks. Buy when the stock is selling at a bargain price, that is, when the risk of losing your capital is low or negligible and the return substantially higher. The good investors aim for high returns with minimal risk taking.
Is there a time when you should not be buying any stocks?
1. Generally, when the market is trading at a high valuation. There is always another time to buy the stock. Be patient.
2. However, if you are not knowledgeable in stock selection (QVM) and money management, you should not be investing directly in the stock market. You are better buying a mutual fund when the market is trading at low valuation or to park your fund with a personal fund manager. The stock market is a dangerous place for the uninitiated.
3. Avoid investing money in the stock if the money you invested may be needed urgently anytime or in a short time. Investing in the market should be for the longer term. There is too much uncertainties in the returns over a short time frame.
Is now a good time to buy stocks?
Anytime is a good time to buy stock.
Rather than timing the market, one should buy or sell base on the price of the stock offered by the market. Even in the peak of the bull market, one can pick up some bargains. Of course, in the depth of a bear market, there are many good stocks selling at very low prices.
Is buy and hold, a safe strategy?
The recent severe downturn in the market brought this strategy into question once again. It is very safe for those who employs this strategy using certain criterias. It is safe for selected stocks. These stocks should be of the highest quality (QVM). These stocks should be bought at a bargain price with a margin of safety. The only time you may have to sell the stock urgently is when there is a fundamental deterioration in the business of the company. Other than this, you have the leisure of selling.
The market is cyclical. The bull-bear-bull-bear cycles ensure that the bull will always follows a bear and vice-versa. Here are a selection of Malaysian stocks that have stood the test of time over at least 3 severe bear markets: Nestle, DLady, Petdag, Guinness, Petgas, PBB, PPB, Resorts. There are also others too. At certain short period of time, each of these stocks may underperform but if assessed over a longer period of time, the returns have ALL been positive. By minimising the downside and aiming only for modest returns, investing can be surprisingly rewarding for a large number of investors and with little effort.
How to maximise returns?
1. First, ensure that there is safety of your capital. Remember not to lose your capital. By ensuring that you do not lose money and aiming for moderate returns, you can maximise total returns too with low risk. Don't be greedy for high returns by taking unnecessarily high risks.
2. Stick to the few high quality stocks you are familiar with. This is the circle of competence mentioned by Buffett. Stay within your circle of competence and never, never, never, never, get out of this circle. :-) If your circle of competence is only 6 stocks, stick to these 6 stocks.
3. Only buy high quality stocks at bargain price. At a certain price, the stock is a bargain and at another price, it is trading at a fair price. Never, never, never buy these high quality stocks when it is trading at high price. By buying these good quality stocks at a bargain price, one is buying with a margin of safety to minimise loss to your capital in the event you got it wrong. At the same time, if the event turned out to be as you expected, your return will be greater.
4. Also do not over-diversify. According to Buffett, adding the 7th stock into your portfolio reduces the overall return of your portfolio. Bet big if you are very certain of your selection.
5. Allow the wonder of compounding to grow your return over a long period of time.
Investing can be very safe. Keep it simple and safe. (K.I.S.S.)
When is the best time to buy share?
Anytime really. You should track a list of high quality stocks. Buy when the stock is selling at a bargain price, that is, when the risk of losing your capital is low or negligible and the return substantially higher. The good investors aim for high returns with minimal risk taking.
Is there a time when you should not be buying any stocks?
1. Generally, when the market is trading at a high valuation. There is always another time to buy the stock. Be patient.
2. However, if you are not knowledgeable in stock selection (QVM) and money management, you should not be investing directly in the stock market. You are better buying a mutual fund when the market is trading at low valuation or to park your fund with a personal fund manager. The stock market is a dangerous place for the uninitiated.
3. Avoid investing money in the stock if the money you invested may be needed urgently anytime or in a short time. Investing in the market should be for the longer term. There is too much uncertainties in the returns over a short time frame.
Is now a good time to buy stocks?
Anytime is a good time to buy stock.
Rather than timing the market, one should buy or sell base on the price of the stock offered by the market. Even in the peak of the bull market, one can pick up some bargains. Of course, in the depth of a bear market, there are many good stocks selling at very low prices.
Is buy and hold, a safe strategy?
The recent severe downturn in the market brought this strategy into question once again. It is very safe for those who employs this strategy using certain criterias. It is safe for selected stocks. These stocks should be of the highest quality (QVM). These stocks should be bought at a bargain price with a margin of safety. The only time you may have to sell the stock urgently is when there is a fundamental deterioration in the business of the company. Other than this, you have the leisure of selling.
The market is cyclical. The bull-bear-bull-bear cycles ensure that the bull will always follows a bear and vice-versa. Here are a selection of Malaysian stocks that have stood the test of time over at least 3 severe bear markets: Nestle, DLady, Petdag, Guinness, Petgas, PBB, PPB, Resorts. There are also others too. At certain short period of time, each of these stocks may underperform but if assessed over a longer period of time, the returns have ALL been positive. By minimising the downside and aiming only for modest returns, investing can be surprisingly rewarding for a large number of investors and with little effort.
How to maximise returns?
1. First, ensure that there is safety of your capital. Remember not to lose your capital. By ensuring that you do not lose money and aiming for moderate returns, you can maximise total returns too with low risk. Don't be greedy for high returns by taking unnecessarily high risks.
2. Stick to the few high quality stocks you are familiar with. This is the circle of competence mentioned by Buffett. Stay within your circle of competence and never, never, never, never, get out of this circle. :-) If your circle of competence is only 6 stocks, stick to these 6 stocks.
3. Only buy high quality stocks at bargain price. At a certain price, the stock is a bargain and at another price, it is trading at a fair price. Never, never, never buy these high quality stocks when it is trading at high price. By buying these good quality stocks at a bargain price, one is buying with a margin of safety to minimise loss to your capital in the event you got it wrong. At the same time, if the event turned out to be as you expected, your return will be greater.
4. Also do not over-diversify. According to Buffett, adding the 7th stock into your portfolio reduces the overall return of your portfolio. Bet big if you are very certain of your selection.
5. Allow the wonder of compounding to grow your return over a long period of time.
Investing can be very safe. Keep it simple and safe. (K.I.S.S.)
Thursday 21 May 2009
Benjamin Graham 113 wise words
This post is just an occasional reminder for this blogger to revisit Benjamin Graham's 113 wise words.
COASTAL
Buy 1.60
Sell 1.61
PBBANK
Buy 8.55
Sell 8.60
PPB
Buy 11.10
Sell 11.30
(Buy below 9.00)
"The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement." - Benjamin Graham
COASTAL
Buy 1.60
Sell 1.61
PBBANK
Buy 8.55
Sell 8.60
PPB
Buy 11.10
Sell 11.30
(Buy below 9.00)
"The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement." - Benjamin Graham
Conventional Wisdom
Conventional Wisdom
The investor should be able to make up lists of bonds and preferred stocks meeting the rigorous requirements of stable income investment.
The investor should reject many stocks which sell at full prices but which do not pass his test of safety. These stocks are frequently bought nonetheless by investors who have confidence in the business and are attracted by their higher-than-standard dividend yields. There are logical objections to such stocks.
How to select the most attractive stock at their current prices?
How to recommend "those which are likely to perform best in the future"?
By intensive study of the various industries and their prospects, and by close familiarity with individual companies and their managements, an investor can undoubtedly reach conclusions of value. To a great extent these are the results of the application not of formal standards to a set of facts and figures, but rather of business judgment and foresight to an intimate knowledge of conditions in the industry and its companies.
One cannot be taught how to weigh the future. In fact, the emphasis should be placed in the opposite direction. The investor should not trust his projections of the future too far, and especially not to lose sight of the price of the security he is analysing. No matter how rosy the prospects, the price may still be too high.
Conversely, the shares of companies with unpromising outlooks may sell so low that they offer excellent opportunities to the shrewd buyer. Also, the wheel of time brings many changes and reversals. "Many shall be restored that now are fallen, and many shall Fall that now are in honor."
Advice for investor
The investor should select a group of good quality company stocks that are fairly priced suitable to the investor's financial and temperamental requirements.
1. The investor should keep away from buying inferior stocks during periods of enthusiasm and high prices.
2. Next, the investor should be encouraged to buy the selected stocks when the market level is below, rather than above, its indicated long-term normal figure.
3. Finally, the investor should always consciously avoid paying extremely high prices for good stocks.
The investor should be able to make up lists of bonds and preferred stocks meeting the rigorous requirements of stable income investment.
The investor should reject many stocks which sell at full prices but which do not pass his test of safety. These stocks are frequently bought nonetheless by investors who have confidence in the business and are attracted by their higher-than-standard dividend yields. There are logical objections to such stocks.
How to select the most attractive stock at their current prices?
How to recommend "those which are likely to perform best in the future"?
By intensive study of the various industries and their prospects, and by close familiarity with individual companies and their managements, an investor can undoubtedly reach conclusions of value. To a great extent these are the results of the application not of formal standards to a set of facts and figures, but rather of business judgment and foresight to an intimate knowledge of conditions in the industry and its companies.
One cannot be taught how to weigh the future. In fact, the emphasis should be placed in the opposite direction. The investor should not trust his projections of the future too far, and especially not to lose sight of the price of the security he is analysing. No matter how rosy the prospects, the price may still be too high.
Conversely, the shares of companies with unpromising outlooks may sell so low that they offer excellent opportunities to the shrewd buyer. Also, the wheel of time brings many changes and reversals. "Many shall be restored that now are fallen, and many shall Fall that now are in honor."
Advice for investor
The investor should select a group of good quality company stocks that are fairly priced suitable to the investor's financial and temperamental requirements.
1. The investor should keep away from buying inferior stocks during periods of enthusiasm and high prices.
2. Next, the investor should be encouraged to buy the selected stocks when the market level is below, rather than above, its indicated long-term normal figure.
3. Finally, the investor should always consciously avoid paying extremely high prices for good stocks.
Wednesday 20 May 2009
Dividend Yield
Dividend Yield
The yield figure published in the newspapers is usually the historical one.
Analysts will often provide forecasts for dividends in terms of earnings per share (EPS) and thus the forecast yield can then be calculated. Forecast can, of course, go wrong, and consequently there is some risk in relying upon them.
WHY IT IS IMPORTANT
Yield, after the price/earning ration (P/E), is one of the most common methods of comparing the relative value of shares.
The majority of investors like to see a cash income from their shares, althoug to some extent this is a cultureal thing. There are more companies in the U.S., for example, that pay no dividends than in the U.K.
HOW IT WORKS IN PRACTICE
Yields can be compared against the market average or against a sector average, which in turn gives you some idea of the relative value of the share against its peers.
Other things being equal, a higher yield share is preferable to that of an identical company with a lower yield.
The higher yield share is cheaper.
In practice of course, there may well be good reasons why the market has decided that the higher yielder should be so - possibly it has worse prospects, is less profitable, and so on. This is not always the case; the market is far from being a perfectly rational place.
AN ADDITIONAL FEATURE OF YIELD (unlike many of the other share analysis ratios), is that it enables comparison with cash.
You can compare the yield from the interest rate in a bank without capital risk with the yield on shares, which are far riskier. This produce a valuable basis for share evaluation.
If, for example, you can get 4% in a bank without capital risk, you can then look at shares and ask yourself how this yield compares - given that, as well as the opportunity for long-term growth of both the share price and the dividends, there is plenty of capital risk.
TRICKS OF THE TRADE
Care is necessary, however, because unlike banks paying interest, companies are under no obligation to pay dividends at all.
Frequently, if they go through a bad patch, even the largest, most well-known household name companies will cut dividends or even abandon paying them altogether.
So, share yield is greatly less reliable than bank interst or government stock interest yield.
Despite this, yield is an immensely useful feature of share appraisal. It is the only ratio that tells you about the CASH RETURN TO THE INVESTOR, and you cannot argue with cash. EPS, for example, is subject to accountants' opinions but a dividend once paid is an unarguable fact.
The yield figure published in the newspapers is usually the historical one.
Analysts will often provide forecasts for dividends in terms of earnings per share (EPS) and thus the forecast yield can then be calculated. Forecast can, of course, go wrong, and consequently there is some risk in relying upon them.
WHY IT IS IMPORTANT
Yield, after the price/earning ration (P/E), is one of the most common methods of comparing the relative value of shares.
The majority of investors like to see a cash income from their shares, althoug to some extent this is a cultureal thing. There are more companies in the U.S., for example, that pay no dividends than in the U.K.
HOW IT WORKS IN PRACTICE
Yields can be compared against the market average or against a sector average, which in turn gives you some idea of the relative value of the share against its peers.
Other things being equal, a higher yield share is preferable to that of an identical company with a lower yield.
The higher yield share is cheaper.
In practice of course, there may well be good reasons why the market has decided that the higher yielder should be so - possibly it has worse prospects, is less profitable, and so on. This is not always the case; the market is far from being a perfectly rational place.
AN ADDITIONAL FEATURE OF YIELD (unlike many of the other share analysis ratios), is that it enables comparison with cash.
You can compare the yield from the interest rate in a bank without capital risk with the yield on shares, which are far riskier. This produce a valuable basis for share evaluation.
If, for example, you can get 4% in a bank without capital risk, you can then look at shares and ask yourself how this yield compares - given that, as well as the opportunity for long-term growth of both the share price and the dividends, there is plenty of capital risk.
TRICKS OF THE TRADE
Care is necessary, however, because unlike banks paying interest, companies are under no obligation to pay dividends at all.
Frequently, if they go through a bad patch, even the largest, most well-known household name companies will cut dividends or even abandon paying them altogether.
So, share yield is greatly less reliable than bank interst or government stock interest yield.
Despite this, yield is an immensely useful feature of share appraisal. It is the only ratio that tells you about the CASH RETURN TO THE INVESTOR, and you cannot argue with cash. EPS, for example, is subject to accountants' opinions but a dividend once paid is an unarguable fact.
Price/Earnings Ratio
P/E
If a quoted company has a share price of $100 and EPS of $12 for the last published year, then it has a historical P/E of 8.3. If analysis are forecasting for the next year EPS of $14, then the forecast P/E is 7.1.
In the above example, the P/E of 8.3 tells us that investors at the current price are prepared to pay 8.3 years of historical EPS for the share, or 7.1 years of the forecast next year's EPS.
Theoretically, the faster a company is expected to grow, the higher the P/E ratio that investors would award it.
P/E is one measure of how cheap or expensive a share appears.
HOW IT WORKS IN PRACTICE
The P/E ratio is predominantly useful in comparisons with other shares rather than in isolation.
For example, if the average P/E in the market is 20, there will be many shares with P/Es well above and well below this, for a variety of reasons.
If a quoted company has a share price of $100 and EPS of $12 for the last published year, then it has a historical P/E of 8.3. If analysis are forecasting for the next year EPS of $14, then the forecast P/E is 7.1.
In the above example, the P/E of 8.3 tells us that investors at the current price are prepared to pay 8.3 years of historical EPS for the share, or 7.1 years of the forecast next year's EPS.
Theoretically, the faster a company is expected to grow, the higher the P/E ratio that investors would award it.
P/E is one measure of how cheap or expensive a share appears.
HOW IT WORKS IN PRACTICE
The P/E ratio is predominantly useful in comparisons with other shares rather than in isolation.
For example, if the average P/E in the market is 20, there will be many shares with P/Es well above and well below this, for a variety of reasons.
Similarly, in a particular sector, the P/Es will frequently vary quite widely from the sector average, even though the constitutent companies may all be engaged in broadly similar businesses.
The reason is that even two businesses doing the same thing will not always be doing it as profitably as each other. One maybe far more efficient, as demonstrated by a history of rising EPS compared with the flat EPS picture of the other over a series of years, and the market might recognize this by awarding the more profitable share a higher P/E.
TRICKS OF THE TRADE
1. Take care.
- The market frequently gets it wrong and many high P/E shares have in the past been the most awful long-term investments, losing investors huge amounts of money when the promise of future rapid growth proved to be a chimera.
- In contrast, many low P/E companies, often in what are perceived as dull industries, have proved over time to be outstanding investments.
How To Deal With Risk
How To Deal With Risk
People often do not properly assess the potential rewards for taking a risk. Nor do they focus on how well the risks and rewards match.
Your company faced a potential growth initiative that offers both high risk and high reward.
Ask yourself:
1. If you take this high risk and fail, will you lose the ranch?
If yes, you may not want to go ahead. If the risk is not of the bet-the-company type, then ask,
2. If you fail, will it put your company at a severe disadvantage?
Sometimes it is worth betting on a new initiative or idea, but you always want to have a handle on what you are up against. You also want to know how to reduce risk, shape it and manage it.
Convinced the risk is worth taking, you then drill down farther and decide whether the project is too risky, given the other risks in your company's investment portfolio.
Ask again and decide:
3. Would the inclusion of this project push the company over the edge?
If yes, and should you still decide to take the risk ahead, ask,
4. Would sharing the risk by an alliance be an acceptable option?
People often do not properly assess the potential rewards for taking a risk. Nor do they focus on how well the risks and rewards match.
Your company faced a potential growth initiative that offers both high risk and high reward.
Ask yourself:
1. If you take this high risk and fail, will you lose the ranch?
If yes, you may not want to go ahead. If the risk is not of the bet-the-company type, then ask,
2. If you fail, will it put your company at a severe disadvantage?
Sometimes it is worth betting on a new initiative or idea, but you always want to have a handle on what you are up against. You also want to know how to reduce risk, shape it and manage it.
Convinced the risk is worth taking, you then drill down farther and decide whether the project is too risky, given the other risks in your company's investment portfolio.
Ask again and decide:
3. Would the inclusion of this project push the company over the edge?
If yes, and should you still decide to take the risk ahead, ask,
4. Would sharing the risk by an alliance be an acceptable option?
Good growth is profitable, organic, differentiated and sustainable.
Good growth is profitable, organic, differentiated and sustainable.
Profitable
Good growth is profitable.
It is also capital-efficient, that is, it needs to earn a return on its investment greater than what the company could have received by putting its money in something ultra-safe, such as a Treasury bill.
There is growth in revenues and steady improvement in profitability. Gross margin is an important indicator of a company's profitability and often not given the due it deserves.
Increasing gross margin and at the same time growing revenues at a rate better than the overall market is what makes for a great growth company. There is a direct relationship between improved productivity and profitable growth.
The improvement in gross margin also reflects the company's ability to innovate ahead of its competitors.
A company's rapid growth attracts the best managers in the industry - managers who are committed to growth.
Organic
Organic growth is the most efficient way to create revenue growth.
Profitable
Good growth is profitable.
It is also capital-efficient, that is, it needs to earn a return on its investment greater than what the company could have received by putting its money in something ultra-safe, such as a Treasury bill.
There is growth in revenues and steady improvement in profitability. Gross margin is an important indicator of a company's profitability and often not given the due it deserves.
Increasing gross margin and at the same time growing revenues at a rate better than the overall market is what makes for a great growth company. There is a direct relationship between improved productivity and profitable growth.
The improvement in gross margin also reflects the company's ability to innovate ahead of its competitors.
A company's rapid growth attracts the best managers in the industry - managers who are committed to growth.
Organic
Organic growth is the most efficient way to create revenue growth.
When people work with customers in the search for new ideas, translating those ideas into reality requires them to cut across silos and come together to make trade-offs and decisions in launching new products. It also builds the organization's self-confidence. Knowing that it has created a successful growth project makes it easier to tackle the next challenge, and the momentum feeds on itself.
Organic growth can also be based on filling an additional customer need and/or exploiting an organization's existing expertise in products, customer segments, or geographic regions, to capture new markets.
While good growth is PRIMARILY organic, there are times when it makes sense to supplement organic growth with smaller "bolt-on" acquisitions to fill strategic gaps, such as gaining a beachhead in a geographic region, obtaining a new technology, filling an adjacent need, or adding a new distribution channel.
Differentiated
No matter how "commoditized" your business is, good-growth companies find a way to differentiate themselves.
Winners in the quest for profitable growth pay attention to differentiation, however razor-thin.
To do that, they see things through the eyes of their customers and potential customers, detect what these buyers prefer, and hook the customer through products, services, and relationships that are better differentiated than those of the competition.
Dell offers a commodity: personal computers. Yet Dell differentiated its product line by making sure its product are reliable, low-priced, and customizable - that is, customers can design their PCs exactly the way they want.
Lexus truly differentiated itself in the post-purchase experience and in mechanical reliability.
Differentiation can also take place in the service that a manufacturer provides to retailers like Wal-Mart. By helping the customer increase its sales, the manufacturer has differentiated itself from being just another firm that the customer does business with.
Sustainable
Good growth continues over time. It has a sustainable trajectory.
It is not a quick spike upward in revenues, caused by cutting prices or by throwing substantial resources against a one-shot opportunity. The goal is to have the growth continue year after year.
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The only way this growth is going to occur is if everyone in the organization believes in it to be possible. It is up to the organization's leadership to create the right mind-set.
Good Growth
Good Growth
The best companies, those that will thrive over the long run, grow both the top and bottom lines consistently over time, developing a cumulative competitive advantage that creates shareholder value. They may not turn in the best numbers in the industry when measured over any one short-term period, but their cumulative performance is stellar, thanks to the way they approach increasing their revenues.
Their good growth also strengthens the company's DNA by creating new competencies and strengths, thereby building the skills of its people and confidence in the psyche of the organization.
What makes up good growth?
It is profitable, organic, differentiated, and sustainable. (PODS)
The best companies, those that will thrive over the long run, grow both the top and bottom lines consistently over time, developing a cumulative competitive advantage that creates shareholder value. They may not turn in the best numbers in the industry when measured over any one short-term period, but their cumulative performance is stellar, thanks to the way they approach increasing their revenues.
Their good growth also strengthens the company's DNA by creating new competencies and strengths, thereby building the skills of its people and confidence in the psyche of the organization.
What makes up good growth?
It is profitable, organic, differentiated, and sustainable. (PODS)
Bad Growth
Bad Growth
Bad growth is not confined to mergers and acquisitions lacking strategic rationale. Price-cutting to gain market share without a corresponding decrease in costs can also lead to disaster.
Some businesses are capital intensive with high fixed costs and a high breakeven point, for example, the building-materials industry. Cutting prices to gain significant market share maybe successful at least initially. However, the competition had no choice but to respond in kind, since a loss of market share in this high-fixed-cost industry means a loss of both cash flow and profitability. The end result of all that price cutting caused industry revenue and profits to shrink, which obviously, affected every business in the same industry. It may take some time to restore equilibrium to the business.
Cost cutting could have been succesful to gain market share if the company had improved productivity and offered higher-quality products and creating a better cost structure, ahead of the competition. With lower costs and higher-quality products, it would have been possible to cut prices and build market share while maintaining margin. Another approach could have tried to search out the most profitable segments of the market and/or become the industry's innovator.
With no intrinsic competitive advantages, the only result of price cutting was that everyone in the industry suffered, not without its consequences to the managers and management too.
Buying growth through uneconomic price discounting
Gaining market share by giving some customers unusually favourable credit terms - terms that result in your losing money on every sale - is another example of bad growth. It never works long term.
Subsidizing buyers' purchases of your product by charging them little or no interest on the financing options you offer them, or by giving them an extended period until they have to pay you, may spike sales in the short term, but it is never effective as a long-term growth strategy.
In these situations, companies are able to record revenues and profits in accounting terms, and managers get their bonuses for meeting targets, but at the end of the day a cash crisis arises and huge write-offs ensue.
Bad growth is not confined to mergers and acquisitions lacking strategic rationale. Price-cutting to gain market share without a corresponding decrease in costs can also lead to disaster.
Some businesses are capital intensive with high fixed costs and a high breakeven point, for example, the building-materials industry. Cutting prices to gain significant market share maybe successful at least initially. However, the competition had no choice but to respond in kind, since a loss of market share in this high-fixed-cost industry means a loss of both cash flow and profitability. The end result of all that price cutting caused industry revenue and profits to shrink, which obviously, affected every business in the same industry. It may take some time to restore equilibrium to the business.
Cost cutting could have been succesful to gain market share if the company had improved productivity and offered higher-quality products and creating a better cost structure, ahead of the competition. With lower costs and higher-quality products, it would have been possible to cut prices and build market share while maintaining margin. Another approach could have tried to search out the most profitable segments of the market and/or become the industry's innovator.
With no intrinsic competitive advantages, the only result of price cutting was that everyone in the industry suffered, not without its consequences to the managers and management too.
Buying growth through uneconomic price discounting
Gaining market share by giving some customers unusually favourable credit terms - terms that result in your losing money on every sale - is another example of bad growth. It never works long term.
Subsidizing buyers' purchases of your product by charging them little or no interest on the financing options you offer them, or by giving them an extended period until they have to pay you, may spike sales in the short term, but it is never effective as a long-term growth strategy.
In these situations, companies are able to record revenues and profits in accounting terms, and managers get their bonuses for meeting targets, but at the end of the day a cash crisis arises and huge write-offs ensue.
How to Tell Good Growth from Bad Growth
How to Tell Good Growth from Bad Growth
All top-line growth is not created equal. History has shown that most mergers and acquisitions do little to help the long-term health and revenue growth of an organization. Growth that uses capital inefficiently is not the way to go.
How can you tell good growth from bad?
How good growth builds value
Growth of any kind increases revenues. Good growth not only increases revenues but correspondingly improves profits and is sustainable over time. It is primarily organic (internally) generated from the ongoing operations and business of the company and is based on differentiated products and services that meet new or previously unmet consumer needs.
Good growth is thus growth that is profitable, organic, differentiated, and sustainable (PODS). Good growth builds shareholder value over time. In contrast, bad growth destroys shareholder value.
Mergers and acquisitions, a primary example of bad growth, are often based on myopic visions of synergy that have no basis in the reality fo the market place. Instead of 4 plus 4 equaling 10, as promised when the deals are announced, more often than not 4 plus 4 winds up equaling 5 or 6. It is true that a large number of mergers and mega-acquisitions result in one-shot cost synergies - usually cost savings from the elimination of duplication with the merged enterprise - but seldom in an improved rate of revenue growth that is sustainable for the long run.
Compared with growing through a string of major acquisitions, good growth offers better returns over time, is less risky, and saves companies from crippling high debt and cash crises such as those faced by Vivendi and AOL Time Warner.
Vivendi acquired (among other things) Universal Studios, Blizzard Entertainment, and Def Jam. The problem? Vivendi overpaid and used debt to pay for most of those high-priced acquisitions. While the companies it bought were making money, Vivendi as a whole plunged into the red, after taking into account the repayment of interest on the billions of dollars it borrowed. The financial condition of the company became so acute that many wondered if it would survive.
Of course, not all acquisitions are bad. There are times when scale (i.e., your overall size in relation to competitors) matters and it can be impossible to compete against industry giants without it.
Phillips and Conoco were both relatively small fish in the energy market. They were both growing but they were at a huge competitive disadvantage versus ExxonMobil or BP. The Conoco-Phillips merger in 2002 (the new company is called ConocoPhillips) took out costs, and the integration of the two companies has been extremely successful. They have built on each other's strengths.
Similarly, there are times when an industry goes through a consolidation wave. At those moments, you either get bigger or find yourself at a disadvantage.
But, overall, organic growth remains the way to go. It results in a better price-earnings ratio so that when an industry undergoes consolidation, this strength provides a company with the upper hand in making appropriate acquisitions against its competition. The end result is a company with additional scale and scope and greater credibility to go to the next level.
All top-line growth is not created equal. History has shown that most mergers and acquisitions do little to help the long-term health and revenue growth of an organization. Growth that uses capital inefficiently is not the way to go.
How can you tell good growth from bad?
How good growth builds value
Growth of any kind increases revenues. Good growth not only increases revenues but correspondingly improves profits and is sustainable over time. It is primarily organic (internally) generated from the ongoing operations and business of the company and is based on differentiated products and services that meet new or previously unmet consumer needs.
Good growth is thus growth that is profitable, organic, differentiated, and sustainable (PODS). Good growth builds shareholder value over time. In contrast, bad growth destroys shareholder value.
Mergers and acquisitions, a primary example of bad growth, are often based on myopic visions of synergy that have no basis in the reality fo the market place. Instead of 4 plus 4 equaling 10, as promised when the deals are announced, more often than not 4 plus 4 winds up equaling 5 or 6. It is true that a large number of mergers and mega-acquisitions result in one-shot cost synergies - usually cost savings from the elimination of duplication with the merged enterprise - but seldom in an improved rate of revenue growth that is sustainable for the long run.
Compared with growing through a string of major acquisitions, good growth offers better returns over time, is less risky, and saves companies from crippling high debt and cash crises such as those faced by Vivendi and AOL Time Warner.
Vivendi acquired (among other things) Universal Studios, Blizzard Entertainment, and Def Jam. The problem? Vivendi overpaid and used debt to pay for most of those high-priced acquisitions. While the companies it bought were making money, Vivendi as a whole plunged into the red, after taking into account the repayment of interest on the billions of dollars it borrowed. The financial condition of the company became so acute that many wondered if it would survive.
Of course, not all acquisitions are bad. There are times when scale (i.e., your overall size in relation to competitors) matters and it can be impossible to compete against industry giants without it.
Phillips and Conoco were both relatively small fish in the energy market. They were both growing but they were at a huge competitive disadvantage versus ExxonMobil or BP. The Conoco-Phillips merger in 2002 (the new company is called ConocoPhillips) took out costs, and the integration of the two companies has been extremely successful. They have built on each other's strengths.
Similarly, there are times when an industry goes through a consolidation wave. At those moments, you either get bigger or find yourself at a disadvantage.
But, overall, organic growth remains the way to go. It results in a better price-earnings ratio so that when an industry undergoes consolidation, this strength provides a company with the upper hand in making appropriate acquisitions against its competition. The end result is a company with additional scale and scope and greater credibility to go to the next level.
Reading an Annual Report
Reading an Annual Report
Every company must publish an annual report to its shareholders as a matter of corporate law. The primary purpose of this report is to inform shareholders of the company's performance. As a legal requirement, the report usually contains a profit and loss account, a balance sheet, a cash-flow statement, a directors' report, and an auditors' report.
Many companies also provide a lot of other non-statutory information on their affairs, in the interests of general communication. In some cases, this may be little more than gloss, contrived to illustrate the company's wonderful achievement while remaining strangely silent on negative features.
What guarantee is there that an annual reprot is a true picture of a company's performance and not just propaganda put out by directors?
All annual reprots have to include a report from the auditors, independent accountants charged with investigating a company's financial affairs to ensure that the published figures give a true and fair view of performance. Their investigation cannot extend to examining every single transaction (impossible in a company of any size), so they use statistical sampling and other risk-based testing procedures to assess the quality of the company's systems as a basis for producing the annual report. They are not infallible, but they stand between the shareholders and the directors as a way of trying to ensure probity in the running of the company.
Understanding the main contents of an annual report.
Standard sections in annual reports can vary from country to country, but the following is the contents list of a medium-sized UK public company - let's call it X plc.
X world
Chairman's statement
Chief executive's view
Financial review
X in the community
Environment, health, and safety
Board of directors
Directors' report
Board reprot on remuneration
Director's responsibilities
Report of the auditors
Financial statements
Five-year record
Shareholder information.
Financial statements - are the main purpose of the annual report. In the example of X plc, these consist of:
Every company must publish an annual report to its shareholders as a matter of corporate law. The primary purpose of this report is to inform shareholders of the company's performance. As a legal requirement, the report usually contains a profit and loss account, a balance sheet, a cash-flow statement, a directors' report, and an auditors' report.
Many companies also provide a lot of other non-statutory information on their affairs, in the interests of general communication. In some cases, this may be little more than gloss, contrived to illustrate the company's wonderful achievement while remaining strangely silent on negative features.
What guarantee is there that an annual reprot is a true picture of a company's performance and not just propaganda put out by directors?
All annual reprots have to include a report from the auditors, independent accountants charged with investigating a company's financial affairs to ensure that the published figures give a true and fair view of performance. Their investigation cannot extend to examining every single transaction (impossible in a company of any size), so they use statistical sampling and other risk-based testing procedures to assess the quality of the company's systems as a basis for producing the annual report. They are not infallible, but they stand between the shareholders and the directors as a way of trying to ensure probity in the running of the company.
Understanding the main contents of an annual report.
Standard sections in annual reports can vary from country to country, but the following is the contents list of a medium-sized UK public company - let's call it X plc.
X world
Chairman's statement
Chief executive's view
Financial review
X in the community
Environment, health, and safety
Board of directors
Directors' report
Board reprot on remuneration
Director's responsibilities
Report of the auditors
Financial statements
Five-year record
Shareholder information.
Financial statements - are the main purpose of the annual report. In the example of X plc, these consist of:
- Consolidated profit and loss account. The profit and loss account of all the group as one.
- Consolidated and company balance sheets. The former is the group balance sheet and the latter shows the parent company alone.
- Consolidated cash-flow statement. A guide to how the money flowing in and out of the company was utilised.
- Notes to the accounts. These amplify numerous points contained in the figures and are usually critical for anyone wishing to study the accounts in detail.
Five-year record - shows a very abbreviated set of profit and loss and balance sheet figures for the current and previous four years. Some companies provide a ten-year record.
Choosing the right order in which to read the report
1. Start with the auditors' report.
Remember that this thin grey line of accountants is all that stands between the outside shareholder and the directors. To speed up matters, look at the final paragraph, their opinion. Does that statement give a true and fair view? If so, fine. If not, then it is said to be 'qualified'. Qualifications vary in depth from the disastrous, meaning that the company has got something seriously wrong, to perhaps a difference of opinion between the auditors and the board over some accounting matter. Most auditors' reports are unqualified, but, if there is a qualification present, you will have to judge how much the accounts can be relied upon as a measure of the company's performance.
2. Next, turn to the five/ten-year review
This is where you build up a mental picture of the company's financial history. Look at EPS - is it increasing, decreasing, fluctuating wildly? This gives you an idea of how it has been doing over the period. Look at dividend, if any, and consider their patern. Do they follow EPS or, as is likely, are they showing a smoother picture? Look at company debt, if the information is there, and compare it with shareholders' funds. How is it changing over the years?
Generally try to build up a view as to whether the company is doing better, worse, or perhaps has no particular pattern over the period. Depending on your reasons for reading the report, a set of prejudices will have begun to develop from this historical picture. If it shows a declining financial situation, this could be a good thing from some points of view - if you wish to acquire the company, for example. If you are an employee though, it would not be very encouraging. So, reading reports depends to some extent upon which angle you are coming from.
3. Now read the chairman's and directors' comments
These will give a deeper feel for the company's business, over and above the raw numerical data. Try to exercise a degree of scepticism in some areas, because it is natural for directors to attempt to play up the good points and play down the less good ones.
4. Get to the heart of the matter (the financial statements and the huge number of notes that accompany them)
The kernel of the report comprises the financial sttements and the huge number of notes that accompany them. A lot of it is in highly technical accounting terminology, but it gives you the intimate financial detail on the year. Never ignore the notes - they are critical. In fact some investment analysis read the report from the back, because the notes are so important.
Notes have increased dramatically over the years as new legal and accounting standards have been introduced, primarily to enforce standardisation so that accounts are more comparable, but also to avoid 'creative accounting', whereby some companies have tried to conceal (legitimately) financial undesirables.
5. Relax with the glossy stuff
Having absorbed all that really matters, settle back and read the glossy bits that tell you how wonderful the company is. Just remember to exercise a mild degree of cynicism here - this is the least important, though no doubt the most visually attractive, part of the annual reprot. The real picture of the company is the numbers, not the photo of the bloke in the hard hat standing on an oil rig!
COMMON MISTAKES
Paying too much attention to pretty pictures and directors' comments and too little to the accounting data.
This can give a false view of how well, or badly, the company is doing. Understandably, a large number of people have difficulty in comprehending the figures. But if you want to appreciate annual reports properly, then learning to read accounts is essential.
Some cynics among investment analysts have even expressed the view that there is an adverse relationship between the number of glossy pages in an annual report and the company's actual performance. Maybe that's a little harsh but ... there might be something in it.
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