Monday, November 4, 2013

Last Words


I hit "publish" for my first post on this site on November 1, 2010.  Over the last three years, we have covered a lot of ground exploring the topic of investing.  This is the last Wall Street Smarts blog post, and it seems appropriate to end with final thoughts from several of the authors we have studied.

Al Frank, in Al Frank's New Prudent Speculator, had this final advice for his readers:

If you feel overwhelmed by information overload, step back and consider what is being asked of you, and what you must ask of yourself, in order to speculate successfully in the stock market.  Basically, all you need to do is buy some undervalued shares of several corporations' stock.  With a few hours of self-training, you can select undervalued stocks as well as the next person, if not better.  Spending a few more hours to understand the long-term positive nature of the market, the average upward trend of 10 percent or more for many years, within which are selloffs and rallies, you will be armed intellectually to cope with stock and market price fluctuations.

Ben Graham ended The Intelligent Investor with these parting words:

We are not going to end with J.J. Raskob's slogan that we made fun of at the beginning: "Everybody can be rich."  But interesting possibilities abound on the financial scene, and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three-ring circus.  Excitement is guaranteed.

Burton Malkiel concluded with an analogy for investing in A Random Walk Down Wall Street:

Investing is a bit like lovemaking.  Ultimately, it is really an art requiring a certain talent and the presence of a mysterious force called luck.  Indeed, luck may be 99 percent responsible for the success of the very few people who have beaten the averages......The game of investing is like lovemaking in another important respect, too.  It's much too much fun to give up.

Peter Lynch listed his 20 Golden Rules for investing at the conclusion of Beating the Street, and the following is one of them: 

Owning stocks is like having children -- don't get involved with more than you can handle.  The part-time stockpicker probably has time to follow 8 -- 12 companies, and to buy and sell shares as conditions warrant.  There don't have to be more than 5 companies in the portfolio at any one time.

Jesse Livermore may have summed it up best in How To Trade In Stocks: 

There is nothing new on Wall Street or in stock speculation.  What has happened in the past will happen again, and again, and again.  This is because human nature does not change, and it is human emotion, solidly built into human nature, that always gets in the way of human intelligence.  Of this I am sure. 

Thank you for reading.

Monday, October 28, 2013

Enough is Enough


Throughout this blog, I have repeatedly pointed out that an individual must set a goal as the first step in any investment plan.  Why are you investing?  What is the purpose of the money you hope to make with the investment?  Saving for a rainy day or for a child's college tuition each require a different investment strategy.  The strategy for both of them will differ from the strategy for investing a retirement portfolio.  The Cat in Lewis Carroll's classic Alice's Adventures in Wonderland gave Alice the following directions: 

"Would you tell me, please, which way I ought to go from here?"
"That depends a good deal on where you want to go to," said the Cat. 

Ben Graham advised individuals that they should not invest to "beat the market."  Rather, the investor should focus on achieving his or her specific investment goal. You may recall the TV ads for an investment firm which promised to help you reach your "retirement number" (whatever that means).  They never explained what a person should do if and when they reach their number?

Al Frank, author of Al Frank's New Prudent Speculator quoted from the fourth century book on Chinese philosophy, Tao Te Ching, when he gave the following advice to successful investors:

In verse 9 we are told, "Going to extremes is never best...The way to success is this: having achieved your goal, be satisfied not to go further.  For this is the way Nature operates." *

In his book Where Are the Customers' Yachts? or A Good Hard Look at Wall Street, Fred Schwed, Jr. asked the following questions:

If a man makes thirty million dollars, and then loses the entire thirty million and some more to boot, would you say that such a man is quite bright in the head? I should like to carry this inquiry into intelligence a little further and ask a second question:  what do you think of the mentality of a man who goes down to Wall Street with very little and wins, by speculation, thirty millions, none of which he has as yet lost?  My own considered opinion is that he too is pretty loony.  In order to make his second unimportant million he had to risk his first precious million?  Obviously he did so, and did it time and again.  That he happens to have been successful each time does not really change the picture.  What could he have been thinking of each time he took all those risks?  The very contemplation of it makes my bourgeois soul shudder. **  (Author's emphasis in bold) 

If you have run through the ribbon at the end of a foot race, stop running.  If you keep going after crossing the finish line, all you can do is hurt yourself.  Some folks still believe the mantra from the 1990s that "More is better."  If you really think about it, more is just more and enough is enough.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

**  Excerpts from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright © 1940, republished by John Wiley & Sons, Inc, pages 152-154

Comments are always welcome.

Monday, October 21, 2013

Retirement - Your Second First Job (5)


In recent posts, I have touched on risk tolerance.  Your risk tolerance, whether you have measured it or not, is the basis of your investing style.  Your personal risk tolerance level will define your ability to withstand the basic investing emotions: fear and greed.  These inner pressures affect most investors as their portfolios move up or down with the market.  Justin Mamis,  a famous technical investor and author, felt that your view of risk is formed, in part, in your childhood.  In his 1991 book The Nature of Risk, Stock Market Survival and the Meaning of Life, he discussed this phenomenon as follows: 

The first word parents want a baby to understand and respond to is not Mama or Daddy--it's No.  How is anyone going to learn to venture, to take a risk, when "No" resounds?  Parents and baby may exchange smiles, but as soon as the baby wants to take a risk--that is, do something venturesome--the infant hears: "Don't touch that," Watch out," "Be careful."  From infancy's earliest days, taking a risk becomes a negative concept.  "Don't" becomes a family motto. An infant knows no risk; all is ahead.  Parents know all is risk, and try to protect.  The child learns what the parents teach, and a world that starts out full of possibilities becomes full of limits and danger.

Americans are often described as basically optimistic, when in reality it is that they are perpetually hopeful.  The market seems to represent hope itself.  And yet, among professionals, even those who function on the stock exchange floor, a frequently heard stock market expression is, "No one ever said it was going to be easy."   It never can be easy because the rule of the market is that you have to act before you know enough.  Because it is a process there is no one moment or single point, at which one can make an obvious "sure" decision. 

Thus it is not just information that becomes the key to taking a market risk; it is also necessary to understand such information in terms of our relationship to that knowledge.  "What do we know?"   "How do we know it?" and "What is our reaction to that information?" - as well as "What do we need/wish/want to know?" - are all questions that affect the decisions we make every day.  When a decision is required, the way we take information in, and how we use it, affects that decision.  Our self's style goes back deep into childhood.  The manner in which we let information in, our ability to understand it, to deal with it, and perhaps even distort it, all start with who we are, as developed from the moment of beginning, on our hands and knees, to explore the world.

Thus the risk we are about to take via our next decision is not a simple choice of "do it or not" or "yes or no."  Before deciding, we need to know why what we know is never enough, a question that, in turn, leads to what kind of information do we believe or trust? and is it us or the market?  But we must remember that there are times when the market, or life itself, is incoherent, unclear, and/or conflicting: times when it isn't us, it's it.  The risk can never be cured by knowing enough.

But when information is insufficient we need the trust and belief in ourselves, and the inner acceptance that we'll be okay anyhow.  We need the discipline to accept whatever is available.  We need the experience to understand all the ifs, ands, and buts, and yet still confront the risk and make the decision.  Setting ourselves free from the quest for information, oddly enough, is what reduces risk even as it appears from the freedom itself that risk is being scarily increased. 

Keep all of this in mind as you approach your job of retirement investing.  Enjoy your retirement.  Now get to work!

Excerpts from The Nature of Risk, Stock Market Survival and the Meaning of Life by Justin Mamis, copyright 1991 are used by permission of Mr. Mamis and Fraser Publishing Company.

Comments are always welcome.  

Monday, October 14, 2013

Retirement - Your Second First Job (4)


You have been saving, investing and growing your retirement portfolio during your working career.  As a retiree, you should now think like the British and focus on income.  The amount of income you need in retirement is dictated by your desired lifestyle.  How much will you need in order to do what you want for the remainder of your life?  You should start with a budget and see how your retirement income matches how you want to live.  If you have enough to "live the dream", great!  If your income falls short and you do not want to continue to work in some capacity, you have two choices: change your lifestyle or change your income level.  You need to decide how you will handle your retirement assets to support your retirement and not run out of money.  Answering that key question is your Second First Job. 

In the 1990s, William Bengen, a certified financial planner, studied this issue.  He made three assumptions, i.e., the portfolio was in an Individual Retirement Account (IRA) or other tax-deferred account; the retiree did not intend to leave any inheritance, and the savings had to last for thirty years.  Based on those premises, he determined that a retiree would not outlive his or her savings if withdrawals were limited to 4% of the account valued annually.

As with all other financial research and rules, not everyone agrees with Bengen's 4% rule.  Some look to the condition of the market at the time of retirement as a factor.  If the market is down or in danger of decline in the near future when you leave the work force, 4% may be too much to take out early in retirement.  If the market is rising and a retiree has a high risk tolerance (severe stock market fluctuations do not bother the individual), the rate might be set higher than 4%.  Like asset allocation rules, deciding on a rate of withdrawal is not a one time decision.  Both asset allocation and withdrawal rates should be revisited annually.  You might consider the 4% rule as a starting point for your first year of retirement.

Let's review your $800,000 combined hypothetical and cash portfolio from the last post.  As you may recall, we arrived at a notional value for your Social Security benefits of $400,000 (based on a 3% interest rate generating a $12,000 annual payment) and a cash IRA of $400,000.  The cash IRA was divided into debt securities worth $120,000 and the balance, $280,000, was invested in stocks or mutual funds.  Counting the Social Security payments as a debt security gives you a 65/35 percent allocation between your notional and actual debt assets and your equity assets (the age based allocation rule).  Using the 4% rule, this means that you can withdraw 4% of your $800,000 portfolio ($32,000) annually with the goal of your assets lasting 30 more years.  You are receiving $12,000, which is 3% of the $400,000 hypothetical value of your Social Security account.  In order to average 4%, this means that you might withdraw up to 5% of your $400,000 cash IRA.  Your retirement income of $32,000 would consist of the Social Security payments of $12,000 plus $20,000 (5% of $400,000) from your cash IRA.  Obviously, you would want to first withdraw the interest and dividends generated in your IRA to preserve principal.  If that is not enough, the balance would have to come from your principal.

The hope is that your equity holdings will appreciate at a rate greater than your withdrawal rate so your portfolio either remains the same or increases.  Another way to handle this might be to take out only the income generated by your portfolio.  In all probability, you would be taking out less than 4% from the total portfolio.  Conversely, you could increase your withdrawal rate to maintain your standard of living.  Keep in mind that with a higher withdrawal rate, your savings may not last as long as needed.  You might allocate more assets to equities for a potentially higher yearly return, but this would expose your portfolio to a greater degree of market risk.  To sustain a desired life style, you might make a greater equity allocation, a higher withdrawal rate or both.  You would have to decide if you can comfortably accept greater market risk.  What is your risk tolerance?

Decisions, decisions: yes, this is your Second First Job.

Comments are always welcome.

Monday, October 7, 2013

Retirement - Your Second First Job (3)


More on asset allocation.  When considering their portfolio's division between equity and debt, many retirees look at their retirement savings as the only assets which must be considered in arriving at their debt and equity percentages.  Many individuals do not look upon their monthly Social Security check as a retirement asset, but it most certainly is.  I believe your Social Security benefit should play a part in formulating your portfolio allocation.

AARP, formerly American Association of Retired Persons, recently reported that the average 401 (k) balance for individuals in the 55+ age category had reached $255,000.  Let's assume, for the sake of discussion, that by the age of 65, the 401 (k) balance of a person who is retiring today has reached $400,000.  This sum constitutes his or her entire retirement savings.  The individual retires and transfers that money into an Individual Retirement Account (IRA).  Now, how to invest that money?  Following the traditional age based allocation rule, 65% of the portfolio ($260,000) would be invested in debt securities, such as US Treasuries, state or municipal obligations and corporate bonds.  The balance, $140,000, goes into publicly traded stocks or mutual funds, i.e., equity securities.  

However, if you consider your Social Security check as a monthly interest payment you receive on a government debt obligation that you own, those dollar allocations change.  The first step is to find the interest rate on a one year US Treasury obligation.  This information is available every day in the Wall Street Journal.  Assume you receive a monthly benefit of $1,000 from Social Security - $12,000 per year.  Assume further that the current interest rate on a one year Treasury is 3% per annum.  Your hypothetical treasury obligation generating a 3% return of $12,000 would have a notional principal of $400,000 ($400,000 x 3% = $12,000).  In effect, you may now consider that you have an $800,000 retirement portfolio consisting of $400,000 in a hypothetical one year 3% treasury obligation and your actual $400,000 cash IRA.  Under your age based allocation, your total portfolio of $800,000 (hypothetical plus cash) should then contain $520,000 of debt securities and $280,000 of equity securities.  Given the $400,000 notional value of your Social Security "investment", your cash IRA could then be divided into $120,000 of interest bearing securities and $280,000 of stocks or mutual funds.  Under this scenario, your IRA, on a cash basis, could contain twice the equity securities that it would if you did not include the Social Security payment in your allocation decision.  Equities have proven in the past to be a much better defense against inflation than debt securities.

Once a year, maybe each January, you should recheck the going interest rate for one year Treasuries, redetermine the present value of your Social Security "investment" based on your monthly checks (which are increased for inflation) and reallocate between debt and equity.  As stated in an earlier post, asset allocation is not a one time decision.  It should be revisited at least annually.  The allocation also changes as you age, resulting in more debt and less equity.  The age based reallocation need not be precise, year by year.  During your 60s, you might allocate 65% and when you are in your 70s, the debt percentage of the portfolio goes up accordingly. 

The age based allocation has been touted for many years by financial advisers; however, with the extended longevity expected for today's retirees, it may be necessary to consider an allocation which reflects a larger portion of equity in your portfolio than called for under the age formula.  This decision depends, however, on your capacity for risk tolerance.  Like Mr. Morgan's troubled friend, do your stocks or mutual funds keep you up at night?

Comments are always welcome.

Monday, September 30, 2013

Retirement - Your Second First Job (2)

The old rule of thumb regarding asset allocation calls for a portfolio to consist of a percentage of debt securities equal to your age and the balance invested in equities.  At the age of 65, you would have 35% of your retirement funds in equities under the rule.  As with all rules of thumb, they should not be followed blindly.  Setting your allocation percentages is not a "one and done" decision.  You should expect to change your allocation over time as circumstances dictate.There are a couple of other factors to keep in mind.  

A retiree must take the present state of the market into account in establishing his or her allocation between debt and equity securities.  Is the Market rising, declining or moving sideways?  Some consideration of the market is necessary when deciding how to allocate your portfolio.  As the Market changes, it is possible that your asset allocation must follow in some fashion.  How that occurs must be based in part on your investment mentality.

More important than the state of the market is your mental state.  You must honestly determine your risk tolerance.  Warren Buffett said that if you could not tolerate a decline of 50% in your portfolio's value without selling out your position, you should probably not invest in individual stocks.  Over your remaining years, the Market will rise and fall several times, carrying a portfolio of common stocks with it.  If a drop of 50% in value will likely lead you to panic selling, your equity allocation should be smaller than that of an investor who is psychologically able to ride out the decline.  It is said that someone once told J.P. Morgan that frequent changes in the value of the individual's  portfolio were causing him to lose sleep and asked what he should do about it.  Morgan's famous reply was "sell down until you can sleep."  Although anecdotal, the advice may be a good way to decide how much you keep in equities.  Retirement is supposed to be relaxing, not nerve wracking.

The most frequent question asked by the soon to be retired individual focuses on how large a portfolio he or she needs.  Remember the TV ads with the tag line, "What's your number?"  Fred Schwed, in his book Where Are the Customers' Yachts? or A Good Hard Look At Wall Street pointed out an interesting difference between American and British investors as follows:

The British, as a race, have been engaged with the problems of capital investment for a longer period than we have, and accordingly have reached a greater maturity regarding it.  Have you noticed that when you ask a Britisher about a man's wealth you get an answer quite different from that an American gives you?  The American says, "I wouldn't be surprised if he's worth close to a million dollars."  The Englishman says, "I fancy he has five thousand pounds a year."  The Englishman's habitual way of speaking and thinking about wealth is of course much closer to the nub of the matter.  A man's true wealth is his income, not his bank balance.

The retiree's goal is to manage his or her portfolio in such a fashion that there is enough income to sustain a desired life style.  It is up to the individual to do this; the Second First Job.  We will continue to look at this issue in the next post.

Excerpt from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright 1940, republished by John Wiley & Sons, Inc, page 190.

Comments are always welcome.


Monday, September 23, 2013

Retirement - Your Second First Job (1)


Congratulations!!  You made it to retirement.  As the title of this post implies, you now have a new job.  During your working career, the majority of your retirement savings have, in all likelihood, been managed by a pension administrator or a 401K plan provider.  You may have picked the investment options or opted for the portfolio suggested by the plan provider.  In other words, while you were busy with your career, someone else was making most of the investment decisions for your retirement portfolio.  Like many others, you will probably choose to receive a lump sum transfer of those retirement proceeds into an Individual Retirement Account (IRA) after you have wrapped up your last days of work.  

You are now sitting at the kitchen table on that first morning of your "golden years" wondering where all the time went.  At some point you will begin to wonder about how much money you have and will you outlive your savings.  Your new job, what I call your Second First Job, is to make sure your money is there for you through the remaining time you have, hopefully a few decades.

When Social Security was created in 1935, the retirement age (when benefits could be received) was set at 65.  There were approximately 7.8 million people that age when it was established. Today, a 65 year old enjoying reasonably good health can expect to live at least an additional twenty plus years.  Most women have even more time left.  Remember, these are averages, and when trying to calculate your remaining life expectancy, you need to factor in family history and your life style. For our purposes, let's assume that, as a 65 year old man or woman, you have another twenty years of life ahead of you.  Your money has to last that long if you are single.  A couple must make the expectancy calculation based on the prospects for the survivor.  Here is a link to the Social Security website with a life expectancy calculator.  Another issue to consider is whether you want to leave a legacy for your children, but that is beyond the scope of this post.

The truly organized individual has probably lived within a budget for many years.  Many of us have not, thinking that there is always going to be another paycheck.  The game has now changed.  There will be no more paychecks, unless you intend to keep working in some capacity.  If you are not going to continue full time employment, the size of the paycheck will shrink.  It is now time for a budget to figure out what you can spend and where that money will come from for the duration of your life.  Once a budget is established, your Second First Job begins: how to fund that budget.

A typical retiree will have three sources of income:  Social Security, proceeds from an employer's retirement benefit program (pension or 401K plan) and personal retirement savings, usually an Individual Retirement Account (IRA).

As mentioned in an earlier post, there are three certainties in this life: death, taxes and inflation.  Of the three, inflation is a retiree's worst financial enemy. The annual inflation rate is low these days, but anyone 65 or older will remember the late 70s and early 80s when annual inflation rates were double digits.  There is no reason to believe that this could not happen again in the next twenty or so years.  Even low inflation rates, over time, will significantly erode the purchasing power of a retiree's income.

We will continue exploring this topic in the next post.

Comments are always welcome.

Monday, September 16, 2013

Einstein's Eighth Wonder


One of Albert Einstein's famous quotes dealt with finance, not physics.  He said, "Compound Interest is the eighth wonder of the world.  He who understands it, earns it...he who doesn't...pays it."

Compound interest is interest on a debt which includes any previously unpaid interest as principal.  In other words, interest on interest.  The classic example is the credit card.  Assume you have a balance of $1,000 on your card which accrues interest at 12% per annum.  Therefore, the simple interest on the debt is $120 per year or $10 per month.  If you make a payment of $5 one month, the unpaid $5 of accrued interest becomes part of the principal the next month.  Next month, your new balance is $1,005 on which the interest rate is again calculated.  On a larger scale, think of America's national debt.  One of its bonds comes due.  To raise the cash to pay off the bond, the federal government issues a new bond which includes the principal of the old bond plus the accrued interest.  

Compounding also works in calculating returns on investments using the mathematical Rule of 72.  It states that you can determine your annual rate of return on an investment if you know how many years it takes for the investment to double.  If you divide the number 72 by the number of years, the result is the rate of return.  Conversely, if you know your rate of return on the investment, you can determine how long it will take for your investment to double.  Using the same formula, you divide 72 by your rate of return and the result is the approximate number of years it will take for the investment to increase 100%.

All Wall Street professionals advise people to start investing as early as possible, length of time being one of the factors in growing a portfolio.  The sooner an individual starts investing, the longer for the portfolio to grow.  One simple example (and a suggestion to parents and grandparents).  Assume you open an Individual Retirement Account for your child with $2,000 per year starting when he or she is 14 years old.  You invest an additional $2,000 each year for four years for a total of $8,000.  Neither you nor your child make any further deposits into the account.  Assume that amount is invested in an S&P 500 Index fund, which has, despite yearly ups and downs, grown at an average of 8% per annum over the last several decades.  If the return is 8% per annum, then the Rule of 72 states that the amount will double every nine years.  At that rate of return, the $8,000 will have doubled by the time he or she reaches 27.  The $16,000 will become $32,000 by his or her 36th birthday.  When your adult child celebrates his or her 45th birthday, the IRA will be worth $64,000.  That amount will have grown to $128,000 by age 54.  By 65, with one more double, the IRA will be worth $256,000.  And this is without putting one more penny into the account!  With continued $2,000 investments over and above the initial $8,000 (that's his or her job), the IRA should grow to well over $1 million dollars by the time that former 14 year old reaches retirement.

Compounding is an investor's best friend and a debtor's worst enemy.

Comments are always welcome.

Monday, September 9, 2013

Does My Money Need A Passport? (2)


It has been reported that 54% of investment opportunities in the world, based on capitalization, are located in countries other than the US.  Of the ten largest car manufacturers in the world, only three of them are American.  Similarly, seven of the ten largest companies engaged in telecommunications are in other countries.  Half of the ten largest household products manufacturers are located outside the US, but their products are available here.  The vast majority of mining operations are found overseas.

If an individual investor has decided that a portion of his or her portfolio should be invested in foreign stocks, there are several alternatives available.  International investing can be accomplished with mutual funds, exchange traded funds (ETFs), direct investing in a foreign market and American Depository Receipts (ADRs).  The costs, expenses and difficulties of directly buying a stock in a foreign market put this strategy out of the reach of most individuals.

Mutual funds and ETFs come in two varieties.  A "Global Fund" invests in companies throughout the world.  This means that a portion of the fund will hold stocks in the investor's own country.  If the fund is labeled "International" or "Foreign", there will be no stocks from the investor's country in the portfolio.   

Some mutual funds and ETFs invest only in developed countries, such as England, France, Japan and Germany.  Others focus on emerging markets, less developed countries with prospects for increased rates of growth.  In 2003, the investment firm Goldman Sachs identified Brazil, Russia, India and China as the four emerging markets with the greatest potential to become dominant in the global economy.  The countries are collectively referred to by the acronym BRICGoldman projected that China and India would together lead the world in manufacturing.  Russia and Brazil would become leading suppliers of raw materials. These countries are, obviously, not a political bloc.  However, if they worked together financially, they could become a very powerful economic force in the global economy by 2050BRIC could surpass today's economic powers, including the US.

The investment firm JP Morgan introduced ADRs to American investors in 1927.  This was one of the first ways to invest internationally in this country.  An investment firm purchases and holds large amounts of foreign stocks in safekeeping.  It then sells shares or receipts in that portfolio (just like a mutual fund) to US investors.  Those receipts are traded on Wall Street in US dollars, just like US stocks.  These days, some foreign companies cut out the middle man, the investment firm sponsoring the ADRs, and issue their shares directly into the US markets.

International investing brings added risks.  Since foreign companies are not necessarily subject to the disclosure requirements imposed on US companies by the Securities & Exchange Commission, financial information can be difficult to get and may not be entirely reliable.  Political instability in emerging countries could detrimentally affect companies in those countries.  There are many examples of companies being nationalized by foreign governments.  Currency exchange rates fluctuate daily, which can impact the US dollar value of an investment.  Inflation rates vary from country to country and could drive down the value of a foreign stock held by an American investor even though the actual business of the company has not changed.

One last thing to keep in mind.  US companies are increasingly becoming global in their own right.  Approximately half of the companies on the S&P 500 Index break out global sales in their financial reports.  Global revenues of the reporting companies represented 46% of their total revenues.  Therefore, almost 25% of all S&P 500 revenues came from foreign countries.  If you assume that the same percentages hold true for the companies which do not break out their foreign business, it could be that almost 50% of the revenue of the S&P 500 companies is international.  If this is the case, an individual investor might safely invest "internationally" by simply buying an S&P 500 Index mutual fund or ETF.

Comments are always welcome.

Monday, September 2, 2013

Does My Money Need A Passport? (1)


Once upon a time Corporate America was top dog and paid little attention to the industries of other countries and their products.  Then change started to happen in the US.  People began driving Volkswagens and Toyotas instead of Chevys and Oldsmobiles.  Some bikers bought Honda motorcycles instead of HarleysSony televisions became market leaders, pushing aside Zenith and Magnavox.  Pasta actually came from Italy.  You could find excellent wines from South America at your local liquor store at a reasonable price.  Chocolate lovers traded their Baby Ruth bars for Nestle Crunch.  Interestingly, Baby Ruth bars are now made by Nestle.  Globalization hit with a vengeance and continues to this day.

One of the earliest pioneers in international investing was Sir John Templeton.  Born in Tennessee, Templeton ultimately moved to Nassau where he became a naturalized British citizen.  He was knighted for his work in several fields, including philanthropy.  He formed the Templeton World Fund in 1978, one of the first mutual funds to invest on a global basis.  Templeton had a value/contrarian investment strategy.  Unlike most of his contemporaries, however, he would look for low priced companies beyond America's shores.  He is considered one of the top international investors in the history of Wall Street.

Peter Lynch managed the Fidelity Magellan Fund  for thirteen years with an astounding average return of 29% per annum.  A little known fact is that a portion of that return was attributable to his foreign investments.  In his book, Beating the Street, he revealed what he called his "adventures abroad" as follows:

With the exception of John Templeton, I was the first domestic fund manager to invest heavily in foreign stocks.  Templeton's fund was a global version of Magellan.  Whereas I might have 10 - 20 percent of the money invested in foreign stocks, Templeton invested most of his money abroad.

With the pile of cash I now had to invest, I was almost forced to turn to foreign stocks, particularly in Europe.  With a big fund, I needed to find big companies that would make big moves, and Europe has a higher percentage of big companies than we do. 

So, what does this mean for the individual investor?  Investment possibilities are now global.  Many Wall Street professionals advise their clients to diversify a portion of their portfolios with the stocks of foreign companies. 

We will explore the world of global investing further in the next post. 

Excerpts from Beating the Market by Peter Lynch with John Rothchild, copyright 1993, published by Simon & Schuster, pages 122-123

Comments are always welcome.

Monday, August 26, 2013

Thank You, Mr. Dow


We have looked at equity mutual funds and their constant struggle to beat the stock market.  What, exactly, is that market?  The short answer would be that the market can be whatever you want it to be.  Stock markets are composed of thousands of publicly traded companies and can be measured in various ways.  The goal of a stock market index is to compile a group of stocks that reflect the general movement of all of the stocks traded in a particular market.  Today, the three most recognizable stock market indices are the S&P 500, the NASDAQ and the grandaddy of them all, the Dow Jones Industrial Average (DJIA).  When people ask, "How did the market do?", they generally expect to hear what happened to the DJIA that day.

Charles Dow, Edward Jones and Charles Bergstresser formed Dow Jones & Company in 1882.  Their original publication was the Customer's Afternoon Letter, which later became the Wall Street Journal.  In 1884, Dow published his first stock average, which highlighted growth stocks of the time.  His first benchmark average included nine railroads (probably seen as high tech then), a steamship company and Western Union.  In May, 1896 Dow converted these original stocks into his Transportation Average and created his first Industrial Average, based on twelve companies.  One of the original industrial companies still remains as part of the average to this day, General Electric, which was organized by Thomas Edison in 1890.  Although the companies changed over the years, the DJIA included only twelve stocks until 1916 when it was increased to twenty companies.  The number increased to thirty in January, 1929, where it has stayed ever since.  The 1929 average included some companies still recognized today, but no longer in the average, such as General Motors, Goodrich, Sears Roebuck, Westinghouse and US Steel.

Originally, the average was calculated each day by adding up the stock prices of the Dow components and then dividing that by the number of stocks in the average.  This provided an accurate average only so long as none of the companies announced a stock split or issued a stock dividend to it shareholders.  As that occurred over the years, the divisor had to be recalculated.  The Dow divisor today is 0.14452124.  The DJIA is a price-weighted method of calculation.  Most of the other stock indexes today are based on the weighted market capitalization of the component companies.

In January, 1900 the  smaller average (12 stocks) was 68.13.  It took until 1920 for the DJIA to first break 100.  It peaked at 307.01 in January,1929 (then thirty stocks) before plunging after the stock market crash and subsequent depression to a low of 41.22 in 1932.  The average remained in the 100s from 1934 until December, 1949 when it closed over 200.  It did not break 1,000 until 1972, but seesawed thereafter until the beginning of the roughly eighteen year bull market in 1982.  The Dow went on to surpass 2,000 in 1987 and 3,000 in 1991.  The bull market continued with the DJIA breaking 4,000 in February, 1995 and 5,000 nine months later.  It went above 6,000 in 1996 and crossed the 11,000 mark in 1999.  The subsequent market drop, starting in 2001, lowered the average and it did not recover to its previous high until 2006.  Subsequent market increases and falls continued until May, 2013 when the DJIA crossed 15,000.

The Dow's reaching each benchmark of 1,000 points piques the interest of the public and garners media attention.  However, most experienced investors recognize that it is just that, interesting but not really significant from a financial standpoint.

Comments are always welcome.

Monday, August 19, 2013

Index Funds: If You Can't Beat The Market, Buy It


Professor Burton G. Malkiel, the famous proponent of the Random Walk theory, wrote an article in the May 29, 2013 Wall Street Journal titled, "You're Paying Too Much For Investment Help."  In the article he analyzed the costs and expenses charged by actively managed mutual funds and concluded that investors looking for a better return should focus on index funds instead.  He advised investors that while they can not control the market, they can control their cost to invest in it.

An index fund is essentially a portfolio of stocks which make up an index such as the S&P 500 or the thirty stocks in the Dow Jones Average or some other index of market assets, such as the Wilshire 5,000 Total Stock Market Index.  Index funds were first offered only to institutional investors in the early 1970s.  John Bogle's company, Vanguard, was the first to offer this form of fund to individual investors, the Vanguard S&P 500 Index Fund.  Once the index of stocks has been duplicated, trading is minimal since the fund advisers only need to rebalance the fund depending on what happens to the stocks comprising the index.  This provides the individual investor with the opportunity to buy a particular market with a low expense ratio.

Given this background, an individual could rightfully ask whether it matters which particular index fund he or she purchases if they track the same index.  Won't two S&P 500 Index funds produce the same results?  Sadly, the answer is "not necessarily."

Although the costs and expenses of an index fund are lower than actively managed funds, they still exist.  The operation of an index fund involves the same functions as an active fund (see my earlier post).  A larger fund can spread those costs over more investors.  Another drag on returns is the efficiency with which a fund can buy and sell stocks, the execution/trading costs it incurs.  Some smaller funds do not actually buy all of the stocks in an index.  It is just too expensive.  They try to duplicate the index by the process of sampling.  Sampling means that the fund creates a portfolio of stocks with the same characteristics as the total index.  Keep in mind that a sample will not provide the exact same return as the total index.  Hopefully, the costs and expenses saved by sampling are passed along to the fund's shareholders to make up for the lower return they will receive.

To see how close the return of an index fund tracks the return of the actual index, the investor must look at the R-squared rating of the fund.  R-squared is a mathematical measure of the difference in returns.  If the fund's return is identical to that of the index, the R-squared is 100%.  Virtually all funds fall short due to their costs of operation and execution.  Aswath Damodaran, in his book, Investment Philosophies, suggests that investors check Morningstar rankings of index funds to find out what their R-squared percentage is.   He advised investors, "As an investor looking at index funds on a specific index, you want to pick the fund with the lowest expenses and the highest R squared."

Investment Management is a collection of chapters written by investment professionals and edited by Peter L. Bernstein and Aswath Damodaran.  The advantages of index funds are described in the book as follows:

First, no information costs or analyst expenses are associated with running these funds, and transaction costs associated with trading are low.  Most index funds have turnover ratios of less than 5 percent, indicating that the total dollar volume of trading was less than 5 percent of the market values of the funds.  Transaction costs for these funds are 0.20 percent to 0.50 percent, or less than one-third the costs of most actively managed funds.  Second, the index funds' reticence to trade reduces the tax liabilities that they create for investors.  In an typical actively managed fund, the high turnover ratios create capital gains and tax liabilities even for those investors who buy and hold these funds.*

*Excerpt from Investment Management, edited by Peter L. Bernstein and Aswath Damodaran, copyright 1998, published by John Wiley & Sons, Inc., page 228.

Comments are always welcome.

Monday, August 12, 2013

Mutual Funds: Behind The Curtain (3)


John C. Bogle, the founder of The Vanguard Group, decried some investors' habit of only focusing on past performance when looking for a mutual fund.  He labeled it, "a flawed and counterproductive way to select a mutual fund."  He recommended looking at a fund's structural characteristics as well as performance in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor.  He suggests every investor check the following when looking for a suitable mutual fund.

Three of the most obvious characteristics are the size of a fund, its age and the tenure of the managers.  Bogle suggests investing in funds in existence for at least five years which have more than $50 million and less than $1 billion in assets.  you should also look to see how long the portfolio manager or the team of managers have been running the fund.  Assume that the past performance of a fund is due for a change if the managers who generated those returns are no longer in charge.  Another characteristic to consider is the cost of owning shares in a fund.  Are there sales charges when you buy and redemption charges when you sell?  Search for "no load" funds.  Funds are required to publish their expense ratios, so an investor should compare them when deciding between a number of funds.  The lower the ratio, the more money remains for the investor.

Of primary importance is the fund's portfolio of stocks.  The investor must learn a fund's cash position, since all funds have to keep some cash reserves.  As Bogle points out, it makes no sense to pay advisory fees to someone just to hold cash.  Avoid funds with cash positions of more than 5% of total assets.  Portfolio concentration is another area to investigate.  The investor should look at the top ten stock holdings of a fund and determine what percentage of the total portfolio these ten holdings represent.  If the top ten stocks comprise more than 50% of the total holdings, Bogle feels that there is a good possibility of the fund providing extraordinary performance.  Unfortunately, that performance can be either positive or negative.  Also check to see if the fund is really a disguised "sector" fund, with a concentration in only one or two industries.  Another important characteristic is the market capitalization of the stocks in the portfolio.  Bogle points out that an average market cap of $5 billion to $8 billion is what you will find in a typical stock fund.

Since taxes and expenses must be considered, the investor should also confirm a fund's turnover rate.  How often are the securities in a fund purchased and sold?  A fund devoted to a long term strategy will have a lower turn over rate than a fund devoted to quick trading profits.  The more trading, the higher the costs and the larger the tax bill for capital gains.

In short, investing in a mutual fund requires as much research and study by an investor as when he or she is purchasing an individual stock.  If an individual must work just as hard for either type of investment, is there an easier way?

The answer is yes.  Look to index mutual funds.  We will consider these in the next post.

Comments are always welcome.


Monday, August 5, 2013

Mutual Funds: Behind The Curtain (2)

In addition to the drag on annual returns from fees and expenses, mutual fund returns must also be reduced by the income taxes generated during the fund's tax year.  Under the federal tax code, mutual funds are "pass through" entities which do not pay income taxes.  They annually distribute all dividends received and capital gains generated in the portfolio to their shareholders, who elect to receive that money either in the form of a check or by reinvestment in the fund (more shares).  Most distributions are made in December of each year.

If an investor buys shares in the mutual fund just before a distribution, that individual incurs a tax liability on the entire year's worth of income even though he or she may have only held the shares for a month or so.  By way of example, assume you invested $500 in a fund and received 10 shares at a per share price of $50.  Two days later, the fund makes its annual distribution, $5 per share.  Assuming you elected to reinvest distributions, you now have 11.11 shares at approximately $45 per share.  You still have the same $500 invested in the fund, but you owe taxes on the $5 per share distribution.  Before investing in a mutual fund, an investor should check to see when the fund makes its annual distribution and time purchases accordingly.

To make matters worse, there have been loss years in which the mutual fund shareholders watched the value of their investment decline, but still had to pay capital gains tax.  When the bubble burst, many mutual funds which had invested in high tech stocks ended the year with a loss.  Despite the losses, the funds had sold quite a bit of the stock they had earlier purchased at much lower prices to meet redemptions, thus generating capital gainsThe shareholders had to not only watch their investments lose money, but also send a check to the IRS for gains that were of no economic benefit to them.

None of these tax issues matter if you hold your mutual fund investment in a tax deferred retirement account, such as an IRA or a 401 (k).

Much has been written about the apparent inability of a majority of actively managed funds to beat general market averages.  As stated in the last post, due to the imbalance between the number of funds investing in the stock market and the smaller number of stocks available for such investment, it could be that the mutual fund industry actually comprises the market.  Subtracting the fees and expenses of the funds must therefore result in a return lower than that of the market.  In his 2003 book, Investment Philosophies, Professor Aswath Damodaran cites three behavioral factors which might be seen to also contribute to this shortfall in return: lack of investment consistency, herd behavior and  the practice of window dressing.

A mutual fund's prospectus states its goals and the investment philosophy it will use to reach them.  Unfortunately, studies have revealed that investment advisers will pay only lip service to these stated objectives in times of market turmoil.  Fund managers have been seen to repeatedly switch their investment styles in response to the latest market moves, up or down.  The second factor, herding, is simply a human trait.  Human beings tend to act collectively, much like other species.  With so many market professionals engaged in the same activity, it should be no surprise that institutional investors tend to buy and sell the same stocks at the roughly same time.  This magnified action will tend to drive stocks up or down to a greater degree than might otherwise be expected.  The third behavioral factor, window dressing, also reflects human nature.  It is well documented that fund portfolios are subject to a noticeable amount of change just prior to the dates on which the funds must report their results and reveal their share holdings.  The losers are sold, and the most recent market winners are purchased just prior to reporting results.  The  basis for this might be, in part, the cynical belief that the investing public will pay more attention to the reported portfolio holdings than the actual returns made during the period.  Such activity is self defeating since it results in increased trading costs and a concomitant decline in returns.

Looking only at portfolio holdings or returns is not the recommended way to invest in mutual funds.  We will look at how to invest in funds in the next post.

Comments are always welcome.

Monday, July 29, 2013

Mutual Funds: Behind The Curtain (1)


Investing in a mutual fund requires little more than money and some key strokes on your computer or a phone call to a broker.  Notwithstanding the simplicity of interaction, there is a lot going on behind the curtain; much like the Wizard of Oz.  Establishing and operating a typical mutual fund consists of a number of different functions.  The sponsor of the fund organizes the fund  and provides the initial "seed money" to get it started.  The sponsor, as the first shareholder, establishes an initial board of directors to manage the fund.  Once people invest in the fund, they become the fund's shareholders and thereafter elect the directors.  Typically, the sponsor is also the investment adviser, directing the fund's investments and managing the portfolio.  This key function could, however, be handled by a different company.  Administrators perform the "back office" operations.  They provide the various things needed to run a fund such as office space, clerical staff, internal accounting, and the filing of reports with the SEC and the Internal Revenue Service.  Mutual fund investors buy and redeem their shares in the fund through an underwriter.  The underwriter agrees with the mutual fund to buy and sell shares of the fund to the public.  Transfer agents keep track of the accounts and calculate each investor's share of dividends and capital gains distributions.  They also provide account statements, notices and income tax information to the shareholders.  The fund's portfolio of stocks, bonds or other investment assets are usually held in the name of a custodian.  An outside accounting firm audits the books and records of the fund and provides the required opinions concerning its financial status.  In short, a fund has a lot of moving parts, and each party playing a role must be paid.  Hence, the fees and expenses charged the shareholders.

Mutual funds fall into two general categories: active and passive management.  The portfolio of an actively managed fund is overseen by an investment adviser with the goal of beating a recognized market average, such as the S&P 500 index.  This is a difficult job, and a majority of funds fail to reach this goal in any given year.  This gives rise to a good deal of debate as to the true benefits of mutual funds.  On a world wide basis, mutual funds of all kinds invest trillions (yes, that's with a T) of dollars.  In recent years, the number of funds in the US, approximately 7,000 or so, exceeds the number of individual stocks listed on the NYSE and the NASDAQ, roughly 4,500.  If you add stocks listed on other exchanges, the number of stocks climbs to almost 6,500; a number still smaller than the number of funds investing in them.  In effect, mutual funds, collectively, are the market.  Their combined trading of stocks creates a large percentage of the annual market volume and movement, in effect, the market average.  If that is true and you deduct the fees and expenses of mutual funds from that average, it is simple mathematics.  When you deduct the expenses and fees, most mutual funds stand no chance of beating their market average.  Notwithstanding this, mutual funds remain the investment of choice for most people.

John C. Bogle, the founder of The Vanguard Group, explained this phenomenon in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor, as follows:

While the wide selection of mutual fund offerings has provided much of the impetus for the industry's growth during the past two decades, (he is speaking of the1970s & 1980s) four time-honored principles of mutual fund investing are the core of the industry's success.  These principles are (1) broad diversification, (2) professional management, (3) liquidity, and (4) convenience.  They remain as valid today as they were when the first U.S. mutual fund was introduced. 

We will learn more about this type of investment in the next blog.

Comments are always welcome.

Monday, July 22, 2013

Pooled Investment Basics


There are four types of pooled investments, technically referred to as investment companies.  They are open-end investment companies, closed-end investment companies, exchange traded funds and unit investment trusts.

The most familiar type, the open-end, is what is commonly known as a mutual fund.  The shares of the fund do not trade in the market; however investors can quickly and easily purchase and redeem their shares in a mutual fund through the fund sponsor.  The net asset value (NAV) of a fund and, hence, the value of its shares is based on the value of the investments in the fund.  The NAV is calculated and announced at the end of each day of trading.  NAV is the sum of any cash reserves and the closing prices of all of the securities held in the fund less liabilities, if any.  That number is then divided by the number of shares held by investors.  This price then holds for share purchases and redemptions for the next trading day at the end of which, a new NAV is determined. 

A closed-end fund is organized and traded basically as a stock.  The fund is offered to investors in a form of initial public offering.  Their money is used to purchase stocks, bonds or any other investment assets which the fund is intended to hold.  Unlike an open-ended fund, money is not thereafter added or subtracted from the fund.  In other words, the fund is closed to new money.  The shares of a closed-end fund trade in the market just like a stock.  The price of closed end shares may be higher (a premium) or lower (a discount) than the actual NAV of the fund for any number of reasons, such as the basic rule of supply and demand, perceived prospects for future growth or decline of the fund's assets and all the other reasons prices rise and fall in an active market.

Exchange Traded Funds (ETF) are hybrid securities.  Essentially, an ETF is a mutual fund; however, it trades in the market just like a closed end fund or a stock.  ETFs do not have a mutual fund's NAV set daily.  Rather, the value of an ETF fluctuates during the day like a stock.  Many ETFs contain a pool of stocks that mirror a market index, like the S&P 500.  In fact, the first ETF was an S&P 500 index fund, commonly referred to as a spider since its ticker symbol is SPDR.  Some ETFs invest in only certain sectors of the market, such as car manufacturers, health care, emerging markets and virtually any other area of the market you can name.  Like stocks, an investor can short ETFs and buy them on margin.  The management fees and transaction costs of operating an ETF index fund are generally lower than those of an index mutual fund.

A unit investment trust (UIT) combines several features of the other three types of investment company.  Like a closed-end fund, the sponsor offers a fixed number of units in the trust to investors in a public offering.  No additional shares in the trust are ever offered again.  The offering proceeds are invested in securities which remain the same for the life of the UIT.  There is little, if any, change in the portfolio over its life time.  Unlike the other investment companies, the UIT has a termination date, at which point the securities in the trust portfolio are sold and the cash is distributed to the investors.  Like a mutual fund, units may be purchased or sold.  However, the units are traded on a secondary market maintained by the sponsor.  The sponsor itself does not buy and sell units.

There are advantages and disadvantages for each of these forms of investment, but a detailed discussion of them is beyond the scope of this post.  Here is a link to more information about these investments at Investopedia

We will examine the most familiar type of investment company, the mutual fund, in the next post.

Comments are always welcome.

Monday, July 15, 2013

Shotguns and Money


Hunters have the option to use either a rifle or a shotgun, depending on what is being hunted.  Similarly, investors have the option to purchase either a specific investment or a mutual fund.  In order to diversify a portfolio, the individual stock purchaser must spread his or her money over a number of companies in different industries.  You may recall that the collective advice of the value investors we have studied in earlier posts is to purchase between ten and thirty different companies, each in a different industry.  For an investor just starting out, the successful assembly of such a portfolio will take both time and effort.  Not everyone has the time or the inclination to do this.  Once a person starts a career and has the funds to invest, there never seems to be enough time for much more than work, family and friends.  Most retirement plans offered by employers offer only mutual funds as investment options.  Many individual investors take the shotgun approach and put their money into mutual funds.  It would seem that a majority of people in the market do so via pooled investments.

Pooled investing has been around for centuries.  Many financial historians point to a Dutch investment trust (called a negotiatie) as the first such investment established in 1774.  Its stated purpose was to provide diversification to individual investors at a small cost.  Numerous negotiaties were organized in the latter part of the 18th century to invest in the credit of a new country, the United States of America.  The organizer of the original trust, Adriaan van Ketwich, organized a second one in 1779 which remained in existence for 114 years.  It was dissolved in 1893, the same year that The Boston Personal Property Trust, one of the first American investment trusts, was formed.

The fore bearer of the modern American mutual fund, the Massachusetts Investors' Trust, was established as an open-end fund in Boston in 1924.    The Wellington Fund, launched in 1928, was the first mutual fund to specifically invest in both stocks and bonds, a balanced fund.  The value investor, Phillip Carret, was one of the organizers of the Pioneer Fund in 1928.  Pioneer is still in business today.  The number of funds increased over time, but many were wiped out during the 1929 Wall Street Crash.  Investigations into these failures revealed a fair amount of chicanery and self dealing on the part of the operators of the  failed mutual funds.  This led to the passage of The Investment Company Act of 1940 which placed numerous restrictions on the operations of US mutual funds and required certain disclosures to investors.  The Act also attempted to reduce the conflicts of interest revealed in the investigations.

Over the years, the popularity of mutual funds has waxed and waned.  Mutual funds grew rapidly during the 1960s, but the number dropped precipitously after the bear market of 1969, with only 360 funds remaining in 1970.  Later, two tax law changes gave the industry a big boost.  The Individual Retirement Account (IRA) and a form of retirement plan known by the tax section which authorized it, 401 (k), provided large platforms for the sale of mutual funds to millions of Americans saving for their golden years.  Interest in mutual funds dropped again in 2003 with the revelation of wide spread scandals in which a number of funds were alleged to have  allowed their large hedge fund customers to engage in abusive trade timing practices at the expense of their smaller customers.

Memories are short on Wall Street, and the mutual fund industry has recovered since 2003.  It is reported that there were approximately 14,000 mutual funds, including money market funds, in existence in 2011.  The funds offer every sort of investment strategy in stocks, corporate bonds, government debt, gold, oil and any other investment asset you can think of.  The irony is that, year in and year out, a large percentage of the funds (some say as high as 80%) fail to meet or beat the annual performance of their respective markets as a whole.

We will look at mutual fund investing in the next post.

Comments are always welcome.

Monday, July 8, 2013

Are We There Yet?


Every parent has heard this complaining question from the back seat of the car at one time or another.  Usually, it is a daily chorus as the family's summer road trip plays out.  Many times, the question is followed with another old standard, "Why is Daddy so crabby?"  Children just do not comprehend the distance and time involved in reaching vacation destinations.

Some investors approach their investments in a similar manner.  They fail to identify their destination and formulate a realistic time frame in which to reach it.  They forget to tailor specific methods of investing to specific goals.  For some, the goal is just making money.  There is nothing wrong with that.  Making money is a good goal; but then what?  Long term goals, such as meeting college tuition for the children or investing for a comfortable retirement, are best reached with long term investments.  Years of short term trading with its ups and downs is probably not an appropriate way to achieve retirement security.  The risk of suffering a crippling loss shortly before reaching retirement age is just too great.

In Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow discussed the interplay between goals, strategy and time as follows:

A prime ingredient in any investment strategy must be a considered time frame, which will be directly related to major, intermediate, or minor price objectives.  How long is one willing to wait in anticipation of an x percent move?  What happens to one's calculations if the stock moves the wrong way?  Should one sell automatically, regardless of time, if a goal is reached? or protect the position with puts?*

Once a person sets a goal and establishes the amount of time needed to achieve it,  the next step is to consider and adopt the appropriate investment strategy or philosophy.  The investor or trader needs to develop basic ideas on which their way of investing is based.  Aswath Damodaran, a Professor of Finance in the Stern School of Business at New York University summed this up in his book, Investment Philosophies, as follows:

An investment philosophy represents a set of core beliefs about how investors behave and how markets work.  To be a successful investor, you not only have to consider the evidence from the markets, but you also have to examine your own strengths and weaknesses to come up with an investment philosophy that best suits you.  Investors without core beliefs tend to wander from strategy to strategy, drawn by anecdotal evidence or recent success, creating transaction costs and incurring losses as a consequence.  Investors with clearly defined investment philosophies tend to be more consistent and disciplined in their investment choices.**

Although most of the advice given above would seem to apply to long term investors, traders also need a goal, a strategy and a time frame.  The most famous trader, Jesse Lauriston Livermore, followed the basic tenet of quickly selling losers and letting profits ride.  He had a strategy for identifying and selling stocks which were not performing to his standards:

Hope is the villain here and it has ruined millions of speculators over the course of time -- take your losses right away they are real whether you sell the stocks or not.

To put this in another way I have two stops in mind when I enter a trade I have a "PRICE STOP" and I have a "TIME STOP."  I will not stay with any trade more than a few points if it moves against me and I will not stay with a stock position for more than a few days if the stock does not perform as I expect it to perform.***

It would seem that he did not always follow his own advice.  Livermore is reputed to have made and lost four multimillion dollar fortunes over his forty year trading career.

Aimlessly wandering from place to place without a plan and a map is a recipe for a bad family vacation.  Likewise, aimlessly bouncing from one investment to another without a goal and a strategy is a recipe for financial disaster.

*  Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder

**  Excerpt from Investment Philosophies, Aswath Damodaran, ©2003, published by John Wiley & Sons, Inc., page 13

*** Excerpt from How to Trade in Stocks, Jesse Livermore, ©1940, updated edition in 2001 with comments from Richard Smitten, published by McGraw-Hill, page 108

Comments are always welcome.