Everyone wants THE stock tip in the hopes of getting rich quickly. The sad truth is that sound investment is a "get-rich-slow" undertaking. Sure, you COULD randomly hit the right combination, but the chances are about as good as the lottery. As an example, a Canadian newspaper once asked 5 investment experts to pick their 10 best stocks for a period of 1 year. Their picks were stacked up against a random pick: 10 darts thrown at the newspaper's stocks listing page. The darts outperformed the experts the majority of the time. Nobody can repeatedly pick the best investments for any given period. The experts have NO IDEA what's going to happen with markets.
So how do you come out ahead? In this, my first instructable, I hope to provide you with some answers
Step 1: The Myth
The first thing we have to do is dispel the myth. That a “stock tip” is going to make you rich. If you get a stock market tip that will make you rich, you’re probably involved in something illegal anyway. Stock tips work on rumours and hearsay. If a rumour is confirmed by a source in the know before it is announced to the public, that is insider trading and will buy you 5 to 15 being someone’s jailhouse toy. The tips that you are allowed to trade on are just indications and guesses. A good stock broker, can help you there BUT… as we’ve seen earlier, the experts aren’t as sharp as the darts (pun intended). What you REALLY need is an investment STRATEGY.
For that, we need some basic understanding.
Step 2: What Are Stocks?
Stocks or shares are the smallest unit of ownership of a company. Shares are issued by companies in order to raise capital for expansion and growth. By investing in the company, you are lending them your dollars and trust that they will use them wisely to make the company grow, earn more, and make the value of your share rise proportionally. The theory is that the increased value of the company will make the stock more desirable to own. By a simple process of supply and demand (there is a limited supply of shares in circulation), the price is driven up.
That's the theory. In reality, the stock markets move on perception and herd psychology. It moves on two basic human traits: nobody wants to lose money, and nobody wants to look stupid. An investor who notes that a share price is starting to go up will try to get in on the off chance that someone knows something he doesn't (don't want to look stupid). Then when the stock starts to drop, the investor holds too long because he wants to at LEAST break even (don't want to lose money) and doesn't want to admit he made a bad pick (don't want to look stupid).
Stocks are usually traded on exchanges (such as the New York Stock Exchange (NYSE) or the Toronto Stock Exchange (TSE). They are purchased through brokers who take a commission on each purchase or sale of a particular stock. Whether you are selling 10,000 shares of company ABC, or just one, the commission is the same. That's how investment brokers make money.
TIP: Stay away from small-cap stocks (known as "penny" stocks) sold over the counter or at smaller exchanges.
Step 3: Two Ways to Gain/lose With Stocks
Capital gains/loss: A capital gains investment is one that increases in value. The change in value is related to the "desirability" of the investment vehicle, in essence, how many people want to buy something. During the "Tickle-Me Elmo" craze, if you had been sitting on 12 cases of brand new "Tickle-Me Elmo Dolls", you would have made a killing selling them. Of course, if you didn't sell those 12 cases at that time in the hopes that people would launch the "Great Elmo Deification" and drive prices even higher, you'd now be sitting on some pretty valueless stuff. The difference between what you paid for the dolls and what you sold them for would be your capital gains (or loss). Stocks fall into this category of investment.
Dividends: This is a further wrinkle on purchasing stocks. Some companies promise to give you a certain amount of money every three months to a year just for buying and holding their stock. This is the dividend. Note that when a company gets into trouble, the first thing that usually gets axed is the dividend. Dividends are expressed in "yield" (as a percentage) which is calculated by dividing the dividend by the stock value. For example a yearly $0.40 dividend on a stock price of $20.00 means a yield of 2%.
TIP: Your best bet is a stock that covers you on both of these. Something that has good long-term growth, and the added revenue of dividends.
TIP: Re-invest ALL your dividends.
Step 4: Two Types of Shares
Common shares: They are the shares most widely in circulation. With just one share, you get one vote at the annual meeting of the company on decisions that need to be made by the owners (you). If the stocks pays dividends, you get a share of that too.
Preferred shares: These are shares that have no vote, but get first dibs at the dividends (see. Also, should the company fold, they also get first dibs on the assets of the company, before the common shareholders. Mind you, this doesn't mean much. After the creditors and bankers are done with a bankrupt company, there's usually nothing left for the investors anyway.
TIP: Stick with common shares. Preferred shares don't usually have as great a return on your investment, and there are many more choices in common shares.
Step 5: Is Investing Right for You?
Take a hard look at your finances. How much do you owe on your mortgage? How much on credit cards? How much on your car or loans? Can you easily shoehorn an amount for investment in there? If your debt load is high, it makes a lot more sense to get rid of debt first.
TIP: It is much better to get rid of a debt that has a 19% interest rate than to invest in a stock that reutrn 10%. Finding an investment that will consistently provide a 19% return is nigh impossible.
TIP: The snowball method is an excellent way of getting rid of debt fast. Let's say you have the following debts.
Car, owing $2,500 at 12%. Min. payment $250/month.
Line of credit, owing $5,000 at 8%. Min. payment $200/month.
Credit card 1, owing $12,000 at 12.9%. Min. payment $110/month.
Credit card 2, owing $18,000 at 17.9%. Min payment $175/month.
Let's also assume that your debt repayment budget is $1,000 per month. Many would say pay off the highest interest one first. I say pay the smallest debt first, the car. For the duration, pay only the minimum amounts on your other debts (total of $485) and start paying the balance of $515 on your car debt. That debt will be cleared in 5 months. Then do the same with the next debt. Pay the minimum on the credit cards ($285) and pay $715 on your line of credit. That debt will be gone in 7 months. Tackle the first credit card next (paid off in 15 months) and the other last (18 more months). In a little under 4 years, you will be debt free and in a great position to invest.
This method has the advantage of giving you some encouraging quick wins, which helps keep you on track. Would you rather clear a debt quickly in 5 months or clear the highest interest debt and take a year and a half doing it?
Finally, when everything is paid off, swear you'll never get that much debt again.
Step 6: Where to Get the Money
Pay yourself first. You work hard for your pay cheque, why pay all the bills first and make the big corporations richer before you finally pay yourself? Pay yourself first!! If you're realistic, you'll see that you spend a lot on frivolous little things for which you never budget. That's your investment money that you're frittering away. Do the following:
Open another chequing account at your bank. This is your "paying-yourself-first" account.
Transfer 10% of your pay to that account on payday every pay
Don't touch that money until you're ready to start investing it.
It's that easy. Ten percent may look like it's going to be a big hit, but it's not. It means one less meal out, one less cup of coffee daily, having your hair done every 5 weeks instead of every 4, whatever. Chances are you WON'T EVEN FEEL IT! If you do feel it, it's time for some debt reduction or some serious budgeting.
TIP: If you're still having a tough time finding the money, look at cutting some expenses. Do you really need 100 channels on your TV? Do you really need a Starbucks latte in the morning? Can you get a better car insurance rate somewhere else? These money savings can be the foundation of your investment portfolio.
Step 7: Risk and Return
How much risk are you willing to take with your Ã¢â¬Âpay me firstÃ¢â¬Â money? Could you sleep at night knowing the stocks you selected have dropped 50% of their value in the last two weeks? Are you a gambler? Can you afford to lose some money? These are the hard questions you will need to ask yourself before you choose an investment vehicle.
Look at the chart below. It shows the entire history of the New York Stock Exchange's Dow Jones Industrial Index (DJIA). If you'd invested $1,000 in 1982, it would have been worth $10,000 by 1999. Mind you, if you'd invested $1,000 in 2000 (especially in a tech stock), that investment would have dropped to $700 by 2002. Risk and return are two sides of the same coin, the lower the risk, the less the return potential. The higher the risk, the higher the return potential (and loss potential as well). With stocks, it is impossible to totally erase risk.
TIP: If you cannot afford to lose the money you invest, consider interest-bearing investment. They are safe and are usually backed by some form of government guarantee. But don't expect great returns. Low risk equals low return.
Step 8: Learning From Charts
Take another look at the chart. While it looks good overall, you can spot times when the bottom fell out and people lost their shirt (and sometimes their life). The great crash of 1929 is a case in point. You can also spot the downturn due to the oil crisis in 1973, the stock market crash of 1987, and the market downturn after 9/11. While these look like mere blips, people STILL lost their shirts. Note also that ALL these downturns were preceded by periods of unprecedented growth. Remember our examples? One invested $1,000 and saw it turn to $10,000 while the other invested $1,000 and saw it drop to $700? In the first instance, we invested for 17 years, in the other, for only 2 years.
What we've learned:
- Values rise consistently over long periods of time (usually 10 years or more)
- Downturns happen suddenly.
- You CAN lose your shirt.
From this we can extrapolate that:
- We should invest for the long term.
- We shouldn't try to "time" our investment
- Don't invest the grocery money
Step 9: Diversification
Buying stocks from a whole load of companies spreads your risk. Some of your stocks may go down, but others will go up and, hopefully, your overall holdings will appreciate in value. For example, if the technological sector is going down, investors will try to sell, further depressing the price. Investors will move toward something safer, like safe interest-bearing investments sold by banks. As a result, it's very likely that the stock of financial institutions will go up. If you own both types of stock (tech and banks), it's likely you will fare better than your neighbour who only invested in tech stocks. This is called diversification. Diversification is hard to achieve on your own.
The Dow Jones Industrial Average (DJIA) is composed of the 30 of the largest, most widely held companies in the US. If you tried to buy just one share of each of those companies, it would put you back almost $1,500 at the time of this writing. And that's BEFORE commissions. If your commission is $5.00 per transaction, it will cost you $150 to buy one stock of each company, and ANOTHER $150 when you sell them. You basically start $300 in the hole because of commissions costs. That's how the large brokerage firms make their money. They get a commission from every purchase and sale.
Step 10: So How Do I Diversify?
Mutual Funds derive their name from the fact that the mutual find company will pool small amounts of money from a large number of investors into one fund, and make purchases on the stock exchanges on behalf of the whole group. It is a good way to "target" a specific type of investment. For example, if you are interested in investing in companies that specialize in gold and precious metals worldwide, there is a mutual fund for that. If you are interested in investing in large companies that pay high dividends in the United States, there is a mutual fund for that. If you are interested in investing in new high risk venture in Canada, there is a mutual fund for that. In fact, unless you're trying to financ uncle Kim's plastic flower shop in Outer Mongolia, there's probvably a mutual fund for it.
The key to good mutual fund investment is history and manager. Both go hand in hand. Use free online tools such as "The Fund Library" or "Globefund" to find mutual funds that match your criteria. Look at the historical data and try to find funds that have been performing in the rage of return you are looking for (usually 10%+ per year returns). Look at the management of these funds, and check if the manager has been with the fund for all this time. This is key: find a successful fund manager and stick with him or her. If the manager moves to another fund sell your mutual funds and move to another. You may also want to follow that manager to the wherever he is going or you may want to pick a different fund entirely. New managers want to put their print on something and usually change a winning portfolio. Usually with bad results.
TIP: Before choosing a mutual fund, check the loading and MER (management expense ratio). A "load" is a cost that is charged to you for buying the mutual fund. Look for "no-load" funds. The MER is the percentage of commission that the mutual fund company will take from your investments every year. If your mutual fund value increased by 9% last year and the MER is 3%, you will only have realized a 5% gain. A low MER is preferable, somewhere below 2%.
TIP: Ahnother simple of diversifying is to buy an index fund. Index funds are mutual funds that invest in the very same companies that form an index. There is an index fund that matches the Dow Jones, another that tracks the National Association of Securities Dealers Automated Quotation (NASDAQ), and another the Standard & Poor indices (S&P 60, S&P 500). In Canada there are index funds that track to the TSX as well. These are usually affordable, and will not break the bank on commissions. A single $5.00 commission allows you to buy a totally diversified portfolio. Your returns will be exactly the same as the market. You will never outperform the market, but you will never under-perform either. Many reputable mutual fund companies offer such funds at low MER, usually at 1% or below.
Step 11: Buy Low - Sell High?
That is the theory. Experts agree that timing the market is very hard. We've seen earlier that experts couldn't find their butts with a map anyway, so I'm going to go ahead and say it's impossible.
TIP: The best bet is to buy constantly and consistently.
The best thing to do is figure an amount that can come out of your "pay-myself-first" account on a monthly basis and invest continually every month on the same date with the same amount. This is called dollar-cost averaging. Here's how it works:
Let's say that I will invest $200 a month; $100 on stock ABC and another $100 on stock XYZ. In my first month ABC is at $20 and XYZ is at $10. I will therefore buy 5 shares of ABC and 10 shares of XYZ. In the following month, the market has a severe slump and ABC falls to $10, while XYZ falls to $5. I will still buy, but will get 10 shares of ABC and 20 shares of XYZ. The following month sees a moderate rally in both stocks. ABC goes up to $15 and XYZ to $7.50. I will be buying 6 shares ABC 14 shares of XYZ.
Let's see how I've done. I now own 21 shares of ABC with a value of $315. I own 44 shares of XYZ with a value of $330. Even though the price of the stock went down, I am still ahead!! I invested $600, and my holdings are worth $645. Why? By using dollar-cost averaging, I bought many more shares when the price was low and less when the price was high... automatically!!
Step 12: Hedging
A hedge is a secondary investment you make to offset any losses you may have in your primary investment. For example, if you note that the gold goes up when the market goes down, investing in a gold or precious metals mutual fund can help offset losses in your index fund. Be careful of your hedges, make sure there is a historically accurate correlation between one investment going up when the other goes down. Even then, there is no guarantee that history will repeat itself.
Step 13: I've Started Investing. Now What?
Congratulations. You've started investing is a solid future.
Now, forget about it.
That's right, don't follow your investment, forget about them. Let the dollar-cost averaging take care of itself. The mutual fund company will send your quarterly updates that will indicate the growth (loss) for the past quarter. Read and file. You don't care, right? You're in this for the long haul, at least 10 years. Over that time, your investment are almost sure to grow in size.
Step 14: Beating the Market
Even though this is almost impossible. Let me tell you what's entailed in out-performing the market (aka day-trading).
TIP: Quit your job. That's right, quit your job. Beating the market is not something you can do part-time. You have to become a stock market expert and follow developments as they happen. This will become your full-time job.
TIP: Buy monitors. At least three. You will require a news feed, stock exchange feed and a high speed connection your brokerage firm for purchasing and selling stocks.
TIP: Sit at the computer all day and read, read, read. Remember, the stock markets fluctuate on herd mentality. So when the investors at the exchanges see a trend (up or down), they tend to "ride the trend". As a daytrader, that's what you have to do as well. When you notice that prices are starting to rise on an issue you're following, or fall on an issue you own, follow the trend.
TIP: One of the biggest helps for daytrading is knowing when to get out of a losing position. Set a "stop loss" level for your investments. That means that you instruct the brokerage firm to sell automatically if the share price drops to a certain level. For example, if you purchase shares at $23.55, you may want to put a stop-loss at $23.45.
TIP: Another is to set a gains target. It's easy to get greedy so before buying a stock, decide what return on investment you're looking for and lock that return in by selling as soon as that price is reached.
TIP: Learn to read charts. Charts are much better than ratios at giving you an idea of what the next trend MAY BE. Look at the chart below (pic 2). This is a chart from stockcharts.com. It shows the daily price for Bell Canada Enterprises (BCE) with a 15-day and a 50-day moving average. The intersections of the moving averages are your buy and sell indicators. As you can see, even this tactic leads to some uncertainty. This is not an exact science, folks. You CAN lose your shirt, your house, your car, your dog...
Step 15: Final Words
Glamour costs money.
The investment strategy outlined in this instructable is not glamorous and it's not sexy. It's staid, stolid, steady and a whole other bunch of words that begin with "st", and are not synonymous with glamorous. Glamour costs. Yes, you will meet someone someday who will say "I doubled my money when I invested in QRS Inc. last month. I had this hunch..." That person WILL have the wrong hunch one day. Besides, your comeback should be "Oh, I don't follow the stock market that much... but I still got a 14% return on my investment last year". Then walk away from that person knowing that YOU will be a millionaire WAY before the glamour guy.
I hope my exposÃ© has helped you make your investment choices. If you enjoyed it leave a comment. If you want clarifications, leave a comment. If you're just bored, leave a comment. If you feel like leaving a comment... I think you get my drift.
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Burning Questions: Round 5