In previous chapters we talked about IPOs and what it takes to be a public company in the U.S. To remain a public company in good standing with the Securities and Exchange Commission (SEC), after its IPO a company must “file” certain information on a quarterly and annual basis. The SEC then makes this information available to the public so that all investors have a level playing field and have access to the same information at the same time.

Here are the 3 most frequently filed documents with the SEC:

• 10-K The annual SEC filing by public companies that includes their audited Income Statement, Balance Sheet, Cash Flow Statement and other detailed notes about the companies financial and operating conditions. – this is the annual report that is filed by a public company with the SEC. This is an extremely in-depth document that contains lots of information including a description of the business, audited financial statements for the company’s most recent fiscal year (income statement, balance sheet, cash flow statements, and a statement of shareholder equity), executive compensation, a description of the company’s option plan, future commitments for leases, a review of any legal issues pending, and much more. An independent accounting firm confirms that the information presented is accurate by auditing the financial statements. A 10-K must be filed within 75 days of the company’s fiscal year end.
• 10-Q The quarterly SEC filing by public companies that include abbreviated, unaudited financial statements. – this is a company’s quarterly report that is filed with the SEC. The 10-Q is less detailed than the 10-K, but it gives you a snapshot of its financial statements so you can see how the company has performed in the most recent 90-day period. These financial statements are generally unaudited. Companies are required to file their 10-Q within 45 days of the end of their quarter.
• 8-K – this form informs company shareholders of “unscheduled material events that are important to shareholders”. This would include the resignation of an officer of the company, a major purchase or business deal the company has made, and even bad news like an SEC investigation into the company’s business practices. These are all material events that would require an 8-K to be filed. The 8-K is extremely common, and many companies will file a number of 8-K’s throughout the year.

When you start reading a company’s SEC filings, you will notice that they are boring, dry and full of legalese. But they are supposed to be that way because they are full of objective FACTS about the company, and FACTS are what you need to evaluate a company’s prospect for success. The SEC filings deliver the pure information about a company, unblemished by brokerage analysis.

Mark's Tip

I always like to read the latest 10-K report first to see how the company has performed over its latest fiscal year, and more importantly, how that performance compared to their previous 12 months. Then I look for the most recent 10-Qs and compare the sales growth, profit margin percentage, and net income. I hope to see trends established in the 10-K continuing in the 10-Qs.

You can find out almost everything that you ever wanted to know about a company just by skimming through the pages of their quarterly or annual reports. Are their sales increasing or decreasing? Is their profit margin growing or shrinking? How much cash do they have on hand? How much debt do they have? How are their European operations progressing? What kind of compensation package does the CEO of the company have? Who are the officers and VPs of the company? What is the company’s dividend policy? It’s all in there.

Most companies will also prepare an “Annual Report” and distribute it to their shareholders. It is this Annual Report which often contains the “glitz” and positive “spins” on the company’s performance. While smartly constructed and well-written, you should learn to separate the prose in the Annual Report from the true financial and operational performance as exhibited in their 10-Q and 10-K SEC filings.

Money Watch SEC Filings

Mark's Tip

Notice that I said the company prepares an Annual Report and distributes it directly to the shareholders. The Annual Report is NOT filed with the SEC and therefore has less objective information. While the Annual Report is usually attractive and enjoyable to read, there will be little valuable information in the Annual Report that is NOT in the SEC filings.

Exit Strategies Are Designed to Protect Your Value

Rule #7 – Have an Exit Plan and Target for Every Stock

Few experienced traders ever invest in any stock without having an exit strategy. In its simplest form, an exit strategy is a plan to get you out of something you’re in. In the investment universe, it means you should have an exit plan for each investment, before you enter into that investment. Understand what you’re trying to accomplish, set limits on market values to define your accomplishments (on both the upside and the downside), and have an action plan that allows you to exit successfully.

Three primary considerations typically dictate your exit strategy development:

• 1. How long do you plan to own the security? You should have an idea of the time period you want to own the investment. It matters little whether you favor a short- or long-term duration. The choice is yours. Also, should circumstances change during your hold period, you can always modify your original plan and shorter/lengthen the ownership target period.
• 2. What level of risk do you plan to endure? Zero risk would be wonderful, but that’s impossible. Decide how much risk you feel comfortable to take with a stock. This can appear to be a moving target, but you’ll feel more comfortable in setting a risk parameter. Even if you’re wrong, addressing this issue will help your eventual success rate. How much are you “willing” to lose on this investment? That is your risk level.
• 3. At what price do you want to exit? This component is both the easiest and, sometimes, the most troubling component of your exit strategy. You’ll invariably find that you ask yourself:

“Should I wait until the price goes higher than my original exit target?”

“Maybe I should hold the stock a bit longer, even though it’s decreased to my exit target, to give it a chance to recover?”

In most cases, if you’ve developed a thoughtful, fact-based exit strategy, you should resist the temptation to change your plan. Of course, if factual events occur that indicate a strategy change, make it to protect your portfolio.

Protecting your values should be at the top of your exit strategy checklist. A good exit strategy is faithful to Rule #1: Ride your winners and cut your losers. Here are a couple of popular options to achieve these goals:

• Stop-Loss Orders (Stops) (S/L): These are common components of many exit strategies. Stops encompass orders you can give your broker that direct him/her to sell a security at a pre-determined price. When your price point is reached, your stop becomes a market order to be executed right away.Stop-Loss Orders are an excellent tool to protect your values. By setting high and low price points, you are “programming” your profit and capping your losses.
• Trailing Stop (T/S) Orders: A modification of an S/L is the Trailing Stop Order. You set a “distance” between the market price and your Stop Order. While you don’t want this order to move downward on the loss side (you could only increase your losses), it can be useful on the upside. For example, assume you place a Stop-Loss Order on a stock that you bought for $85 for when it reaches $135. But, suppose it projects to go even higher? You might lose further profits. You decide to issue a Trailing Stop stating that your S/L should be $20 below current market price.As long as the price of your security keeps moving upward, your T/S will trail (follow) its rise in value. Once your stock begins to fall, your T/S Order will become a market order to sell when the stock’s market price falls $20 below its peak. Once again, you have protected your values quite effectively.

Summary

You’ve made your first purchases and now you have some idea what to do with them. While you’re not yet an expert, you should now have enough information to create a basic holding strategy and an exit plan. You understand that you should ride your winners and dump your losers. Having a sensible exit strategy helps you maximize your profits and minimize your investment losses. You’re ready to get into the game. Play well.

• Cutting Your Losses
• Stop Loss Orders
• Stock Exit Strategies: Knowing When to Sell is Important
• Stock Volatility Information
• When to Sell Stocks
• Limit and Stop Orders Video Tutorial

Further Reading
Exercise 1. Create target selling prices for each stock you hold in your virtual account. Use your order history to record your exit strategy and target price.

2. Create Stop Loss orders for each stock you hold in your virtual account.

Identify Market Tops to Maximize Profits

Market tops are subjective opinions that often quickly become fact, for better or worse. How can you possibly identify a market top? Here are some suggestions that many experts believe will help you identify market tops.

• Closely watch the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500. Pay particular attention to the relationship between volume and the index. At some point in a bull market, the volume will fade as the index continues to be strong—this is a bad sign that there aren’t any more buyers.
• Also watch the relationship between volume and your stock’s prices. Low volume doesn’t tell us much, but large volume helps support price movements.
• Track the above noted activity over a four or five day period. This trend often precedes an overall market downturn. Feeding upon itself, as an almost a self-fulfilling prophecy, the “mood” of the market also tends to change, becoming a bit of a bear rather quickly.

Rule #6 – Sell into rallies that have fading volume.

Try not to miss these market top indicators. You may lose profits you’ve already achieved. If you have been on a good streak, you don’t want to quickly change from offense to defense if you can avoid doing so. Identifying market tops can be a profitable component to your market strategy in both the short and long term.

Rule #5 – Know When to Hold’em, Know When to Fold’em

Avoid falling in love with any one particular stock as the market can turn on it very quickly. While you may love a particular stock, millions of others may develop a dislike on a moment’s notice. You must be prepared to cut ties with an investment when as this condition starts to emerge. This brings us to the only exception to Rule #1.

• Exception – Market Tops: As you become more experienced, you’ll get a “feel” for those times when one of your winners is at a “market top.” As you watch stocks day after day and month after month, you will get the feel that a stock has gone too far too fast and it just has to come back down a bit. This is the time to consider just selling your winners (or tightening up your stop-loss order to 4%) so you can increase your cash holdings so that you can find another stock that’s on the way up.

As you can see, your possible first reaction (sell the winner and keep the loser), for reasons that have been proven over time, is typically the wrong one. Remember, your winners deliver profit “on paper,” but your losers involve real money you’ve already invested. It’s critical that you cut (minimize) your losses to safeguard your overall portfolio value. For this reason, you should develop effective exit strategies.

Rule #4 – Diversify, diversify, and diversify

Reminder: Always diversify your portfolio into at least 10 different stocks. It doesn’t matter if you are starting with $10,000 or $100,000–you’ll have more success if you think big and proceed as though you were a major-league investor. Diversification is important because while one sector of the economy might be falling 10%, rarely does the whole market sell off 10% in the same time period. So, with a properly diversified portfolio, you may get stopped out on one or two stocks, but hopefully you will have gains in others.

Mark's Tip

Some of the great investors and portfolio managers over the last 30 years (Peter Lynch, Warren Buffet) talk about having the “ten-bagger” in their portfolio. Sure, it’s nice to pick a stock that gains 10 or 20 percent a year, but what really drives a portfolio higher is a stock or two that tenfolds, or earns a 1,000% return. Over the years, Apple Computer (APPL), The Gap (GPS),Coca-Cola (KO), are some of the few that fall into this category.

Rule #3 – Never, ever, ever lose more than 10% on any single trade.

Traders, finance professors, and common sense all say that you should never let one sour apple ruin all of the other apples in your basket! Picking 9 stocks that gain 10% will be a waste of time if your 10th stock loses 100%, so DON’T LET THIS HAPPEN TO YOU! Having 9 stocks that gain 10% and one stock that loses 100% still results in a net LOSS of 1%!

The easiest way to follow this rule is to place a stop-loss order on your stocks as soon as you buy them. If you buy IBM at $100 a share, then immediately place a stop loss order at $90. This way you will be able to sleep at night and not have to worry about a market crash erasing more than 10% of your portfolio value in any given day, week or year.

Mark's Tip

Placing a stop loss order or a trailing stop at 8 to 10% below your purchase price is a routine you must practice religiously. William O’Neill, the father of technical analysis and the founder of Investor’s Business Daily recommends the 8% point, but others say 10%. Yes, you will get burned at times. If the stock falls 10%, you get stopped out, and the stock may recover. But more often then not, a stock that falls 10% will continue to decline even further. Sure, it’s OK to buy the stock back later at the cheaper price, but don’t buy it on the way down, wait until it has bottomed, formed a base pattern on the chart, and then shows signs of life again.

Rule #2 – Don’t fall in love with your stock purchases – winners OR losers (particularly losers).

Remember, you are not a welfare agency, rehab specialist, or air/sea rescue professional. If an investment is going south, sell it – without remorse and move on. Don’t forget, investing is a business, not a hobby or a charity.

Mark's Tip

Remember, stock trading is a zero sum game. If you are not the winner then you are the loser. If you bought a stock and it went down, then you made the seller of that stock happy because they were able to pass that loss on to you. If you bought a stock and it went up, then you made the seller of the stock very sad.

Admitting that you were wrong to buy a stock is the most difficult fact to accept in investing. It makes every investor feel bad when they see their portfolios losing money, which makes it even more difficult to sell. The reason why most investors fail is due to their feelings about the stocks they buy and sell. Don’t let your ego get in the way of making money, or in the case of a losing trade, from stopping the bleeding. If you can master your ego and your emotions, you will have more profits on your winning trades and smaller losses on your losing trades – guaranteed.

This lesson will teach you some generally accepted trading rules. But unfortunately, trading is an art — not a science — so don’t be shy. Create your own investing strategies as you grow and learn.

When you are learning a new skill, it always seems as though there are a few general rules of thumb that you must know in order to get started in the right direction. In golf you must “keep your left arm straight” (if you’re a righty) and in blackjack you must “assume the dealer has a 10.” In stock trading the first rule is:

Rule #1: Ride your Winners and Cut your Losers.

This rules looks simple and seems obvious, however, it is the opposite of what most people do when they start trading stocks.

There is a common affliction that hits most new investors that causes them to do the exact opposite—they can’t admit that they were wrong. This condition is best shown by example. Assume you invest $1,000 in two companies as your first two trades. After the first month, Stock A’s market value has increased to $1,200 while Stock B’s market value has decreased to $800. What is your first reaction? Is your first thought to sell your winner (Stock A) and take your profit, and wait until your loser (Stock B) regains its value? This is the LOSER’S mentality! Yet, this game plan is usually the first one followed by newer investors.

At first glance, it may appear to make sense. You sell your winner and take your profit and then you get emotional about Stock B and think “it will come back soon and I will sell it when I can get all of my money back.” Don’t do this! Many, many, many experienced investors would disagree with your plan – strongly disagree. See Rule #1—Ride your winners and cut your losers! This cuts your losses (and you WILL have some losses as everyone does). If your winner is “hot,” it’s likely that its market value will increase further. Similarly, if your “problem child’s” price is declining, the declines will probably continue, causing you to suffer further losses.

Mark's Tip

Gordon Gecko, the main character in the 1987 movie Wall Street, said it best when he said “don’t get emotional about stocks, it clouds your judgment.” You should only buy a stock after researching it and having a strong conviction as to why you want to own that stock—but if you are wrong, admit it and move on to your plan B.

This concept can be understood better when looking at what it takes to re-coop your losses. This is NOT intuitive. You see, due to the way percentages work, it takes a much larger percentage gain to recover your losses. For example, for a stock that has lost 15% of its value will require a run-up of 18% just for you to break even.

These calculations get worse the more your stock goes down. Take a look:

My Stock Loss	Gain Required to Break Even
20 percent	25 percent
30 percent	43 percent
50 percent	100 percent

For example, if you buy Stock XYZ at $10 a share and it drops to $5 then you have lost 50% of your investment. Now for you to recoup your investment, the stock must now double just to get back to $10 a share. No one wants to be in the situation of having to pray for a stock to double, just so that they can break even. In fact, that’s a nightmare. It is much better for you to cut your losses early, at 8-12% rather than get into this predicament.

The law of percentages seen above also works in reverse (and in your favor) when you hold on to your winners. The longer you hold onto a winner, the less a stock needs to move in order for you to rack up really exciting gains. Let’s take a look at the table as stocks rise:

My Stock Gains	Gain Required to Double Original Investment
20 percent	66 percent
30 percent	54 percent
50 percent	33 percent
75 percent	14 percent

The gains get even better when your stock has doubled or tripled already. For example, let’s say you bought Google (GOOG) in 2004 at $100 per share. If the stock is trading now at $400/share, every 1 percent rise in the stock produces for you a 4 percent gain. Not bad, eh? That’s how you get rich: finding winners and sticking with them as long as they keep rising consistently.

Summary

It’s time to decide on how you’d like to construct your portfolio. Whether you decide to invest virtual money or real funds, you should now have a basis to create your own thoughtful plan and strategy. Using your virtual portfolio and trading ability, you can test your strategy and “tweak” it, if necessary, to achieve profitable results in both the virtual and real world.

Glossary

Diversification:

A way of reducing the risk and variances in your portfolio returns by buying a variety of stocks across different industries, market caps, etc.

Peter Lynch:

Past portfolio manager of Fidelity Magellan, which became the largest mutual fund in the 1990s.

Risk:

The expected variance of the returns of your investments.

Sharpe Ratio:

A measure of the success of your portfolio by considering its return and its variance.

Warren Buffet:

Chairman and CEO of Berkshire Hathaway, and generally regarded as the greatest buy and hold investor of the last 30 years.

Further Reading

• Diversify to Reduce Risk
• What’s The Risk? Learning about the Various Risks of Investing
• Market Risk or Systemic Risk
• Bond Basics | What are Bonds?
• What is Market Capitalization?
• CD Basics (Certificates of Deposit)
• What is Inflation?
• Investing in Real Estate through REITs
• What is Hyperinflation?
• Small Cap Stock Investing Can Lead to Big Score
• Dollar Cost Averaging
• Sharpe Ratio Explained
• Buy and Hold Strategy
• Buy What You Know
• Hedge Fund Definition

Exercise

Make a list of stocks that you are interested in. Identify their industry, market cap, and dividend yields. Now build a balanced, diversified portfolio of at least 10 stocks on your virtual account. Make sure you have with a selection of stocks from different industries, market caps, dividends, and countries.

Thanks to the Internet and the wonderful amount of information you have at your fingertips, you can quickly scan 20,000 stocks in a matter of seconds if you know what you are looking for. Stock screeners can save you time by finding stocks in that meet certain financial or analytical measures you are looking for. Although some have more variables than others, all stock screeners work just about the same.

You decide on a mix of financial and investment preferences and parameters. You can then input this data and allow the stock screening software to locate securities that “fit” your perceived descriptions. With some freely available and others offered on a subscription basis, stock screeners are easy and convenient helpers.

While stock screeners operate with the same goal – finding stocks that match your wishes – you can choose different formats for results. Some will generate results on expected returns, riskThe expected variance of the returns of your investments., and projected yields, while others can offer stock suggestions based on growth, effective strategies, and other parameters.

Among his many accolades, Lynch is noted for an important and simple theory: Invest in what you know. In one of his books, he talks about Saturday as his day with his daughters. Every Saturday, his daughters said “Daddy, take us to The Gap (GPS) so we can buy some clothes.” Reluctantly, he went for several Saturdays in a row, gave his daughters $100 and sat out in the mall waiting for them. After a few weekends of this routine, his eyes lit up! He started noticing all of the teenage children dragging their parents to the store. He sat outside for an hour and counted the number of people going thru the cash register lines and estimating the average ticket price to come up with a rough estimate of sales. Suddenly, he started liking The Gap and he had his staff research the company the next Monday. Soon it was in his portfolio and it soon become one of his best buys ever, returning over 25,000% from the mid-1980s to its peak in 1999 (that run was from $0.20 to $50.00!).

This is an excellent starting strategy, and possibly enduring strategy for all investors. Instead of spending valuable time becoming an expert on complex investing strategies, expand your “local knowledge” and use your personal industry expertise to purchase securities of companies and industries you know personally.

Think about stating your goal as building a portfolio of “non-losers” as opposed to a group of “winners.” A strategy of finding “non-losers” combined with investing in companies and securities you know often leads to locating under-valued stocks and true bargains that maximize your investment dollars.

You may also find one or more “ten-baggers,” a world-famous Lynch-ism. In baseball, “bags” are a popular term for the “bases.” Finding a ten-bagger (hitting two home runs and a double) means you’ve found a stock that returns ten times your original purchase price. Even finding a group of two- or four-baggers should make your portfolio and bank account quite happy!!!

Mark's Tip

You don’t have to find the next Gap stock or stand in lines at the new restaurants to look for your next 10-bagger! Look for the negative side of things too. Are you getting lousy service at your favorite restaurant? Are you shopping at a store and you look up and notice you are the only one there? Does the tough economy mean that you are not stopping at Starbucks (SBUX) twice a day? Is nobody buying Crocs (CROX) plastic shoes anymore? Don’t forget that you can short these stocks that your experience tells you are losers!

As an example, the legendary investor Warren BuffetChairman and CEO of Berkshire Hathaway, and generally regarded as the greatest buy and hold investor of the last 30 years. has amassed his fortune without using a wide variety of exotic strategies. Buffet is the Chairman and CEO of Berkshire Hathaway (BRK.A) which has a stock price of $99,000 as of December 2009. His company owns large positions in companies like Coca-Cola (KO), American Express (AXP), Wells Fargo (WFC), Proctor and Gamble (PG), Burlington Northern (BNI), and GEICO.

You can check out his holdings, which shows the percentage of each company’s outstanding shares that are held by Berkshire Hathaway, Warren Buffet’s investment holding company.

All holdings are as of  September 30, 2009 as reported in Berkshire Hathaway’s 13F, except for Moody’s, which is as of December 8, 2009.

He is a classic “buy-and-hold” investor. He purchases securities the “old fashioned way.” Buffet studies companies and determines their core values based on the products they make and/or sell, profitability, management quality, and their future growth and sustainability projections.

He never acts on rumors or pure market price indicators. Incredibly, although recognized as one of the preeminent investment gurus on our planet, Buffet seldom sells items in his portfolio. He prefers to use his income stream to keep increasing his portfolio.

Warren Buffet Documentary

https://www.youtube.com/watch?v=RYHPlLsdW0A

Often, a “KISS” approach (keep it simple stupid!) is the best place to start. It can work for you better than many of the other so-called “experts” and sources of information out there. Ask yourself “what field am I an expert in?”

Are you a doctor and do you know what the hot new drug or pharmaceutical company is? Are you a school teacher and do you know what the latest gadget or software program is that your school is buying? Do you work at a grocery store and suddenly everyone is asking for XYZ product and you can’t keep in on the shelves? Are you a mother and suddenly all of the kids are asking for a certain brand of plastic shoes or a new iPod?

Mark's Tip

Each of us knows more than we think we know because everyday we contribute to the profits (or losses) of the stocks that we are choosing in the marketplace. We choose to go to Starbucks (SBUX) for coffee and skip our morning Diet Coke (KO). We eat lunch at McDonald’s (MCD) and not at Taco Bell (YUM). We buy our kids clothes at The Gap (GPS) instead of Limited (LTD). Why do we make these decisions? Because there is something about one product or the way one company is run that makes us want to go there versus its competitor. Do you ever walk into a store or restaurant and say “Wow! This place is packed all of the time?” If so, don’t walk out mad. Instead, find out more about that company and see if they are publicly traded. When my wife comes home from shopping, the first question I ask is “Where did you go?”, then “How much did you spend?”, and then “Was it crowded?” I am not just making idle conversation with my wife, I am researching stocks!

Which portfolio would you rather have? The 2nd portfolio would be great if you sold out on March 1st and locked in your 20% return, but it sure didn’t hold that value for long. What if you had to sell out on April 1st and lost 5%?

To measure this relationship between a portfolio’s variance and its return, Wall Street has developed several ratios or indices. The most popular is also the simplest. It is called the Sharpe RatioA measure of the success of your portfolio by considering its return and its variance.. Nobel prize winner, William Sharpe, created this formula over 40 years ago. The Sharpe Ratio informs you whether the higher returns you receive from certain securities are the product of your wonderful investing strategy or higher riskThe expected variance of the returns of your investments. and volatility. This Ratio provides important feedback and helps you select the right stocks for you and your plan.

Simply put, “risk’ is the term used to determine the likelihood and volatility of your results. Risk typically goes hand-in-hand with returns: the more risk you take, the higher the return you would expect, and conversely, the lower risk you take, the lower the return you would expect.

The term “return” generally means profit, and in the finance/investing world is usually expressed as a percentage and is frequently annualized. Investing $100 and getting a $6 profit in 2 years has a return or profit percentage of 6% and an annual return of 3%. Investing $100 and making a $50 profit over 2 years has a 50% return and an annual return of 25%.

To understand risk and return, consider these 4 brothers (Adam, Bob, Charley and David) who have different ways to invest $100, and think about the “risk tolerance” of the each of them. Where do you fit?

• Adam is extremely risk averse and puts the $100 in cash in a jar in his kitchen and sleeps very soundly at night knowing that he will always have $100 in the jar.
• Bob is also risk averse, but he puts that same $100 in a money market account at the biggest and oldest bank in town. That money market accounts pays 1% and Bob is (almost) positive that in 12 months he will have $101 in that account.
• Charley likes to take some risk and buys $100 worth of IBM stock. He researched the stock and discovered that over the last 10 years IBM’s annual return has varied between -10% and +57% so he is somewhat confident that his $100 will turn into an amount somewhere between $90 and $157.
• David has a friend that’s a broker and his broker said that stock XYZ is in the bio-engineering industry and they ran a small test on a drug that seemed to cure cancer in 6 out of the 10 patients that tried it, and now they are in a test with 1,000 people. David’s broker says that if this second test has similar results, the stock will pop from $1 to $100 over the next year; but if it doesn’t go well, the company is out of cash and will likely have to fold. David buys $100 shares of XYZ hoping that the stock will at least triple, but he also knows that there is a greater chance the company will be bankrupt and he will lose his $100.

Obviously, these are 4 different personalities (think “risk-tolerances”) with 4 different expectations about their rewards. Since no one has a crystal ball to see the future, none of these 4 brothers knows what their final return will be in a year. Adam’s wife might mistakenly throw the jar away that has the $100 in it because she forgot he put it there; Bob’s bank could announce it is closing and money market funds were stolen by a malicious Ponzi scheme; Charley’s IBM stock could turn worthless if the company collapses Enron-style; and David’s bet on XYZ stock could be worth $10,000 or $0.

A primary investment goal is to minimize risk and diversification is the most reliable method of minimizing investment risk. Diversification is simply spreading risk around so that “all of your eggs are not in one basket.”

Now suppose the 4 brothers above had a 5th brother, Edward, who couldn’t make up his mind what to do with his $100 so he copied each of his brothers by investing $25 in each of their styles. This is a simple example of what diversification means.

Mathematically, diversification is about minimizing the variances in your returns by averaging the expected returns of each of your stocks. If Stock A had returns of -50% to +50% a year and Stock-B had returns of -10% to +10% a year, then it would make sense that a portfolio that was 50% invested in each of these two stocks would expect to have returns of -30% to +30%.

Now if we added Stock C which always has returned 5%, then a portfolio equally weighted with A, B, and C would have expected returns between -18% and +22%. But if I put 50% in C and 25% in each A and B, then we are at -13% to + 18%. Think of it like you are making a recipe for a spaghetti sauce. You know you will put in 3 ingredients, but if you like yours a little salty, you will go with more salt and less pepper.

This explains how we can average out our returns by buying different stocks, but the most important ingredient to diversify successfully is by buying stocks across different industries. As you might expect, you certainly DON’T want stocks in your portfolio that are all performing at their extreme worst at a single point in time. In other words, you want to choose stocks whose returns don’t correlate very strongly. If one stock is falling, you hope to have a few stocks that are rising to help offset the loss in the falling stock.

As we discussed in earlier chapters, understanding the business cycle and product life cycles helps to understand why some companies perform well at times that other companies are doing very poorly.

Mark's Tip

Diversifying across industries is not as difficult as it might seem, if you can take a step back and look at things from a very macro level. History is full of examples of some industries doing well while others are hurting. How do you think horse and buggy companies performed when Ford starting selling Model-Ts? How do you think vacuum tube companies did when hi-technology started moving towards the semi-conductor? How do defense stocks relate to medical stocks if the current U.S. President is expanding the budget for the military and asking cutting funding for Social Security benefits? Finally, don’t forget that sometimes investors don’t want to be in the market at all so they invest their cash in other investments like money markets, bonds, precious metals, etc. Remember, individual stocks and the stock market can move in 3 directions: Up, down, and sideways!

Now suppose we added stock D to our portfolio above which moves opposite to Stock A so that when Stock A is losing 50%, Stock D was gaining 20% and when Stock A was gaining 50% Stock D would lose 5%. Our equally weighted portfolio of A, B, C, and D would now have expected returns in the -9% to +15% range.

Here is a quick summary of some ways to accomplish diversification.

• Across Stocks: It certainly helps to have more than one stock in your portfolio. College professors used to say that it took a minimum of 30 stocks to have a well-diversified portfolio. Lately, these academics are becoming more comfortable with a portfolio of only 10 stocks as long as they are very diversified.

• Across industries: Investing in different industries spreads around the risk that any one industry could suffer a serious slump. For example, totally investing in oil, real estate, or auto manufacturers may generate wonderful returns in the short-term. However, a downturn in any one industry will wreak havoc with your portfolio overall.

• Across market caps: Market capitalization, or “market cap” for short, is a way to identify and classify companies by the size of the total value of their public stock outstanding. Typically, stocks are classified as large-cap (greater than $10 billion market cap), mid-cap ($1-10 billion market cap), and small-cap (Less than $1 billion) companies. There are also newer classifications, like mega-cap (greater than $100 billion), micro-cap (Less than $100 million), and even nano-cap (less than $10 million). You can classify companies along these lines or with a different method of your creation. The key for you, as a newer investor, is to consider investing across different sized market caps to mitigate risk and increase the diversity of your portfolio.

• Across dividend yields: Companies often differ widely in their approach to paying dividends. Some Boards of Directors strongly favor distributing earnings in the form of dividend payments, while others want to conserve cash to fund Research & Development (R&D) and/or growth. By investing in some securities with a track record of high dividend yields and also those that display cash conservation to fund new products or expansion, an individual gains some risk protection.

• International and emerging markets: Economic globalization of the world overall has made emerging markets an excellent source of diversification. Emerging markets such as those in Brazil, Russia, India and China (the “BRIC” countries), are those countries that are quickly growing their national economies and tend to reflect a market-oriented philosophy. They typically seek direct investment at all levels of funding, including from the smaller investor. If you do your homework, you may find some wonderful opportunities to increase your portfolio and manage the risk factor, while enjoying good earnings and appreciation. International markets typically are riskier than mature markets in North America and Europe, but they also offer highly attractive returns.

• Precious metals and commodity ETFs:

Many people believe investing directly in precious metals (gold, silver, etc.) or through commodity ETFs (exchange traded funds), which are tied to precious metal indices, because these investments are valuable as diversification and risk mitigation tools. Once again, you should become familiar and comfortable with the historic movement of precious metals AND the global economic conditions that preceded or existed during these price movements. In addition, precious metals have “inherent” value along with market pricing.

• Dollar Cost Averaging (buying and selling): Designed to reduce risk, dollar cost averaging strategies dictate that you buy smaller blocks of the same securities (versus large lump sum purchases) over time to reach the investment position you want. This often “smoothes out” the cost factor of these securities to help you manage the vagaries of market price changes – both up and down.

Mark's Tip

Don’t forget that you can dollar cost average when you sell, just like we taught you to dollar cost average when you are buying. When you’re not sure about a stock or stocks in your portfolio, don’t hesitate to sell 1/3 or ½ to start reducing your position over time. By spreading out your sales of a group of securities, you often “even out” the market price changes with dollar cost averaging to generate a more risk-free and stable return.

Summary

Ok new investor, you should be ready to begin. You can now leave the bleachers, put on a uniform, cross the white lines, and play. Stay focused, positive, and realistic. You might not make the Majors right away, but you can enter the investment world armed with solid knowledge, upon which you can expand by practice and repetition at a virtual trading simulation.

Glossary

Buy on Margin:

Borrowing money from your broker to buy stock.

Dividend Yield:

The annual dividend amount divided by the current stock price.

GTC Order:

A Good-Till-Cancelled order stays in effect until the order fills or it is cancelled by the account holder.

Limit Order:

An order that only executes when the target price has been reached.

Market Order:

An order that executes immediately at the best available price.

Sell Short:

Borrowing shares from your broker to sell a stock that you don’t own with the hope of the price going down so that you can then buy the shares back at a lower price and return them to your broker.

Stop Loss Order:

An order to sell a stock below the current price so that if the stock price starts to fall you will sell and limit your losses.

Further Reading

• What is a Ticker Symbol?
• What is Beta?
• Earnings Per Share (EPS)
• Daily Volume and Price
• What are Dividends?
• What is a Limit Order?
• What is a Stop Order?
• What is Margin?
• What are the margin requirements?
• Short Selling Stock

Exercise

If you haven’t done so yet, go to your virtual account and make at least 6 trades:

• Place a market order and see if it gets filled quickly
• Place a buy limit order to below the current market price of a stock and see if and when it gets filled.
• Place some of these orders as day orders and some as GTC.
• Place a stop loss order on one of the stocks that you have bought.
• Place a limit sell on one of your stocks that you have bought.
• Don’t forget to short a stock that you think is overpriced.

Don’t worry if you haven’t done a lot of research for your stocks at this point. This is just for the practice of looking up ticker symbols and placing orders.

Spend some quality time with yourself, thinking about what you really want to accomplish. Stating that you simply want to make money or become wealthy is not helpful. There is no specific target or goal. Without a target, you’re a walking example of Yogi Berra’s great quote: “We’re totally lost, but we’re making good time.”

Create a game plan and target showing where you want your portfolio to be as compared to your desired objective. If you want income, decide how much income and in what time periods you’d like to receive it. Looking for appreciation? Decide what appreciation and growth percentage you’d like. The goal and target you select is less important than the requirement of having a comparison mechanism. This gives you a working “scorecard” of your performance. You can change, ratchet up or down your comparison target as often as you wish. Just be sure to have something to measure your performance.

Comparing Your Portfolio to Benchmarks

So, you’ve bought several stocks that you have spent hours researching and one month later, you have gained 2 percent. You’re a hotshot investor, right? Maybe, maybe not.

How well did the overall stock market perform during that time frame? Because if the overall market gained 5% in that same month, then you’re really wasting your time. Instead, you could have bought an ETF that mimics the overall stock market like SPY and made more money with less effort.

On the other hand, if the overall market fell by five percent over that period, then you are quite a savvy investor (at least over that short time frame). Many professional traders are not able to beat the market over 1 year, let alone 5 or 15 years.

Let’s look at some common stock market benchmarks:

The S&P 500 index takes the prices for the 500 largest companies in America and averages them into a single number so that is easy to see the overall direction of the stock market. It is generally the most used index for benchmarking stock portfolios. You can buy an ETF that mimics the S&P 500 – its ticker symbol is SPY.

The Wilshire 5000 index captures the entire of U.S. stocks large and small and is the broadest measure of U.S. stock market performance. The ETF that mimics the Wilshire 5000 is TMW. The Russell 2000 index captures the world of smaller publicly traded companies in the United States. The ETF that mimics the Russell 2000 is IWM.

There are also benchmarks for stocks traded in other countries like the TSX index (Canada), the Nikkei (Japan), the DAXX (Germany) and virtually every country in the world that has a stock market.

Recording the gains and losses of your stock portfolio seems pretty basic. You can simply list your cost of the security in your portfolio. When you sell it, record the price you received. The difference is your gain or loss on that stock. Simple right?

In the real world, however, things are not always that clear cut. You might buy 100 shares of LUV at $10, another $100 at $10.10 and then 50 shares at $11. Then, suddenly one day you need cash, and you sell 125 shares at $15. What was your profit on those 125 shares? As an investor, you must decide how you will record your cost. There are generally 2 methods that stock traders use. The first is First-in, First-out (FIFO) which simply means that you sold the shares that you bought first—in this case you would have sold 100 shares you bought at $10 and 25 shares you bought at $10.10.

The other way to calculate the cost is to use the “average cost basis” which means you average 100 shares at $10, 100 shares at $10.10 and 50 shares at $11 to get a total cost of $2,560 for those 250 shares which averages out to be $10.24 each.

Mark's Tip

Warning: The accounting for your stock transactions can get real messy real fast. So the best thing to do is to keep a running spreadsheet of all of the trades that you have made and keep track of the profitability of each trade and the cost of each of your open positions. There is nothing more frustrating or time consuming then sitting down on April 14th and trying to calculate the profit and losses on a whole year’s worth of trades. On top of that, you must keep track of which trades you held for the short-term and which you held for the long-term because Uncle Sam treats those differently. All of your gains are taxable, but you can only deduct $3000 per year in losses.

When working with your broker, accountant, and tax advisor, you’ll always have an up to date idea of where you stand with your investment activities using this simple recording method. You can then let your expert advisors handle the more complex accounting and tax issues involved in your investing activities.

Most virtual trading accounts will allow you to short sell so you should definitely practice shorting with your virtual account before you try it in your real brokerage account. You might want to wait a while before you consider a short selling strategy. Sure, you can make money selling short, but you could also come up very short if the stock that you shorted skyrockets.

Here is how it works in detail:

Suppose you do some research and think that LUV’s traffic is falling and the price of oil is skyrocketing and you believe it will continue to do so for at least the short-term. You place an order to Sell Short 100 shares of LUV and you get filled at $10.

Your broker will borrow the shares for you and sell these shares and your cash balance will go up by $1,000 and your Market Value of your stocks will now go down by $1,000 (you now owe the broker 100 shares of LUV). If you’re correct – and the price of LUV starts to drop – you can then purchase that number of shares at a lower price and replace those that you “borrowed.” This is called “Covering Your Short” and you will pocket a decent profit on the short sale.

However, should you be wrong and the price of LUV increases, you may be less than pleased with this strategy as you will have to go out and buy the LUV shares at a higher price such as $12.00 and now you have lost the difference in the prices or $200.

For a walk through of how to short sell, see the Short Selling Stocks Video Tutorial.

Mark's Tip

A lot of people talk about how risky shorting is, but the reality is that the only difference between shorting and buying on margin is that if you short a stock it can go upwards to $1,000s of dollars, but when you buy a stock the most it can down is to $0.00. So, when you buy on marginBorrowing money from your broker to buy stock. you know that the most you can lose is the value of the stocks you bought, but when you short stocks you could technically have unlimited losses if the stock goes to infinity!

Margin buying can be very convenient and cost effective. However, you should always maintain good control of these activities to avoid a financial problem in the future. This is a bit complex, but makes sense with some practice.

You can normally borrow up to 50% of the value of the securities you’re buying. There are also minimum margin requirements that must be maintained. Should your account or collateral fall below the minimum required, you’ll be issued a “margin call.” You’ll be required to add to your account or be forced to sell securities at their current market value, whether you want to or not. You should try to keep appropriate minimum margin requirements at all times. Margin calls can often be costly for you because they usually force you to sell stocks at low prices thereby locking in losses on your account.

The good news: You can maximize your buying ability by using less cash to purchase more shares. Your power will depend on the amount of leverage your broker allows. For example, most brokers have a 50% margin requirement which allows a 2:1 leverage ability. With 50% margin requirement, $10,000 deposit of cash by you in your brokerage account can be used to buy up to $20,000 of stock.

The bad news: You’ve maximized your buying power, but should your stock fall in value, your losses are maximized, too. Also, should your account fall below the margin minimum requirement, you’ll have to come up with more cash or stock to get your account back in compliance.

Mark's Tip

Here is a brief example that should clear away any fog. Assume you want to purchase 100 shares of LUV at $10.00 per share—that will cost $1,000. You decide to use $500 of your own cash and $500 borrowed from your broker. You’ve just made a margin buy. Your net value is $500 ($1,000 stock less the $500 loan). If the stock goes to $15 and you sell you will receive $1,500. The broker will take $500 to pay off the loan, and you pocket the other $1,000. In this example, you made a 100% return because you turned your initial $500 into $1,000. Had you not bought on margin you would have only been able to buy 50 shares at $10 for a total cost of $500, and then you would have sold your 50 shares at $15 for $750 or a profit of $250 or 50%.

Likewise, if you bought 100 shares on margin and the stock went down to $5 and you sold that $500 from the sale would go to payoff your loan and you would be left with $0—meaning you lost 100% of your investment on a 50% decrease in stock price.

When placing your Market, Limit or Stop orders, you can also place orders to control the duration of your order.

• Day Order: Regardless of the type of order you issue (market, limit, stop, etc.), a day order means it is only good for one day. Should your broker be unable to execute your order by the close of the business day, regardless of its type, your order is cancelled. Should your broker execute your order, in error, the next day, you are not obligated to honor it. Should you forget to specify a time period when you place your order, brokers will assume you’ve issued a day order.
• GTC (Good Till Canceled): A GTC orderA Good-Till-Cancelled order stays in effect until the order fills or it is cancelled by the account holder. indicates that your instructions to your broker are “open ended.” Technically, a GTC order stays in effect until it is executed or you cancel it. For everyone’s protection, many brokers will set their own time limits such as 60 or 90 days.
• Fill or Kill Order: Less common than the two favorites listed above, a fill or kill is a Limit OrdersAn order that only executes which the target price has been reached. that you want executed immediately. If your order cannot be filled exactly as placed, it is immediately killed or canceled.

Finally, understand that a new order typically cancels a former order. For example, let’s say you issue a day order to your broker combined with a stop order. You rethink your decision and issue a GTC. Your day order is canceled and replaced with a GTC.

Go to your free virtual trading account and you’ll see several options for order type—market, limit and stop.

You have already found the symbol to trade “LUV” and you can enter any quantity of shares to buy. Many virtual trading accounts implement a position limit that forces you to diversify so you can buy up to 25% of your portfolio value. At real-money brokers, of course, you can “put all of your eggs in one basket” and buy as many shares of a stock as your cash and buying power will allow.

There are several different types of orders you can use when you place a trade. A few of the most popular and those you should become familiar with include:

• Market OrdersAn order that executes immediately at the best available price.: The simplest variety, a market order instructs your broker to execute your order immediately at market prices, whatever they may be. Depending on which “hat” you’re wearing (buyer or seller), as long as there are other willing buyers or sellers of the stock you want to acquire or dispose of, your order should be quickly carried out. Your buys will always be executed at the best ask price, and your sells will be executed at the best bid price.
• Limit OrdersAn order that only executes which the target price has been reached.: When you place a limit order, you’re asking to buy a stock at no more than or sell a stock at no less than a specified price that you set. For example, suppose you decide you want to buy shares of LUV at $9.25 when it is currently trading at $9.45. You would place a limit buy order for $9.25 which should fill if the price drops down to $9.25 or lower. Once you buy the shares, you might want to place a limit sell at $10.00 which should fill if the price gets to $10.00 or higher.
• Stop Order When you place a Stop Order, you are asking to buy a stock once a certain upper price point is reached, or to sell a stock once a lower stock price has been reached.: For example, suppose you bought your LUV shares at $9.25 and instead of placing a Limit Sell Order at $10.00 you decide to place a Stop Sell Order at $8.75. This order, also known as a “Stop Loss” order, would sell your LUV shares if the stock price dropped to $8.75. These orders are used to limit your losses. A Stop Buy Order would be used if LUV was trading in a $9.25 to $9.50 range and you only wanted to buy it if the stock price spiked up to $9.60. People use Stop Buy orders so that they can buy a stock only when it breaks out of a narrow trading range.

You can easily use the quote page on your brokerage account to locate stocks you might want to buy. If you know the ticker symbol you want to buy, or know the company’s name, you should be successful in locating the current price and status of any publicly traded security. Remember, some companies have multiple classes of stocks and/or other securities. You should know exactly what stock or security you’re looking for so you don’t get incorrect information and pricing.

Type in “LUV” into the quotes page on your free trading account and should get something like this:

You should become comfortable with the data you receive when you look up a stock. Here are some brief explanations of the numbers:

• Last Price: The most recent price that the stock has traded.
• Today’s Change: The change in price (and the percentage change) compared to yesterday’s closing price.
• Today’s open: The first price at which this stock traded when the markets opened up this morning. Note that stocks DO NOT open at the same price that they closed at the day before.
• Volume: This indicates the number of shares that have traded today. Some stocks may trade millions of shares each day, and others only trade a few hundred or even zero shares per day.
• Previous Day’s Close: This number is the price of the stock for the last trade of the previous day.
• Bid/Ask:  The “bid” is the highest price a buyer is currently willing to pay for a stock, while the “ask” is the lowest price at which a seller is currently willing to sell (sometimes this is also called the “offer”). The size is the number of shares for the bid or ask price.
• 52 Week High/Low: This is the highest/lowest price the stock has traded at during the last 52 weeks and allows you to compare the current price to its 52 week range.
• Charts: Stock charts come in a variety of formats. They all track pricing data, usually the OHLC (open, high, low, close), but they can display this information with different styles (lines, bars, candlesticks), different date ranges (day, week, month, year, 5 years) and other information like volume, moving averages and dozens of other indicators. If you like pictorial representations, you’ll find charts for every statistic and relationship for stocks.
• Annual Dividends: Dividends are cash payments that some companies make as a way of returning operating profits to the shareholders. If you own enough stock, you might have a wonderful income just from your stock dividends.
• Annual Dividend YieldThe annual dividend amount divided by the current stock price.: This is an important measure of return of the stock and is calculated as the Annual Dividend amount divided by the current stock price. If the stock is at $10.00 and the company pays out a cash dividend of $0.50, then the Annual Dividend Yield is 5%.
• EPS: Earnings Per Share displays the company’s earnings (profit) per share. It is calculated by dividing the company’s most recent annual income by the number of shares outstanding.
• Beta: Beta is used to measure the volatility of a stock as compared to the market as a whole. A beta of 1 means that it moves equally with the market. A beta greater than 1 means the stock moves up or down more quickly than the market overall; a beta between 0 and 1 means the stock doesn’t move as much as the market, and a negative beta means the stock moves in the opposite direction of the market.

Mark's Tip

Find a website that gives you the type of information you are looking for when you get stock quotes.

Stock ticker symbols are usually 1 to 5 letters long. (Occasionally they contain a “.” or a “-” to designate a subtle difference or class of shares.). Some of the oldest and biggest companies have only one letter as their stock symbol:

• C (Citigroup)
• F (Ford Motors)
• S (Sears)
• T (AT&T)
• X (U.S. Steel)
• Z (Woolworth)

Ticker symbols for some of the largest and most widely held stocks are below. These are the 30 stocks that make up the Dow Jones Industrial Average that you hear quoted all of the time:

The Dow Jones Industrial Average consists of the following 30 companies:

Some ticker symbols have a sense of humor like LUV (Southwest Airlines), and YUM (Yum Brands), which owns Kentucky Fried Chicken, Taco Bell and Pizza Hut.

Glossary

Mutual funds and ETFs (exchange traded funds) have been available since the mid-1970s (mutual funds) and early 1990s (ETFs), attracting billions of investment dollars. An easy way for investors to diversify their portfolio without doing extensive research on individual companies and stocks, they are attractive to the casual or, perish the thought, lazy investor. Over time, mutual funds, ETFs, and Index ETFs (funds specializing in and tied to an industry index) have performed quite well.

You should understand, however, that few of these funds have outperformed the market in general. More than 90% of mutual funds fail to beat the S&P 500 index (a compilation of the 500 biggest U.S. stocks) every year, making mutual funds an expensive way to pay for diversification and risk management.

One of the many reasons that funds cannot beat the markets is because of the obvious expenses that they have. They buy ads in magazines and on TV. They have large legal and accounting expenses. And they have to mail you your statements every month. Some mutual funds charge rather large fees for trades and/or management. Always learn about these fees before you decide which mutual fund is best for you. In most cases, these fees reduce your return by 0.50-2.00% and make investing in individual stocks by yourself the logical choice.

One of the myths about the stock market is that you get what you pay for and that by paying big fees, you’ll get a big return on your return. That simply isn’t true and, in fact, the opposite is more often true: low fees and no expenses usually lead to the biggest returns on your money.

To learn about other market myths, see Myths About Stock Market Investing.

The stock markets of the world are a wonderful opportunity to increase your wealth. However, you must bring your brain and knowledge with you when you enter these waters. It’s important that you learn all that you can about the market: how it works, market cycles, how it faces roadblocks and problems, and how you should react to the highs and lows that eventually occur. Be strong, be confident, be smart, hopefully be lucky – and be profitable!

Over time, stocks have proven to achieve a consistently high ROI. For example, over the entire century, from 1900 to 2000, global stocks returned 9.2% on average, per year (U.S. stocks returned an even better 10%!) while bonds generated 4.4%, and cash (short-term Treasuries) returned only 4.1% on average, per year.

The difference between investing in stocks versus staying in cash and earning short-term Treasury rates over a lifetime of saving can end up being hundreds of thousands of dollars! Take a look at the chart below of two different investors. One invested in cash (Investor A), the other in stocks (Investor B). Both investors had the exact same amount of money to invest ($100,000) and same amount of time to see their investments grow (20 years). Look at the difference:

Investor A ended up with $214,567, a 114% return – not bad. But Investor B who bought stocks ended up with $532,590, a 433% return!!! By investing in stocks by simply buying the broad stock market through the S&P 500 index, Investor B made $317,823 more money than Investor A who remained in cash and earned short-term Treasury rates..

Uninformed people think you can get rich or poor fast with stocks as compared to other more stable investments. You certainly could achieve these dubious results. However, if you follow the simple rules you learn in this course, you will prevent yourself from falling into that trap. It is a fact: over the last 100 years, stocks have proven to be the BEST investment despite their daily – sometimes hourly – ups and downs.

Mark's Tip

You must understand our emphasis on the long-term value of investing in the stock market. Investing in the stock market will not allow you to “get rich quick” but, as the last 100 years prove out, investing in stocks WILL allow you to “get rich slowly.”
However, timing and your investment horizon (the amount of time you have to leave your money invested) will determine your success. Take a look at this table below. If you had only 1 year to invest in the stock market, over the last 100 years you could have earned anywhere between 61% and -39% in that 1 year. But if you had 10 years to invest in the stock market, you would have AVERAGED somewhere between 19% and 0.50% per year, with a likely return of 11.10%.

US Stocks Average Returns for Different Holding Periods

Years	Highest	Lowest	Average
1	61.00%	-39.00%	13.20%
3	33.00%	-11.00%	11.60%
5	30.00%	-4.00%	11.90%
10	19.00%	0.50%	11.10%
20	15.00%	6.40%	9.50%

Finding the right full service broker is somewhat like locating the right doctor, accountant, lawyer, or psychologist. Sometimes you have to kiss many frogs before you find your prince. At other times, you can get a strong recommendation from a trusted friend or family member for a broker and you may have immediate chemistry with their broker. Much depends on how active you want to be in the investment market and which types of investments you favor (stocks, mutual funds, bonds, etc.).

The very fact that you have read this far indicates that you want to be more of a do-it-yourself type of person, so a discount broker is probably all you need. Discount brokerage accounts are easy to open, and generally require as little as $1,000 open an account.

If you can learn to anticipate market trends before they occur, you will become a very successful investor.

Be careful though. Timing, which can make or lose you money, is not easy to master. There is no underlying secret to getting it right.

Because timing markets requires you to be correct twice: first when you buy a stock at a cheap price and a second time when you sell it back at a higher price. Most investors have a hard enough time simply buying low, let alone selling high.

This difficulty in market timing has led many investors to adopt a “Buy and Hold” strategy where they buy a stock and hold it for as long as it is profitable. When famed billionaire investor Warren Buffet was asked how long he likes to own a stock, he shot back, “Forever.”

Also, remember that there can be serious costs if you have poor market timing. Unlike some other investments (e.g., real estate), stock trading often comes with a short clock. Prices can change – for better or worse – very quickly. Even expert stock traders experience losses because of timing. The best thing an investor can hope for is merely to be right a bit more often than be wrong.

Mark's Tip

When trading stocks, we all would like to consistently buy at the bottom and sell at the top of a stock’s trading range. But you need to accept the fact that this is impossible. A good target is to try to buy in the bottom 25% and sell in the top 25% of a stock’s trading range–that is a more reasonable goal.

The table below shows that over 5,037 days (a 20-year period from 1994 to 2013), $10,000 invested in an S&P 500 index would have generated a gain of $58,352.

If an investor tried to time the market and missed the top 20 days with the largest gains in that 10-year period, they would have ended up with a different result—a loss of $360! Missing just 5 of the biggest days drops your annually return from 9.22% to 7.00%.

Nevertheless, don’t let the dangers of timing the market dissuade you from trying to learn and recognize the trends in order to buy low and sell high.

Mark's Tip

Remember that stock market prices are based on future earnings potential, and not necessarily past or current results. Therefore, even though the economy might be in a recessionA recession occurs if a business cycle contraction is severe enough and the GDP declines for 2 consecutive quarters., that doesn’t mean that stock prices must be falling. If the majority of investors feel that the recession has ended and a Bull MarketA prolonged period of optimism and rising stock prices that seems to feed on itself and generates even more optimism and even higher stock prices. is coming soon, stock prices will start going up in anticipation of the next bull run.

• When a Bull MarketA prolonged period of optimism and rising stock prices that seems to feed on itself and generates even more optimism and even higher stock prices. exists, the majority of investors feel very positive about the current business cycle, the stock market, and the overall condition of the U.S. and/or global business. More and more investors leave the spectator position and get in the game by buying stocks. More investors mean more money in the market. More money in the market usually translates to more buying activity and higher stock prices. This is a perfect example of supply and demand in action.
• Bear Markets indicate the opposite philosophy of large sectors of the investment community. Investor confidence is down and the community perceives that the current business cycle is at or in a downturn. Many investors tend to become spectators, not players, and sell stocks. They are fearful about the prospects for investing and as money leaves the market, stock prices tend to drop. Investors then take their cash and usually buy safer investments like U.S. Treasury and Corporate bonds. (Bond prices then rise, making their yields less attractive, thereby slowing the exodus from the stock market.)

The reason why these two market extremes are called “Bull” and “Bear” is not clear. Some say that a Bull wants to “buck up” prices while the Bear wants to “claw down” prices. In any case, the Bull and Bear are iconic symbols on Wall Street that are continually fighting each over for control over the market’s overall direction.

As an investor, you need to know who is winning this battle between the Bull and the Bear and invest appropriately. Once you understand the trend – Bull or Bear – treat the trend as your friend.

This cliché, “the trend is your friend”, is one you must remember. If we are in a Bull market and the trend is up, then it is a perfect time to buy low and sell high. In a Bear market, the trend is also your friend, and there are ways to make money when stock prices are declining.

Mark's Tip

“The trend is your friend” and “buy low and sell high” are great clichés to remember. In a Bear market, another cliché is “sell high and buy low”. This is called Selling Short and this topic will be discussed next in Chapter 3. Also, another hot cliché is to “buy high and sell higher.” This one is about identifying stocks with strong momentum and that are breaking out of a narrow trading range—more about Momentum Trading in Chapter 8.

Your first requirement is to understand ” business cyclesThe typical business cycle consists of periods of economic expansion, contraction (recession) and recovery to a new peak..” Understanding what business cycles are is relatively easy to do, but predicting them is nearly impossible and even the best economists at Harvard University rarely agree.

If you are over the age of 18, you know that business cycles exist. We have all heard the terms of recessionA recession occurs if a business cycle contraction is severe enough and the GDP declines for 2 consecutive quarters., depression, expansions, boom, and bust. The economy seems to go strong for a while where everyone has a job, feels optimistic about the future and we hear the stock market setting new highs. Then it seems as if overnight, we hear about companies that have overbuilt, laying people off and freezing wages. You may not have realized it then, but you were riding the ups and downs of a business cycle.

Don’t confuse one company’s sudden success with business cycles. Fads and single industries or conditions seldom influence a business cycle. Like a perfect storm, business cycles are the product of multiple components. As a newer investor, you should understand and accept that they happen. It’s never a question of “if,” only “when” a business cycle will peak or bottom out. Investing just before a peak can be costly. Conversely, investing at the bottom can be quite profitable.

The typical business cycle consists of periods of economic expansion, contraction (recession) and recovery to a new peak as seen in the graph below:

A business cycle is usually identified as a sequence of four phases:

• 1. Contraction (A slowdown in the pace of economic activity)
• 2. Trough (The lower turning point of a business cycle, where a contraction turns into an expansion)
• 3. Expansion (A speedup in the pace of economic activity)
• 4. Peak (The upper turning of a business cycle)

A recession occurs if a contraction is severe enough and the GDP declines for 2 consecutive quarters. During recessions, which generally last 1 or 2 years, interest rates decline to help stimulate new business. A deep trough is called a slump or a depression.

Now, here’s the premise behind economic cycles: They are more than just mere fluctuations in economic activity; they are significant oscillations of human behavior consistent and powerful enough to impact the economy. Sometimes the business cycle moves in shorter cycles, and occasionally it might take a decade to recover back into a growth mode (think Depression here).

Economists and Wall Street argue all of the time about when we have topped out and when we have bottomed out. That is why so much attention is paid to the economic indicators that the U.S. Government releases monthly or quarterly like the Indicators below:

For the purposes of this introductory course, suffice it to say that you must start paying attention to the cycle the current economy is in. If you want to explore further the deep and fascinating world of cycles, here are some of the more important cycles you should look at:

• The Kitchin Cycle
• The Juglar and Kuznets Cycles
• The Kondratieff (Kondratiev) Wave
• The Schumpeterian Cycle of Innovation
• The Armstrong Cycle of Economic Confidence

Knowing where you are in the overall business cycle is very important as an investor. As you might expect, just as the economy moves in cycles, so too does the stock market. In fact, the stock market generally moves in advance of the business cycle because the stock prices are based on both past earnings and future expectations of earnings.

Furthermore, as the economy is moving in its cycles and the stock market is moving in its cycles, stocks also move in cycles. After all, you can find the best stock to buy in the world, but if it is not timed well with the overall business and market cycles, it may turn into a loss. Every stock or asset class goes through a classic cycle that is similar to the business cycle. Here is a diagram of the four stages of a stock’s cycle:

Now compare these charts with a chart of how the market has performed since 1900. This is a chart of the Dow Jones Industrials Average. This is simply a composite price of the 30 largest companies in the U.S. and is used as a benchmark as to how the market is performing overall. You will note many up and downs in the market, but with the overwhelming trend being up.

When you look at the chart of any stock or index, it typically moves in cycles that are closely related to the overall business cycle. For more information on timing stock picks with business cycles, our article here: Understanding Market Cycles: The Art of Market Timing

Most companies are private companies and don’t trade on exchanges. The barber shop and the florist on the corner, the guy that cuts your grass, and the plumber that fixes your sink are all likely small companies that are owned by the founder.

As companies grow, they typically find they need additional money to expand. This extra cash can come from company profits, the founder’s personal funds, borrowing (think debt and bonds here), or giving away part of their ownership (think equity here). Selling ownership to a few friends and family would be considered a “private offering” where just a dozen or so people buy ownership, but selling ownership to hundreds or thousands of investors is what is referred to as a “public offering”.

When a company decides to “go public”, they enlist an investment banking or brokerage firm to sell their shares to the public. You may have heard the term “IPOIPO stands for Initial Public Offering. This represents the FIRST opportunity for the public to purchase shares in a particular company.“. IPO stands for Initial Public Offering. This represents the FIRST opportunity for the public to purchase shares in a particular company. Until a company’s IPO date, they have been functioning as a privately held entity. One or a few people owned all of their stock and they were not registered or approved by the SEC (Securities Exchange Commission).

As a potential investor, you should understand a bit about the IPO process from its beginning. The IPO doesn’t happen on a whim. At a bare minimum, it involves the following.

• Compiling an impressive “track record” in business, displaying good profits and future income trends.
• Carefully considering the following:
  1. Market for the stock (Would people be interested in buying shares?)
  2. Ramifications of giving up large chunks of ownership to others
  3. The potential benefits (How much money could it raise?)
  4. The high cost of lengthy IPO preparation (There is a ton of paperwork required.)
  5. How the new money could help grow the company
• Assembling a team of accountants, attorneys, and advisors who are experienced in IPOs and SEC registration and approval.
• Being financially stable enough to afford the time (the process is time consuming and time sensitive) and the large expense of assembling all the SEC-required paperwork (which is massive and detailed), which is necessary to obtain approvals and permissions for an IPO.
• Locating a securities dealer or investment bank willing to sponsor your IPO to the investment market. These entities are the underwriters of your first public sale of stock.

As an investor, you should be aware that you are typically taking more risk when dealing with an IPO than with other stock purchases. Since the company has never had publicly traded stock, you have little assurance that their IPO price will stabilize or increase. However, sometimes you encounter an IPO like Google (GOOG) and your newly acquired stock may double, triple or even quadruple in a short period!

When you buy shares of an IPO, your money goes directly to the firm that you are investing in and they use it for their expansion plans. After you have bought shares in an IPO and you want to sell your shares, you must sell them on the secondary market, like the NYSE, AMEX, or NASDAQ. These shares that trade on exchanges are owned by individuals and other businesses and are sold to other individuals and businesses. When a stock trades on one of the exchanges, no more cash goes back to the company. This is in contrast to an IPO, where the seller is the company marketing their own stock and the company gets the cash from the sale of their stock. The secondary market is the major purveyor of securities around the world.

To see the latest IPO’s hitting the market, see Yahoo!’s IPO center.

Mark's Tip

Don’t think that just because you have a brokerage account at Etrade or Schwab that you will be able to participate in an IPO. The investment banks typically sell those initial shares to other banks, brokerage firms, and high net-worth individuals. When Google went public, E*trade was given the right from Google to sell a certain number of shares, and you had to enter a lottery with Etrade to win the right to buy 100 shares of Google. I didn’t win the Etrade lottery for the Google IPO but one of our employees did. He bought 100 shares at $85 and sold it within 30 days at $125. He made a great 50% in 30 days, but within a year the stock hit $299 for a staggering 252% gain.

In addition to the New York Stock Exchange, there is also the American Stock Exchange (AMEX) and NASDAQ. In the past, the NASDAQ was for smaller companies that were just getting started, and it was prestigious for them to move up to the NYSE or AMEX. These smaller companies included a few you might have heard of, like Apple Computer (AAPL),Intel (INTC), and Microsoft (MSFT). In the past decade, with the success of the NASDAQ and the linking of these exchanges via computers, companies don’t bother switching from one exchange to the other like they use to.

When you place an order with your stock broker, your stock broker sends your request to one of the Stock ExchangeStock exchanges are simply organizations that allow people the ability to buy and sell stocks. to see what the best price is. The price that buyers are willing to pay is called the “Bid” price and the price that sellers want to sell for is called the “Ask” price.

If you are willing to accept the current prices being quoted, your broker will send your order as a “market” order meaning you will get filled at the best price available when your order hits the exchange. If you are buying stock, you will get filled at the price the sellers are “asking”, and if you are selling, you will get filled at the price that buyers are “bidding.” The system is very efficient, and the difference between the bid and the ask priceThe price that sellers want to sell for is called the “Ask” price., known as the bid/ask spread, is usually only a few cents.

Seeing the Bid/Ask prices in the North American exchanges are not free – you generally have to pay to see them. That is one way that the exchanges make money.

Even with this growth of computers, the stock exchanges themselves still function much as they have for many years. Should you watch some video or visit a stock exchange, you will still see a morass of apparent chaos, with people running around with handfuls of small pieces of paper containing purchase and sales orders. If you witnessed this chaotic activity at almost any other business, you’d naturally assume bankruptcy, a tornado, or a tsunami was at the front door.

Yet talk to any trader on the floor of an exchange and they’ll tell you it all works well. While it appears to be total, unbridled chaos, the system has worked for many years and continues to be effective today.

Most stock exchanges are actually incorrectly named. Their former identity, securities exchanges, is more correct. Along with equity securities (stocks), stock exchanges also typically facilitate trading of options, bonds, pooled investment products (e.g., mutual funds), investment trusts, commodity futures and some of the other financial products defined in Lesson 1.

In 1685 the city planners laid out a street running parallel to this 12 foot high wall and for lack of a better name called it “Wall Street.” Wall Street continued to grow in popularity, and in 1789, the Federal Hall building at the corner of Wall Street was the scene of the United States’ first presidential inauguration of George Washington. This is also the same location where the Bill Of Rights was passed into law.

In the late 18th century, a group of traders and speculators started meeting underneath a large, shady, buttonwood tree on Wall Street to trade investments informally. In 1792, twenty-four of theses most active traders formalized their association with the Buttonwood Agreement.

A Stock ExchangeStock exchanges are simply organizations that allow people the ability to buy and sell stocks. also developed in Philadelphia at about the same time period, and the founding members of the Buttonwood Agreement, fearing the success of the Philadelphia exchange, formally created the New York Stock and Exchange Board on March 8, 1817. Originally, there were five securities traded in New York City with the first listed company on the NYSE being none other than the Bank of New York.

In 1889, the newspaper that was the first to list stocks and their afternoon prices, called the Customers’ Afternoon Letter, changed its name to The Wall Street Journal for obvious reasons.

Stock exchanges are simply organizations that allow people the ability to buy and sell stocks, and a stock is simply a representation of fractional ownership in a company. Think of a stock exchange as a cross between a neighborhood flea market and an auction. The flea market part of the analogy is to show that there is a central gathering place for buyers and sellers of various products, and the auction part is to show that whatever is being bought and sold is done so at the best possible price for all of those in attendance.

Each day at the exchange (flea market) brings a new group of individuals with different expectations and different amounts and quality of products to sell. These differences result in slight prices changes each day.

The stock exchanges, through the use of computers, allow for simultaneous auctions going on for every stock that trades on the exchange every second that the exchanges are open. When the buyers and sellers agree on a price, a trade occurs; when buyers and sellers don’t agree on a price, a trade does not occur, but the computers show what price the buyers are willing to pay and what price the sellers are willing to sell.

The stock exchanges provide a convenient environment that allows buyers to buy and sellers to sell quickly and easily. The super sophistication and speed of computers has only helped all investors and stockbrokers receive up-to-the-second prices and execute trades faster.

Bond (Corporate, Treasury, or Municipal):

A debt obligation of a company, the U.S. Treasury Department, or a city where the borrower receives funds (usually in increments of $1,000), makes semi-annual interest payments based on the coupon rate, and eventually repays the borrowed amount ($1,000) to the lender at the maturity date of the bond.

Certificates of Deposit (CDs):

An investment choice at most banks where you agree to deposit a specific amount of money for a fixed period of time (this is called the maturity). By agreeing to keep your money at the bank for a certain length of time, the bank usually pays you an interest rate higher than savings and Money Market accounts.

ETFs:

Exchange Traded Funds are a cross between mutual funds and stocks. ETFs are simply a portfolio of stocks or bonds or other investments that trade on a stock exchange just like a regular stock does.

Money Market Account:

An account typically found at a bank that usually pays a higher interest rate than savings accounts, but limits the number of transactions you can make in a month.

NAV:

Net Asset Value of a mutual fund at the end of the business day. It is the equivalent of a share price of a stock.

Stocks:

Stocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company.

Yield Curve:

A graphical representation of the relationship between yield and maturity. Yield or return is on the vertical axis and the maturity on the horizontal axis. Generally the shorter maturity investments have lower yields and the longer maturity investments have higher yields.

Further Reading

• Benefits of CD’s (Certificates of Deposit)
• What is a Stock?
• What is a Stock Index?
• What are Mutual Funds?
• What is an Exchange Traded Fund (ETF)?
• What is the S&P 500 Index?
• Benefits of an Exchange Traded Fund (ETF)
• What are Bonds? What is the Call Risk of Bonds?
• Profit from a falling Dollar with Currency ETFs
• Investing in Real Estate through REITs
• Introduction To Stock Trading Risk Management

Exercises

Browse through the business section of any major newspaper, (online is ok) and look for stories about the different types of investments: CD’s, Bonds, Stocks, Mutual Funds, ETFs, Precious Metals, and Real Estate.

• MSN
• Fool
• The Street
• Finance.yahoo.com
• Bonds on Finance.yahoo.com
• Funds on Finance.yahoo.com
• MorningStar

Can you recognize the different types of investments just by looking at the headlines? If not, don’t worry, we’ll go into detail about these investments in greater detail in the chapters that follow.

Use this historical information in conjunction with the projected investment horizon for the future to identify your own comfort level and threat index. Use all the solid expert data you can find. For example, if gold values typically increase when the real estate market spirals downward, build this probability into your investment strategy.

Remember, there is no risk-free rate of return or investment. The key is to establish the risk, evaluate the potential return in light of this risk, and decide which investments suit your personality. Your journey into the investment world has now begun. Enjoy the ride!

Mark's Tip

The single most important point to consider when investing is to have clear and reasonable objectives, which includes knowing how long you are planning to invest. “Making as much as you can as fast as you can” is not a clear, reasonable objective. “Investing $500 a month and earning a 5% annual return for the next 10 years so I can put my kids thru college” is a clear and reasonable objective. If you are young then you should be taking some risks because you have time working in your favor. If you are approaching retirement age and need monthly income and need to protect your nest egg, then you should consider that in your investment selection.

For example, regarding real estate, you’ll see the price of homes has fallen from 2006 to 2009, in part owing to a bad economy. As we stated: In normal or expanding economies, real estate investing can be quite lucrative and relatively safe. In down markets, both the potential rewards decline and the possible risks escalate quickly.

• Buy specific pieces of residential and commercial property
• Invest in mutual funds focused on real estate investments or a REIT (real estate investment trust). REITs invest in properties like shopping centers and other rental properties, and therefore, generally pay off a high dividend as long as they properties they invest in stay leased.
• Invest in MBS (mortgage-backed securities) or MBO (mortgage-backed obligations)

In normal or expanding economies, real estate investing can be quite lucrative and relatively safe. In down markets, both the potential rewards decline and the possible risks escalate quickly.

To invest in the Real Estate market in the stock market, you can trade REITs, ETFs like SRS, or the stocksStocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company. of any of the following home building companies:

• DR Horton (DHI)
• Toll Brothers (TOL)
• Lennar (LEN)
• Pulte Homes Inc (PHM)
• Centex Corp (CTX)

Mark's Tip

If you plan on living in a city for more than 5 years, you should buy a house. After you have a house and you have started to grow your nest egg, buy a vacation home somewhere that you want to go to for the next 20 years. Just as you should never put all of your money in one stock, you should never have all of your personal wealth in the stock market. Use REITS in your stock portfolio if you are seeking high dividend yields, but ALWAYS get out before the next recession hits. Home building stocks are generally leading indicators and their activity gives you an indication of where the economy is heading.

Investing in foreign stocksStocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company. is just like investing in local stocks, except you introduce another level of risk. If you try to buy a foreign stock, for example, you are really making two bets at the same time. First you must convert your currency into the currency of the foreign exchange, and then you use that foreign currency to buy one or more foreign stocks. You now have all of the risk and return possibilities of stock ownership, but you are also investing in a foreign currency, which you hope will be profitable when you sell your foreign stock and convert the foreign currency back into your local currency.

Currency speculation and hedging (usually through hedge funds) are similar. You invest in foreign currency believing (sometimes just hoping) that the exchange rate against the dollar becomes more favorable – and profitable over time. As you can imagine, you can make or lose a great deal of money in the arenas of FX (also called FOREX), currency speculation, and hedging.

You should become very knowledgeable or employ a trusted expert to help you become a smart and successful investor in these areas. Most advisors would agree that this area is consistently one of the most “exciting” options for investors.

Mark's Tip

Don’t trade FX unless you have an MBA from one of the top business schools, you have a mentor, AND you have $100,000 to burn.

For example, you should have up to five options on how you’d like to invest in precious metals.

• Coins and bars: If you enjoy a high degree of “tangibility,” accumulating coins or gold bars should satisfy that craving.
• Certificates: If you’d rather not have your spare bedroom filled with gold bars, choose certificates that indicate your ownership in specified amounts of precious metals.
• Precious metal mutual funds: If you’d like to spread your risk over several precious metals, you might like this option.
• Purchase stock directly in mining corporations: Get right to the source of your favorite precious metals if you wish (for example, Barrick Gold (ABX)).
• Purchase precious metal futures: This is often the most “exciting” (and risky) option as you would gamble a bit on what gold or other precious metals will be valued in the future.

Investing in precious metals is more challenging then trading stocks. With Apple Computer (AAPL, we all know what a Apple computer, an iPhone and an iPod is so at least we think we understand the company. But investing prudently in precious metals is much more complicated since it is a global commodity, an inflation hedge, an interest rate hedge, and a the-world-is-ending-soon hedge.

That being said, many advisors are recommending everyone own up to 10% of one’s portfolio in precious metals.

You can trade precious metals using the following ETFsExchange Traded Funds are a cross between mutual funds and stocks. ETFs are simply a portfolio of stocks or bonds or other investments that trade on a stock exchange just like a regular stock does. : GLD (to buy Gold) and SLV (to buy Silver). Look how the GLD ETF effectively matches the spot price of gold:

These ETFs allow regular stock traders to trade these precious metals in a stock account without going into the riskier futures markets.

At Virtual-Stock-Exchange, you can also trade these ETFs, but you also have access to trading commodity spot contracts directly (buying and selling gold, oil, corn, and more).

At StockTrak, you can trade both the ETFs and Spots, but you also can trade commodity futures and even future options!

Mark's Tip

We all wear gold around our necks and fingers, it’s used in electronics, and if you are King Tut, you are buried in a gold casket. I have also read that if all of the gold in the world was melted into one big cube, the cube would only be 20 yards wide. That means limited supply so that is why the price is on a solid upward slope. Buy GLD when you think the world is in chaos, but only if you beat everyone else to it!

After a bond has been issued directly by the company, the bond then trades on the exchanges. As supply and demand forces start to take effect the price of the bond changes from its initial $1,000 face value. On the date the GE bond was issued, a 5% return was acceptable given the risk of GE. But if interest rates go up and that 5% return becomes unacceptable, the price of the GE bond will drop below $1,000 so that the effective yield will be higher than the 5% Coupon Rate. Conversely, if interest rates in general go down, then that 5% GE Coupon Rate starts looking attractive and investors will bid the price of the bond back above $1,000. When a bond trades above its face value it is said to be trading at a premium; when a bond trades below its face value it is said to be trading at a discount.

Here is an example with a bit more of a breakdown:

If you buy a bond at $1000 that pays a 5% coupon, then every year you will get $50 back in interest and when the bond matures you get the $1000 par value. So in this case, your yield is 5%.

If you paid $900 for the bond, you would still get $50 in interest every year plus the $1000 par value when the bond matures. So the $50 return on the $900 cost is 5.55% return per year and the $1000 back on the $900 is another good return so the overall yield will be OVER 5.55%.

If you paid $1100 for the bond, you would still get $50 in interest every year plus the $1000 par value when the bond matures. So the $50 return on the 1100 cost is 4.54% return per year and the $1000 back on the $1100 initial investment is a negative return so the overall yield will be LOWER than 4.54%.

Understanding the difference between your coupon payments and the true yield of a bond is critical if you ever trade bonds.

There are three common types of bonds available for general sale. They offer different levels of security and projected earnings:

Treasuries:

U.S. Treasuries carry the full faith and credit of the U.S. Federal government. Therefore, purchasing Treasuries eliminates much of the risk associated with most investments. As you can imagine, in return for this minimized risk, your earnings rate will also be less than with most of the more “exotic” investment choices.

Treasuries, particularly the 3-month Treasury bill, are sometimes quoted as the “risk-free rate of return,” the minimum rate of return an informed investor will accept for enjoying the minimum risk. In the real world there is no true risk-free investment, although Treasuries do come close. Below is a snapshot of the Government bond page from Bloomberg.com:

You should also understand the meaning of a “yield curveA graphical representation of the relationship between yield and maturity. Yield or return is on the vertical axis and the maturity on the horizontal axis. Generally the shorter maturity investments have lower yields and the longer maturity investments have higher yields. “. Displayed graphically above, a yield curve is the relationship between the interest rate offered and the time to maturity of an investment. While all investments have a yield curve, many traders and economists closely follow the yield curve of Treasuries of different maturities to help make other financial decisions and projections.

Corporate Bonds:

These bonds can be quite secure or sometimes risky. Their inherent value is greatly determined by the credit worthiness of the corporation offering the bonds. Be aware that corporate stability can change over time. For example, until 2009, most bonds offered by U.S. automakers implied good levels of security. However, the bankruptcies of GM and Chrysler, combined with serious financial problems atFord (F), generated much higher risk factors for their corporate bonds. Typically, however, corporate bonds are more secure than corporate stocks.

Municipal Bonds:

States, cities, or other local governments often issue bonds to raise money to fund services or infrastructure projects (road and bridge repair, sewers, purchasing open land, etc.). The primary advantages to investors are security and tax benefits. For example, most municipal bonds offer interest earnings that are exempt from federal taxes. In addition, if you are a resident of the state in which you own one or more municipal bonds issued by local governments, your earnings may also be exempt from state or local taxes. Never assume a high security factor, however. Some local governments may be in dire financial condition and your risk factor may outweigh any tax benefits you enjoy.

Mark's Tip

Bonds are not nearly as liquid as stocks and ETFsExchange Traded Funds are a cross between mutual funds and stocks. ETFs are simply a portfolio of stocks or bonds or other investments that trade on a stock exchange just like a regular stock does. , and therefore there is not nearly as much information publicly and freely available. If you are going to buy bonds, always buy them from a reputable source and always check your prices to make sure you are getting a fair price. Also, you must remember that when you buy a bond your return is called the Yield to Maturity and NOT the Coupon Rate. If you buy a bond below $1,000 you will yield MORE THAN the Coupon Rate; and if you buy a bond above $1,000 you will yield LESS THAN the Coupon rate.

ETFs have the benefits of Mutual Funds in that one investment allows ownership in a group of StocksStocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company. , and usually that ownership is targeted to a specific industry, region or market segment (like gold stocks, financial stocks, small-cap stocks, or the Brazilian market). This built- in diversification is advantageous if you don’t like picking individual stocks but you have an interest in a particular industry.

However, there are differences of which you should be aware. Unlike Mutual Funds, the ETF prices change throughout the day as they are bought and sold based on the performance of the stocks that the ETF is holding. Some ETFs are also leveraged, which means that they have a multiple of 2x or 3x the performance of their underlying industry. This ability to react quickly makes them a favorite of day traders and other active investors because they are usually quite volatile.

Some ETFs are tied to an index, which make them “exchange-traded index funds”. For example, one of the most popular ETFs tries to mirror the composition of the Standard & Poor (S&P) 500, using their performance as an index (see the S&P 500 ETF, ticker symbol = SPY) and another tries to mirror the Dow Jones Industrial Average (ticker symbol = DIA).

ETFs are very popular and more often than not they are top % gainers for the week. Trading ETFs is great because you can ride the many ups and downs of specific sectors of the market like Agriculture, Energy, or even foreign countries.

The leveraged ETFs are extremely popular with traders. With the leveraged ETFs, when the sector gains 1 percent, the ETF can gain 2 or even 3 percent! See the chart below for a comparison between the NASDAQ banking sector index (IXF) and the Direxion 3x Leveraged Financial Bull ETF (FAS):

If you had invested in IXF in the summer of 2009, you would have done well, earning about 17% in one month. But if you had invested in FAS, you would have made a killing of over 70%! That is the power of leveraged ETFs. However, remember that leverage cuts both ways: up and down.

ETF 101

Mark's Tip

ETFs are the rage these days as many investors are shunning mutual funds. Why bother trying to beat the S&P500 anymore when you can just buy the S&P500 ETF (ticker symbol = SPY) and match the index’s performance.

Most mutual funds are called “open-ended” funds because they will continue to take your cash, manage it for you, and issue shares to show your ownership. Each night the mutual funds calculate the value of all of their holdings and divided that value by the number of shares they have issued, and that number is called the Net Asset Value or NAVNet Asset Value of a mutual fund at the end of the business day. It is the equivalent of a share price of a stock.. So if the Fidelity Bank Fund had a value of $10.00 and your write them a check for $5,000 you would now own 500 shares of this fund. Gains, losses, and earnings are mutually shared with investors in proportion to the size of their investment.

Since one of the primary rules of investment is to diversify portfolios, a mutual fund can be a simple and successful way to accomplish this goal. With one investment, you will own shares of stock in many corporations.

How Does a Mutual Fund Work?

Mark's Tip

Mutual funds are a great way to start investing but, because they are so easy, they also carry a cost. Mutual Fund companies have to make money, of course, and they do that by taking some of the funds assets to cover their salaries and other expenses. These are called Management Fees. As noted in the Introduction, mutual fund companies have to pay salaries and marketing expenses and they always get paid FIRST before the investors/owners get paid! The other negative about mutual funds is that if you invest $10,000 in 5 different funds, then you probably own small amounts of as many as 1,000 different stocks! It becomes harder to outperform the market when you own so many different stocks.

To research mutual funds, Morningstar.com is one of the top web sites to check out. The Morningstar website:

• rates funds on a 1-5 scale so you can quickly review a fund’s performance
• shows mutual fund performance against relevant sectors and other funds
• shows the top holdings (what stocks they own) in all mutual funds
• shows the people who manage these funds
• shows the expense fees for each fund

Below is a screen shot from Morningstar of the Fidelity Monthly Income Series.

Mutual Funds are not traded on an open market like stocks and the prices of mutual funds are calculated just once a day, at the end of every trading day. The price for a mutual fund is called the Net Asset Value (NAV) because it is a calculation of the entire value of stocks and other assets held by the fund divided by the total number of shares outstanding:

Mark's Tip

As I said, mutual funds are a great way to start investing in the stock market, but at some point, it is to your advantage to start investing in individual stocks. More and more research is coming out showing that owning lots of mutual funds leads to over-diversification and paying too much in management fees. This is because you will rarely outperform the market because you are the market (you will end up holding so many different stocks).

Stocks are “equity investments” which means that when you own shares of a company you own part of that company. For example, if you own 1,000 shares of Apple Computer stock and Apple has 1,000,000 shares that are “issued and outstanding,” then you own 0.1% of the company. If Apple were then to be sold to another company for $50,000,000, then each share would be worth $50 ($50 million divided by 1 million shares). At $50 a share, you would receive $50,000 for your 1,000 shares.

So, as a stock owner, you are really becoming a business owner. And what do business owners care about? Increasing sales and minimizing expenses. When a company is increasing its sales and minimizing (or at least controlling their expenses) they are increasing their profits and making money! Remember—”Cash is King” and “He who has the gold rules!”

Therefore, the price of a stock is simply the market’s determination of the company’s value. That value is dependent on its assets, its current profits, and its expected future profits.

What is a Stock?

Mark's Tip

By “market” we mean the tens of thousands of people around the world that are following a stock at any given time. This would be analysts on Wall Street, brokers around the world at every brokerage firm, and individual investors that are following the stock. They all have an opinion about the true value of the stock, and the stock price provides that equilibrium between people that think it is undervalued (ie, buyers) and those people that think it is overvalued (ie, sellers). The stock market is a perfect example of supply and demand determining the price of something. The price changes every day, and for most popular stocks, nearly every second, based on the supply and demand provided by the thousands of buyers and sellers that are now connected electronically.

When business is good and companies are making lots of money (or even if the expectation is that the business climate will improve in the near future), the prices of stocks generally rise. The opposite is also true: when businesses do poorly (or even if the expectation is that the business climate will decline in the near future), the prices of stocks generally fall.

The place where you can buy or sell shares of stock is called a “stock exchange”. In the U.S. there are three major exchanges: the American Stock Exchange (AMEX), the NASDAQ and the New York Stock Exchange (NYSE), which are located on Wall Street in lower Manhattan in New York City.

Exchanges play a key role in the financial markets. When a company raises money in a stock offering it sells shares directly to the initial investors. But when those investors no longer want to hold shares, the exchanges provide a place where buyers and sellers come together to buy and sell shares. This is called “liquidity”. If you owned 1,000 shares of Apple Computer (ticker symbol = AAPL) but you couldn’t find anybody willing to buy it, then it would really be worthless. But if you knew you could call you broker and your broker could send an order to an exchange where all of the buyers would be standing by, then you could be confident that your shares would be sold to the highest bidder. The exchanges provide this liquidity and help insure that sellers get the highest price possible and buyers can buy at the lowest price possible.

Investors can make money with stocks two ways: 1) through the rise in price of a stock, and 2) through the dividends that companies pay out to their shareholders. Companies that have stable earnings and are generating more cash than is needed to fund additional growth opportunities pay out part of their reserves as “dividends.” It is a direct cash outlay per share owned. Companies will actually send you checks in the mail (typically every 3 months) for owning their stock!

Some larger companies will even take that cash dividend that they would normally pay you and buy you additional shares of the company. This is called a DRIP (Dividend Re-Investment Plan). If your Apple stock paid a cash dividend of $1 per share, then your 1,000 shares of Apple would earn you $1,000. If you chose to participate in the Apple DRIP, and Apple was trading at $100 on the date the dividend is paid, your $1,000 dividend would purchase you 10 more shares of Apple stock. And yes, you will usually end up with fractional shares.

Mark's Tip

Dividends are a wonderful thing and a few high dividend paying stocks should be part of your overall portfolio. The average dividend payout of the S&P500 stocks that pay a dividend is 2.47% as of November, 2009.
General Electric (GE) is currently paying out $0.75 year and the stock is at $16.00 so it is paying out a 4.6875% dividend yield. That’s a great return when banks are paying out less than 1%.

Over long periods of time, stocks have proven to be a very valuable investment because of their very good returns. Over the last 100 years, stocks have gone up, on average, about 6% per year. Dividends add about another 1.5% per year.

As you are probably aware, the prices and values of stocks are volatile. Some can change dramatically, for better or worse, and rapidly while others can remain stable for long periods. Unlike most bank checking and savings accounts, investments in stocks are NOT guaranteed by the FDIC.

Many people are afraid to start picking individuals stocks and would rather pay money managers on Wall Street to invest for them. In the United States, over $1.7 Trillion is invested in mutual funds.

With a CDAn investment choice at most banks where you agree to deposit a specific amount of money for a fixed period of time (this is called the maturity). By agreeing to keep your money at the bank for a certain length of time, the bank usually pays you an interest rate higher than savings and Money Market accounts., you agree to deposit a specific amount of money for a fixed period of time (this is called the maturity). In return, your financial institution agrees to pay you interest (usually higher than regular savings accounts) over this period. However, you will have limited opportunities to access these funds so only use CDs for cash you don’t anticipate needing until after your CD matures.

Your bank will offer you many different maturities or terms for CD’s: 3 months, 1 year, 2 years, 5 years, etc. Generally you will find that the longer the term of the CD, the greater the interest rate you earn. However, there is a catch: if you lock your money in at today’s CD low rates, and then rates go up quickly, you’ve missed out on the higher rates.

When you buy a CD you are locked into that interest rate for the life of the CD. If you take out your money before the full term, the bank will charge you a penalty so make sure you understand the term and the penalties involved if you suddenly need the cash and you have to “bust” your CD. Also, consider which direction you think interest rates are heading. If interest rates are very low, don’t lock in a low rate for 5 years! You can’t just bust your CD and then buy a new one with a higher interest rate if you’re current CD hasn’t matured yet.

On the flip side, you are practically guaranteed of getting a fixed rate of interest on your money for the complete term of that CD. So, if rates are high, then it might be wise to lock in the higher rates for longer terms.

The last time there were really high interest rates in the U.S. was the 1980’s when the rates on CD’s were as high as 18%! Now, however, interest rates for CDs are very low: 2% for a one year CD and just 3% for a five year CD.

Mark's Tip

Watch out for “rollover” clauses with your CDs. After a CD matures, some banks will give you only 7 days to withdrawal your cash before it automatically rolls over into a new CD at the exact same term as the original one!

Money Market Accounts (MMAs)

These accounts are designed to be a combination of the features of a classic savings account and a CD. Some typical features include:

• Higher interest rate than classic savings accounts
• No maturity date as with a CD
• A minimum balance that must be maintained (e.g., $2,500)
• Limited withdrawals each month (typically up to six transactions per month)

Do not confuse bank MMAs with the similarly named accounts offered by investment firms. They are very different. Bank MMAs are another form of savings account and carry the federal insurance, currently up to $250,000 per depositor, which all other deposit accounts enjoy. The similarly named product offered by investment houses is typically a short-term investment in one or more mutual funds that may or may not generate positive earnings. There is also no federal insurance protecting your principal (investment).

When you have one of these savings accounts, you are really “loaning” your financial institution your money. In return, the bank or credit union pays you interest for making these loans. Unlike most loans, however, you are usually guaranteed repayment; even if your institution fails. In case of the bank’s failure, the free federal insurance you receive covers the loss.

Mark's Tip

If you are sitting on some cash and you know you have a substantial payment (like your children’s tuition or you are planning on buying a car at year end) coming due in a few months, go to your bank and see what your choices are. Even a 1% extra return on $10,000 over 6 months is $50. Think of it as spending 5 minutes visiting the bank today and then getting a free dinner in 6 months!

So, you just got your year-end bonus of $2,000. Now what are you going to do with it? Let’s review the obvious choices…

Most financial institutions, banks, credit unions, and savings and loan associations have a similar menu of investment products from which you may choose. Here are the most common and popular products:

Savings Accounts

The benefit of a savings account is that you can make deposits and withdrawals whenever you want, no questions asked. Plus, your deposit is protected by the full faith and credit of the U.S. government. If the bank ever goes belly-up, the Federal Deposit Insurance Corporation (FDIC), which is part of the U.S. Government, will guarantee your money up to $250,000 per person, per bank account. And in 2009, the FDIC has been very busy protecting the deposits for people in the 125 banks that went bankrupt!

From bank to bank, savings accounts are all basically the same, but you need to pay close attention to the fine print. The typical differentiators are:

• Interest rate
• Frequency of interest (earnings) posting periods
• Different minimum balance accounts that pay higher interest rates if you maintain the minimum amount on a deposit
• Fees for withdrawals, statements, etc.

So, as long as you are investing $250,000 or less, this is a very safe investment. On the downside, you can see that your return is practically nothing given the current interest rates.

The first time Tiger Woods grabbed a golf club he couldn’t hit the ball perfectly straight 300 yards and the first time Michael Jordan touched a basketball he couldn’t dunk it, so don’t think that you will be able to earn a 100% return in the first year. Before Tiger could hit a golf ball 300 yards, he had to learn which end of the club to hold, how to hold it, where to place the ball in his stance, and then how to swing it—and then he had to practice thousands of times.

When learning any new skill, like playing golf or investing, you must begin understanding some of the “tools” and “terms” involved. Without this basic knowledge, it is difficult – if not impossible – to practice your new skill properly.

This first lesson covers the primary “tools” you will use to empower yourself to become more financially successful. Once you become comfortable with these “tools” and understand what each can accomplish – and what they cannot – you will be well on your way towards becoming more financially savvy.

As with most journeys, you will encounter some twists, turns, and detours. With your newfound knowledge, however, you should navigate successfully during both sunny and stormy conditions. Enjoy your trip!

Mark's Tip

During these sunny and stormy conditions you are sure to experience what I call the “the thrill of victory and the agony of defeat” (to borrow a line from the old ABC “Wide World of Sports”). The thrill of victory is buying a stock and having it double in a few weeks! The agony of defeat is losing your shirt on a trade when you “knew” it was going to be a solid performer. While we can’t guarantee that you will never suffer a defeat, we will definitely help you minimize the impacts of those defeats and increase the frequencies of the victories.