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.

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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.

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Mark
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.

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Mark

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.


Selling a stock is just as important of an investment decision as buying and you must have a strategy to maximize your profits and minimize your losses. Developing a trading strategy is important to your future investing activities. Even a flawed strategy is better than having no strategy. And trust me, your strategy will always be evolving as you learn from your past successes and mistakes, as the markets change, and even as technology and software change.

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.

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Mark
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

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.


Once you get out of the shopping malls, don’t forget to make sure you are diversifying. Buying a shoe company, a hat company, a jean company, a sock company, and a dress company is NOT exactly what we mean by diversificationA way of reducing the risk and variances in your portfolio returns by buying a variety of stocks across different industries, market caps, etc.! Often you might need to find a high dividend yielding stock, a small cap stock, and an international stock to complete your diversification mix. How will you accomplish this?

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.


chapter4-6aPeter LynchPast portfolio manager of Fidelity Magellan, which became the largest mutual fund in the 1990s., another globally respected investment genius, also embodies a solid – not exotic – investing strategy. After graduating from Boston College (1965), Lynch was hired as an intern at the company that came to be forever linked with his name, Fidelity Investments. This was mostly because he caddied for Fidelity’s president at a local country club. So began his meteoric financial career.

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!!!

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Mark
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!


chapter4-4aInvesting in “what” you know based on “how much” you know can provide an excellent return and a higher level of comfort.

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


With so many stocks out there, what does the new investor buy? If you have plenty of time and wish to become an information and opinion junky, you could spend thousands of hours reading all of the newspapers, websites, financial blogs, discussion boards and newsletters out there that cover just about every single one of the 20,000+ stocks on the NYSE/AMEX, and NASDAQ. However, you’d need to dedicate so much of your time that your “headache quotient” would go off the charts.

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?

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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!


To measure your success of diversifying, several calculations have been developed to provide an indication of how well your portfolio is performing in terms of its variance and its return. There is more than 1 way to get a 10% return. Graph 1 below shows a smooth portfolio increase upwards at a 10% return over the year; graph 2 below shows a 10% return at year-end, but a real roller coaster of performance over the year.

chapter4-2achapter4-2b

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.


chapter4-1aRisk, reward, and diversificationA way of reducing the risk and variances in your portfolio returns by buying a variety of stocks across different industries, market caps, etc. are the most important concepts to understand before you start your portfolio. They are factors in all investment decisions. You must learn more than the textbook definitions of these factors–you need to understand how they, in conjunction with market timing and business cycles, affect your portfolio’s return. Even riskThe expected variance of the returns of your investments., when properly managed and understood, can often help your portfolio. There are different levels of risk and different types of diversification.

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.

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Mark
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:

chapter4-1bMany 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.

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Mark
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

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.


You should have a “game plan” for your investing life. Just as you plan your workday, vacation, college financing, golf matches, and other areas of your personal and professional life, you need a plan, objective, and goal for your investment activities.

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.


Unfortunately, when it comes time to file your tax return, the IRS wants to know how much money you made or lost in your brokerage account. Your brokerage firm will even report to the IRS your total proceeds from all of your sales of stocks, but they don’t report your gains and losses. The reason they don’t report your gains or losses is that there are a couple of different ways of calculating it.

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
Mark
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.


In its simplest form, short selling is selling shares that you don’t own. Just like the broker will loan you cash to buy more shares, the broker will also loan you shares that you can sell. When you sell shortBorrowing 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. and borrow shares, think of it as having a loan of shares (and not cash) that you must return at sometime in the future. This concept confuses a lot of new investors, but it really shouldn’t.

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
Mark
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!


When you are opening a real brokerage, you will be asked if you want to open a Margin Account. Buying on margin means that you purchase securities using some of your own cash and you take a loan from your broker to complete the purchase. The collateral for the loan is the stocks or cash you already own. The difference between the value of the collateral (securities) and the loan is called the “net value.”

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
Mark
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.


As you might expect, just because you place an order, it does not necessarily get executed. Both the timing and the duration of your orders are important to successfully managing your portfolio. When you place the orders mentioned above, you will usually be allowed to specify the duration of the order. You might be placing trades at night when the markets are closed, or you might be getting ready to go on a vacation where your access to the markets is limited, or you might be following a strict strategy that has very clear entry and exit prices.

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.


Once you have the ticker symbol for the company you wish to trade, you are ready to place your first order.

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

chapter3-3a

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.

Order Types



chapter3-2

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:

chapter3-2b

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


The first thing you must understand about trading stocks is that the exchanges have assigned each stock a unique “ticker symbol” for identification purposes. When researching stocks, getting quotes, and placing trades, you usually have to know the ticker symbol.

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:

Company Symbol Industry Date Added
3M MMM Conglomerate 1976-08-09 (as Minnesota Mining and Manufacturing)
Alcoa AA Aluminum 1959-06-01 (as Aluminum Company of America)
American Express AXP Consumer finance 1982-08-30
AT&T T Telecommunication 1999-11-01 (as SBC Communications)
Bank of America BAC Banking 2008-02-19
Boeing BA Aerospace and Defense 1987-03-12
Caterpillar CAT Construction and Mining Equipment 1991-05-06
Chevron Corporation CVX Oil & gas 2008-02-19
Cisco Systems CSCO Computer networking 2009-06-08
Coca-Cola KO Beverages 1987-03-12
DuPont DD Chemical industry 1935-11-20 (also 1924-01-22 to 1925-08-31)
ExxonMobil XOM Oil & gas 1928-10-01 (as Standard Oil)
Walgreens-Boots Alliance WBA Pharmacy and Healthcare 2018-06-07
Hewlett-Packard HPQ Technology 1997-03-17
The Home Depot HD Home improvement retailer 1999-11-01
Intel INTC Semiconductors 1999-11-01
IBM IBM Computers and Technology 1979-06-29
Johnson & Johnson JNJ Pharmaceuticals 1997-03-17
JPMorgan Chase JPM Banking 1991-05-06 (as J.P. Morgan & Company)
Kraft Foods KFT Food processing 2008-09-22
McDonald’s MCD Fast food 1985-10-30
Merck MRK Pharmaceuticals 1979-06-29
Microsoft MSFT Software 1999-11-01
Pfizer PFE Pharmaceuticals 2004-04-08
Procter & Gamble PG Consumer goods 1932-05-26
Travelers TRV Insurance 2009-06-08
United Technologies Corporation UTX Conglomerate 1939-03-14 (as United Aircraft)
Verizon Communications VZ Telecommunication 2004-04-08
Wal-Mart WMT Retail 1997-03-17
Walt Disney DIS Broadcasting and Entertainment 1991-05-06

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

Ask Price:
The price that sellers want to sell for is called the “Ask” price.
Bear Market:
A prolonged period of pessimism and falling stock prices that seems to feed on itself and generates even more pessimism and even lower stock prices.
Bid Price:
The price that buyers are willing to pay is called the “Bid” price.
Bull Market:
A prolonged period of optimism and rising stock prices that seems to feed on itself and generates even more optimism and even higher stock prices.
Business Cycle:
The typical business cycle consists of periods of economic expansion, contraction (recession) and recovery to a new peak.
IPO:
IPO stands for Initial Public Offering. This represents the FIRST opportunity for the public to purchase shares in a particular company.
Recession:
A recession occurs if a business cycle contraction is severe enough and the GDP declines for 2 consecutive quarters.
Stock Exchange:
Stock exchanges are simply organizations that allow people the ability to buy and sell stocks.

Further Reading

Exercise

If you haven’t already place at least one stock trade.

  • Make at least one trade of an index ETF and a Gold ETF in your practice account.

Read some financial web sites and turn on some financial TV shows and see where the “experts” think we are in the economic cycle. Are we in a recession or are we in an expansion phase?


chapter2-10aAs a newer investor, you should also be aware that you can save some research time by investing in mutual funds instead of individual stocks. Mutual funds contain a mix and diversity of stocks in which you will spread out one investment into many small blocks of shares.

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!


While the wild roller coaster swings of the market make the media highlights, stocks remain an excellent choice to achieve a high – and steady – return. In finance textbooks, this is called return on investment (ROI) and is one of the most important measures of all investments choices. After all, when comparing different investment choices, isn’t it all about how much money can be earned upon an investment?

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:

chapter2-9a

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
Mark
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%


When you are ready to make your first trade you must open a brokerage account. Brokers generally fall into two categories: full service and discount brokers. Full service brokers like to make the decisions for you and will call you frequently with their ideas, suggestions and corporate research—but they will also charge you a hefty commission for the service they provide. Full service brokers generally want you to have at least $100,000 in cash to invest.

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.


chapter2-7a The mere perception that a market is becoming Bearish is not a predictor of disaster. Fortunes have been made in Bear MarketsA prolonged period of pessimism and falling stock prices that seems to feed on itself and generates even more pessimism and even lower stock prices.. The trick is to know when one is coming and react appropriately.

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
Mark
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.

chapter2-7b

chapter2-7c

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
Mark
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.


chapter2-6aBull and Bear MarketsA prolonged period of pessimism and falling stock prices that seems to feed on itself and generates even more pessimism and even lower stock prices. play a strong role in extending or ending business cyclesThe typical business cycle consists of periods of economic expansion, contraction (recession) and recovery to a new peak.. Millions of words have been written about Bull and Bear Markets, but here is what you need to know:

  • 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
Mark
“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.


Now that you know what the stock market is and what role the Stock ExchangeStock exchanges are simply organizations that allow people the ability to buy and sell stocks. play, let’s take a step back and look at how stock prices and the economy move. As you might expect, timing is extremely important in investing because you must learn how to time your buys and your sells.

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:

chapter2-5a

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:

Indicator Source Frequency
Advance Monthly Sales for Retail and Food Services Census Bureau Monthly
Advance Report on Durable Goods Census Bureau Monthly
Construction Put in Place Census Bureau Monthly
Gross Domestic Product Bureau of Economic Analysis (BEA) Quarterly Data, Revised Monthly
Manufacturers’ Shipments, Inventories, and Orders Census Bureau Monthly
Manufacturing and Trade: Inventories and Sales Census Bureau Monthly
Monthly Wholesale Trade Census Bureau Monthly
New Residential Construction Census Bureau Monthly
New Residential Sales Census Bureau Monthly
Personal Income and Outlays Bureau of Economic Analysis (BEA) Monthly
U.S. International Trade in Goods and Services Census Bureau & Bureau of Economic Analysis (BEA) Monthly
U.S. International Transactions Bureau of Economic Analysis (BEA) Quarterly

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:

chapter2-5b

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.

chapter2-5c

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


chapter2-4Now that you know what an exchange is, it’s necessary to make a very important distinction between what shares trade on exchanges and what shares don’t.

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
Mark
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.

chapter2-3

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 the mid 1600s simple fences denoted plots and residences in the New Amsterdam settlement in what we now call lower Manhattan Island. This location on the island was critical as it allowed easy access to both the Hudson River and the East River. To protect this settlement, in 1653, the Dutch West India Company led the construction of a strong barrier, a 12 foot high wall of timber, as a defense against attack from Native American tribes.

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.


So what exactly are “Wall Street” and the “New York Stock ExchangeStock exchanges are simply organizations that allow people the ability to buy and sell stocks.“? You have probably heard these words thousands of times, but unless you are a stock owner they might have gone in one ear and out the other.

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

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.

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.


Regardless of your choice of investment types, you should learn about and understand the correlation of risk to the size and type of your investments. First, become familiar with the traditional risk levels of various types of asset groups ( stocksStocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company. , bondsA 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., real estate, etc.) and compare this data with classic expected returns in different economic climates.

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!

Chart of returns over time by investment type.
Investment Risk Level Potential Returns
Bank Certificates of Deposit Very Low Very Low
U.S. Treasury Bonds Very Low Low
Municipal Bonds Low Low – Medium
Corporate Bonds Low – Medium Medium
Real Estate Low – Medium Low – Medium
Stocks (Mutual Funds, 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. ) Medium Medium – High
Precious Metals (Gold, Silver) Medium – High Medium – High
Leveraged ETFs High High – Very High
Options High – Very High Very High
Currency FX Very High Very High

Mark's Tip
Mark
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 those just beginning, a good point of reference is the recent performance of the common investments described above. How have they done over the last five years? These charts illustrate their performance over the same time period. When looking at the charts, keep in mind what you read earlier in the lesson and what you’ve heard about the economy in the news.

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.

chapter1-11a chapter1-11b chapter1-11c chapter1-11d chapter1-11e chapter1-11f


chapter1-10Buying and selling real estate as an investment strategy is quite different from simply buying a home or commercial building. Just as important in determining FMV (fair market value) as comparable properties are when buying a home, the income stream generated by a property is a primary component for an investor. You typically have three options if you want to invest in real estate:

  • 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
Mark
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.


chapter1-9Investing in FX (foreign exchange), currency speculation, and hedging are variations of the same basic investment strategy—you are betting that one currency will strengthen or weaken against the other. Not for the faint-hearted, these investments involve more due diligence and savvy than all of the other security types we have covered so far. Trading in FX is requires a strong macro-economic background and an understanding of interest rates as well.

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
Mark
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.


chapter1-8Precious metals, particularly gold and silver, are attractive investments to many people. But as usual, you must learn to become a knowledgeable investor as precious metals can fluctuate in value as rapidly as common stocksStocks are “equity investments”, which means that individuals who own stock shares of a company actually own part of that company. From a real world prospective, investing in gold or other precious metals has some advantages that other investments do not.

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:

chapter1-8b

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
Mark
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!


Unlike stocksStocks are “equity investments” which means that individuals that own stock shares of a company actually own part of that company., which are equity instruments, bondsA 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. are debt instruments. When bonds are first issued by the company, the investor/lender typically gives the company $1,000 and the
company promises to pay the investor/lender a certain interest rate every year (called the Coupon Rate), AND, repay the $1,000 loan when the bond matures (called the Maturity Date). For example, GE could issue a 30 year bond with a 5% coupon. The investor/lender gives GE $1,000 and every year the lender receives $50 from GE, and at the end of 30 years the investor/lender gets his $1,000 back. Bonds differ from stocks in that they have a stated earnings rate and will provide a regular cash flow, in the form of the coupon payments to the bondholders. This cash flow contributes to the value and price of the bond and affects the true yield (earnings rate) bondholders receive. There are no such promises associated with common stock ownership.

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:

chapter1-7

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

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):

chapter1-6If 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
Mark

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.



A mutual fund is a type of investment where a money manager takes your cash and invests it as he sees fit, usually following some rough guidelines. For example, the Fidelity Group has a fund that specializes in finding high dividend paying stocksStocks are “equity investments”, which means that individuals that own stock shares of a company actually own part of that company., one that specializes in bank stocks, and one that specializes in European stocks, etc. You simply find a fund that matches your objective, you review its past performance and its management team, and then you write a check to that mutual fund.

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?

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Mark
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.

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Management fees are one of the key metrics to watch
out for as an investor because they can quickly and devilishly eat into your profits over time. Do higher management fees correlate to higher returns and better performance? As it turns out, the answer is NO. In fact, many studies have been done that show higher fees generally correlate to lower performance.

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:

Mutual Fund NAV = Value of stocks and other assets / Shares outstanding
Since Mutual Fund NAV’s are calculated just once a day, mutual funds can’t be traded several times during the day like a stock. In fact, it is generally discouraged to trade several times in and out of mutual funds. Most mutual funds impose penalties and redemption fees upon withdrawal from the mutual fund to discourage active trading.

Mark's Tip
Mark
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).


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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?

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Mark
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
Mark
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.

So, in total, stocks appreciate in value:
Stocks Rise in Value Stock Dividends Total Stock Return
6 percent 1.5 percent 7.5 percent

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.

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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
Mark
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
Mark
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!


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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.
Here is a savings account interest rate table from one of the leading U.S. banks:
Balance required Interest rate
$0 0.05%
$10,000 0.25%
$25,000 0.75%

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.


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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
Mark
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.

When talking about Banking, people generally group Banks, Credit Unions, and Savings & Loan companies all in one group. They do provide similar services, but they each have specific differences that might make one a better fit for your financial needs than another.

What They Have In Common

All three of these institutions can do all the things you would normally associate with a “bank” – opening checking and savings accounts, making commercial loans, and issuing residential mortgages.

Savings and Checking Accounts

When you deposit cash at a bank, credit union, or savings and loan, you will put it into a checking (also called “Current”) account or a savings account.

Savings Account

Savings accounts are usually the first type of bank account you might open as a child. This is an account where you can make deposits of cash, and earn interest. How much interest you earn can vary a lot based on how much you have saved, how often you withdraw, the overall market interest rates, and even just by institution.

Savings accounts pay interest because banks use the money you have deposited to make loans to others, including people and businesses. Because the banks are “borrowing” your money, you receive interest in return. The larger your balance, the higher the interest rate you will be offered.  Most savings accounts come with a limited number of withdrawals you can make each month. If you tend to withdraw money from a savings account frequently, the bank has a harder time maintaining that cash balance necessary to make loans to others, so you could be charged a penalty for making more withdrawals.  If you need more frequent access to your money, a checking account is better for you.  Credit Unions generally specialize in savings accounts.

Checking Accounts

Checking accounts are where you store your “day to day” money, meaning you will have a lot of frequent deposits and withdraws. Your checking account is the account that gets drawn down when you write checks, use a debit card, and usually where you pull money from when you use an ATM.

If you are accessing your account frequently for deposits and withdrawals, then you want to use a checking account. Consider a checking account where you store your “day-to-day” money.  When you write a check, use your debit card, or withdraw money from the ATM, your checking account is usually the account that the money is drawn from.  

Commercial Loans

A “Commercial Loan” is a loan made to a business, usually to “start up” or to expand their operations. Banks, Savings and Loans, and Credit Unions differ a lot on how much of their business comes from commercial loans, but for small businesses looking to secure start-up loans, each institution might be a good choice.

Tips To Get Rich Slowly
Just because banks specialize in commercial loans does not mean they offer the best rates for you! If you want to start a business, always explore all your alternatives and shop around for the best interest rates!
Commercial loans have a lot of different types, from a commercial mortgage (to buy new land or build a new building) to just the costs of renting and renovating a storefront and getting open for business. The duration of these loans can be anywhere from 18 months (small, short-term start-up loans) to 25 years (larger commercial mortgages). Unlike a normal mortgage, it is rare for a business to pay off their entire loan. When a business pays off a certain percentage of its loans and has continued to grow, they will usually use the equity they have built up to make more loans to finance their continued growth. This does not apply to some small businesses without a large expansion strategy, but does apply to medium and large-sized businesses. Banks generally specialize in commercial loans.

Residential Mortgages

A residential mortgage is a loan acquired from a financial institution in order to purchase a home.  A residential mortgage is necessary for most new homeowners because of the dollar amount required to purchase the home (usually over $100,000 and sometimes over $1 million).  Since the mortgage amount is large, the borrower(s) make payments over a long period of time, usually 25-30 years.  Savings and Loan institutions generally specialize in offering residential mortgages.

What is the difference between Banks, Credit Unions, and Savings and Loans?

Despite offering some similar services, there can be huge differences between these three types of financial institutions.

Banks

Commercial bank branch. Photo by Mike Mozart
Commercial bank branch. Photo by Mike Mozart

Banks are for-profit corporations with a charter issued at the local, state, or national level. They issue stock which is owned by investors, and those investors elect a board of directors who oversee the bank’s operations. Banks generally specialize in commercial loans – making loans to businesses to help them get started or expand.

Local banks are becoming less common, while national banks are becoming a lot more common. Over the last two decades, many local banks have been bought or merged with State banks, who in turn were bought or merged with National Banks. This has some advantages – by using a national bank, you will have access to a bank branch, ATMs, and in-person account services in a lot more locations than smaller institutions. Larger banks generally offer more account management services and account types than other institutions. For example, a national bank might offer some types of checking accounts that offer points and rewards for certain types of purchases (like gas and groceries).

Because they are much larger, banks also generally have better online banking services, with more account management services. This includes things like transferring money between your checking and savings accounts, viewing the checks you have previously written, checking balances using mobile apps, opening and closing credit cards, and managing automatic payments and deposits. Banks will also generally offer more choices for residential loans as well.

There are some significant drawbacks as well. Banks generally have higher fees than other institutions for its services, with lower interest rates for savings (although this is not always the case). It is fairly rare to find truly “free” checking accounts at banks. The large amount of choice you have for your savings and checking accounts can be a drawback as well – if your life circumstances change from what they were when you first opened your account, you might end up with more fees and less benefits than with a different account type, but very few people consider changing very often.

Credit Unions

Example of a credit union. Photo by Mike Mozart
Example of a credit union. Photo by Mike Mozart

Credit Unions are the financial opposite of banks – they are non-profit, almost exclusively local, and are owned by the people who make deposits. Every member who makes a deposit at a credit union is a part-owner, and can vote on issues relating to the institution. They can also get elected to be the managers of the credit union.

Credit unions specialize in savings accounts and making short-term loans. Since they are non-profit, all the profits made by these loans are given back to the credit union’s depositors as dividends.Many depositors also prefer credit unions because of the more personalized service they receive.  This is because credit unions are almost exclusively local, relying on the client’s deposits to stay in business, so they often have a reputation for providing excellent customer service. Since they are smaller with lower management costs, credit unions will often offer better savings account rates than banks and checking accounts with free services.

Tips To Get Rich Slowly
Just because credit unions do not specialize in commercial loans and residential mortgages does not mean they don’t process them! They might not have as many options available as a bank, but you might find a better interest rate!
Credit Unions also have their own drawbacks. They do not focus on commercial loans, which makes them less than ideal for businesses. They also prefer short-term loans, so you might also not be able to get many options for a residential mortgage. They are also much smaller than banks, which means you might not have access to as many of the online account management features, like bill payment and opening new accounts. If you travel a lot or move, the local credit union will also not be able to provide much service if you are outside their immediate area.

Savings and Loans

savings and loan
Example of a Savings and Loan. Photo by the Boston Public Library

Savings and Loan institutions focus strongly on residential mortgages. In fact, by law they need to invest 65% of their assets in residential mortgages, and only up to 20% in commercial loans. They can also be local or national (like a bank).

A Savings and Loan can be organized like a bank (owned by investor shareholders) or like a credit union (owned by the depositors), but it is always a for-profit institution. Specializing in residential mortgages means that you might find the most flexibility for your mortgage at a Savings and Loan, and their smaller focus means that you will often see better terms for mortgages here than elsewhere (but not always!).

Savings and Loans do suffer from some of the same problems as credit unions. Their emphasis on slow-maturing mortgages means they are often lagging behind banks with account management and online services.

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[qsm quiz=57]

Challenge Questions

  1. Based on your current income (or future) income from a part-time job while in high school, explain which financial institution would be the best fit for you. Include at least three reasons why you would make that choice.
  2. Your uncle wants to start his own business but needs to borrow money in order to do that. What advice would you give him about the type of financial institution most likely to work with him?
  3. You have your first part-time job and are working 20 hours per week. Your parents have asked you to be responsible for paying for your cell phone bill, your car insurance, and for putting gas in the car. They would also like you to start saving for college expenses. Explain how you would use a savings account and a checking account to help manage your finances.
  4. List 3 National Banks, 3 Credit Unions and 3 Savings and Loan Institutions near your home.

If you want to start building real wealth, your spending plan is the first thing you need, and part of your core strategy at every step. You will need to keep referring back to your spending plan as you plan out your financial future, and the careful balance you make between your spending and savings is the key to building up wealth over time.

Definition of Spending Plan

A “Spending Plan” is exactly as it says – a plan of what you will be spending each month. There are usually two parts – your “fixed” spending and your “variable” spending. The fixed part is usually the same every month, with things like rent/mortgage payments, grocery bills, insurance, and car payments. The variable part changes a lot from month to month, and can include things like Christmas shopping, buying new furniture, and paying for repairs.

You can then balance what you need to spend for the month with your take-home pay, and use whatever is left over to allocate as you wish – going out to the movies, adding to your investments, or depositing in your savings account.

How is a Spending Plan different from a Budget?

Spending Plans and Budgets are similar in a lot of ways – you’re making a list of your expenses in order to allocate your income. The biggest difference is that when you make a budget, you are allocating how you are going to spend just about every dollar you earn – take a look at our Home Budget Calculator and see how many choices you need to make!

Budget Burrito
Pictured: the burrito that broke your budget

When you set a budget, you are allocating nearly all your money to specific costs or expenses (like “Groceries” and “Rent”). If you end up going out with friends a few times more than expected for burritos, you might go ‘over budget’, and know you need to cut back somewhere else to make up for it.

A Spending Plan, on the other hand, is more simple. You make your list of fixed, hard expenses that do not change from month to month, and then each month you add your other essential expenses. This means you are left with your ‘discretionary income’, or the money you can spend on whatever you like. If you want to use your discretionary income on a few extra trips for burritos, go right ahead! This only means you have less to spend on other discretionary expenses, not that you went ‘over budget’ and need to start from scratch.

Spending Plan Terms

Fixed And Variable Spending

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When you are reviewing your spending and deciding whether items should be “fixed” or “variable,” you should follow this guideline:  If spending in a particular category (such as groceries) changes from month to month, this item is a variable cost.  If this item’s cost remains the same from month to month (such as your car payment), it is a fixed cost.

This also means that when you want to start controlling your spending habits to increase your savings, any spending you can cut out from your “fixed” expenses will have a bigger, long-term impact.

For example, if you decide to move into a new apartment, a $50 difference in rent will not make a huge difference in your per-month spending, but it adds up to over $600 per year. In contrast, if you skip out on a variable expense, like a dentist appointment, you might get a one-time savings, but it will have a much smaller impact on your long-term ability to save.

Income

When you are building your spending plan, it is essential that you use your take home pay as your income amount.  (This is your net pay, not your salary or pre-tax income, and it represents the amount actually deposited in the bank.)

Savings and Investments In Your Spending Plan

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Your strategy for saving and investing is an essential part of your Spending Plan.

Your Savings is money you have set aside and do not plan to spend, usually in a separate savings account. This has very low risk, and is mostly set aside in case you need cash quickly for an emergency. Investments, on the other hand, would be things like stocks and bonds – an “asset” that grows in value over time. Investments are used to build a retirement account, or simply a way to try to earn higher returns on your money (but there is always risks when investing).

When you are building your first spending plan, start with your Savings and Investments.

  • First, you need an Emergency Fund. This is money set aside, usually in a separate savings account, for emergencies. Your goal should be to eventually save up 6 months of expenses in your Emergency Fund.
  • Second, you should also plan to set aside extra money each month for regular saving and investing.

When building your spending plan, these two items should be listed separately. Your “Regular Savings/Investing” should be treated as a “Fixed Expense”, where you always plan to save at least this much each month. If your emergency fund does not yet cover 6 months of expenses, then you would need to set this aside as an extra “Variable Expense” until you have it fully-funded.

Pay Yourself First – A Saving Strategy

The idea behind “Pay Yourself First” means that you should think about your savings and investments as a necessary, fixed expense. By adding in your savings and investments to your Fixed expenses, you are reminding yourself that it is not an optional part of your personal finance strategy. This is usually accomplished by automatically depositing fixed amounts every month from your bank account into your savings or retirement account with a direct deposit.

Another way to think about it is that before you pay your bills, before you buy your groceries, even before you pay your rent, you have already made your minimum deposit into your savings accounts as a completely non-negotiable expense. You can add more later as part of your variable spending and discretionary spending, but you know you are always starting with a baseline to grow from.

This is one of the core pieces of your savings plan. Every time you consider a new expense, you should be able to automatically visualize how it will impact your ability to save before it impacts your ability to spend more discretionary income.

Charity and Donations

Giving to charity is also an important part of your spending plan, but how much you can give (and where you give it) can vary wildly between two otherwise identical people. You might not be able to make it as part of your fixed spending every month (at least not at first), but it is important to identify charitable organizations you want to support and keep them as part of your overall spending strategy.

Sample Spending Plan

Fixed Spending Variable Spending 
Rent *$800Dentist$200
Car Payment **$135Mother’s Day$60
Groceries$150Investments$100
Health Insurance ***$260Charity$100
Renter’s Insurance$15  
Car Insurance$30  
Cell Phone$60  
Utilities$60  
Gas$100  
Savings ****$200  
Total Fixed$1,810Total Variable$460
    
Total Income$2,500  
Total Spending$2,270  
Discretionary Income$230  
*Assumes $1,600 monthly rent split between two people. Utilities are also halved
** Car payment assumes a $7,800 used car purchased at a 7% interest rate with a 48 month term loan. For more details, see the Car Loan Calculator.
*** Health insurance is based on a 23 year old in 2014 in the United States at the national average. See HealthPocket.com for reference.
**** A $200 monthly savings for a 23 year old is enough to save a million dollars by age 69, earning an 8% annual rate of return. For more details, see the Millionaire Calculator.
Click Here to download this sample as a spreadsheet and update with your own spending habits

 

Outside Factors That Influence Your Spending Plan

There are a lot of factors that can cause your spending plan to change. Some things can be huge, but some might be so minor that you might not even notice.

Marketing

Marketing is what influences you to buy certain products.  The commercials you see on TV, the advertisements you see on the Internet, and even the way products are packaged are all working to sway you to buy particular products, produced by certain brands, and sold at different prices. This is not a bad thing – you might not be aware you wanted something until it was marketed to you, but you should always be aware when you are spending exactly what marketing is at work to make sure you are making an informed decision.

Life Changes

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What you will notice is how your life changes can impact your spending plan. When you are dating, you will need to allocate more spending towards going on dates, buying gifts, and making sure you are always dressed to impress. If you have children, they will probably be the biggest factor in your spending plan for the next 10 years!

Get in the habit of regularly reviewing your spending plan so that you can make necessary adjustments.  As your life circumstances evolve and change, your expenses, both fixed and variable, will change. Reviewing your spending plan will provide opportunities to reallocate your money where it is needed to match your current life necessities.

Sticking To Your Spending Plan

Spending Pie

One reason that spending plans have started to become more popular than full budgets is that they are easier to stick to, and easier to adjust as needed. In our example before, our “burrito spending” would have needed to be added to our budget and carefully planned out, whereas we can just count it as part of our discretionary spending.

If you know you’ll be eating out with friends several times a month, make sure you have enough discretionary income in your spending plan to allow for these dinners out – the key to a workable spending plan is to be honest with yourself about how you spend your money.

Using Automatic Payments

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These days you can likely set up all of your fixed spending as automatic payments from your checking account – including your core savings. For people who struggle with sticking to a regular budget, this can be a major improvement, but it also has a major downside.

When all your bills are being paid with automatic payments, you still need to make sure you have your spending plan in place so you know how much money is going where, and when. For example, a person without a spending plan might not remember which payments for a month have been made and which are still coming up. This means when they just check their bank balance and see $1,000, it is not possible to know how much of that is available to start spending and how much they need to save because their rent payment will be processed next week.

Spending and Non-Spending Alternatives

There are many ways you can convert time and money, and how you balance these will have a serious impact on your income and spending. Always keep in mind that most spending decisions you make will impact this balance – how much you value your time plays a huge role in how your spending plan is shaped.

Imagine you want to eat spaghetti with tomato sauce. There are many choices you can make to get that delicious pasta and sauce which will tip the balance in one way or the other between lowering the time it takes and lowering the spending it needs.

Spaghetti
Pictured: Spaghetti
  • Do you just go to a restaurant and order it? This is the quickest, but most expensive.
    • Total time cost – 10 minutes to get to the restaurant
    • Total spending – $10
    • Added bonus – Professionally-prepared food is tasty!
  • You can also buy it as a frozen dinner. This is less expensive than a restaurant, but takes more time.
    • Total time cost – 10 minutes to get to the corner shop, another 5 minutes to heat the food and clean your dishes after (15 minutes total)
    • Total spending – $7
  • How about buying dried pasta and a jar of sauce?
    • Total time cost – 10 minutes to the store, 15 to cook, 10 more to clean up (35 minutes total)
    • Total spending – $4 on sauce, $2 on pasta ($6 total)
    • Added bonus – You probably get 3 meals out of this, so your per-meal cost is $2, and you can make 2 more meals later for only 5 minutes each (but that doesn’t help you now)
  • What if you make your own sauce?
    • Total time cost – 10 minutes to the store, 3 hours to simmer a delicious sauce, 10 more to clean up (3 hours and 20 minutes)
    • Total spending – $2 on tomatoes (you already have some spices at home), $2 on pasta ($4 total)
    • Added bonus – You probably get 4 meals out of this (since you get a lot more sauce when you make it than from a jar), so your per-meal cost is $1, and you can make 3 more meals later for only 5 minutes each (but that doesn’t help you now)
    • Added bonus – Home-made food can be tastier than restaurants!

Each of these alternatives has a different balance of time, spending, and extra bonuses. These same balances apply to many spending choices too. Do you want to wash all of your dishes by hand, or buy a dishwasher? Would you rather repair your shoes with epoxy or buy new ones if the sole starts to break? Do you want to buy wood and build a bookshelf, or buy one from a furniture store? Each decision has a different factor of spending, time, and added bonuses to consider.

Pop Quiz

[qsm quiz=54]

Challenge Questions

  1. Suppose your friend got her first job and she wants to save for a new car. Explain how having a spending plan would help her reach that goal.
  2. Why is it important that you review your spending plan regularly?
  3. What are three life events that could impact your spending plan? For each event, explain how YOU would adjust your plan.
  4. Explain the relationship between a spending plan and building wealth.

Many years ago before money really existed, when an individual wanted to “purchase” something, the exchange would occur through bartering.  Every item “purchased” would be traded for a different item.  For example, if I needed eggs, I would find a producer of eggs (an individual who raised chickens) and would try to trade something I had, such as milk or cheese from my cow, for those eggs.  This bartering system worked well for a while, but eventually society wanted an easier way to “trade” for those items that individuals needed.  Certain items were selected by society to use in exchange transactions, such as shells or grains or precious metals, but eventually money was created as a way to simplify these exchanges.

Money has value and works as a medium of exchange because we believe it has value.  And because it has value, we want to keep it safe. So rather than collecting money in our homes under a mattress or burying it in a coffee can in the back yard, our financial institutions and businesses have worked to create ways for us to “store” our money safely while still allowing us access to those funds.

Functions of Money

Money has three main functions – it works as a medium of exchange, a unit of account, and a store of value.

Medium of Exchange

“Medium of Exchange” means money acts as a go-between between everyone in the economy to help trade. If you are a farmer that grows corn, you might have a hard time trading your corn directly with a carpenter to help build your house, a manufacturer who builds tractors, a tailor who makes clothes, and producers of everything else you need. But if the markets allow you (and everyone else) to sell your products for money, it means everyone has a common “medium of exchange”.

Unit of Account

“Unit of Account” is the next major function of money. Everything that can be bought or sold is only as valuable as what someone else is willing to pay. Money exists to show what the “Exchange Rate” is between two different goods. Our same farmer from before might be trying to decide if they want to grow corn or soybeans this year – which one will be more valuable?

Because both corn and soybeans are traded with money, he would just be able to check the current prices for each one – and focus on growing more of whatever is most valuable.

Store of Value

Our farmer just finished his harvest of the year, and has a silo full of corn that he can trade. However, he has expenses all year round – buying food, and clothes, paying his mortgage, and all his other living expenses. If he were to trade just a little bit of corn for every purchase, the corn would rot away before the year was finished, losing all of its value.

Instead, selling his corn for money acts as a store of value – money does not expire, and he can save it up over long periods of time.

Types of Stored Value

Checks

Checks might be the oldest form of stored value. Checks are a special document that banks use to transfer money from your account to the person or business whose name you write on the check. 

Every check includes:

  • Your bank routing number (an ID number for your bank, so whoever receives the check can find them)
  • Your bank account number
  • The number of this specific check

When you write a check, you also fill in the name of the person or company you are paying, the amount (both in numbers and written out with words), and the date. You can also include a “memo” with a reminder of what the payment is for.

In the simplest terms, when you give someone a check, they take it to their bank, who then uses the bank routing number to contact your bank, and your account number to specify your exact account. Your bank then confirms your signature, and withdraws the amount of the check from your account (if you have enough money, that is) and transfers it to the other person’s account at the other bank. The check is then “cancelled”, so it cannot be used again, and the cancelled check is returned to you showing that it has been processed. Some banks will allow you to “overdraw” your account to pay a check, but they will charge you an extra fee to do so.

This allows you to send any amount of money from your account to anyone else who has a bank account. Some check-cashing services also offer to convert checks directly into cash (for a fee) for people who do not have a bank account.

Try It!

Advantages of using Checks

Checks are less popular in recent years, but they have some distinct advantages.

First, they are the safest way to send a payment by mail, it is much harder to steal and modify a check than it is to just take cash out of an envelope.

Second, checks are traceable. When a check is cashed, you get a picture of the final cancelled check to show it was processed, so you can see if it was modified in any way (and serves as a perfect financial record to show the payment was received).

Disadvantages of checks

Writing checks requires a checkbook, which very few people want to carry around most of the time. Since checks are only validated using a signature, check fraud (people passing fake checks as genuine, or editing the amounts on a genuine check to be a greater amount) has historically been a major cause for concern.

Checks also take time to “clear”, or have the money transferred from your bank to another. This means that if you have any outstanding checks, you need to constantly reconcile your bank account to subtract any outstanding checks to know your “true” balance.

For businesses, taking checks can be risky, and very few still do. This is because it is impossible when receiving the check to know that the person giving it actually has the funds in their bank to make the payment. Another problem of check fraud was people writing checks that they knew were unable to be cashed, often in other towns, leaving the businesses very few ways to recover their losses. Local businesses would often refuse to take any checks from non-local banks for this reason.

Debit Cards

Debit Card

Debit cards are very similar to checks, and are usually tied to your “checking account”. The biggest difference is that all payments are controlled electronically, so transactions are usually processed instantly.

In place of the signature of a check, you instead need to input a PIN number to verify your identity and authenticate the purchase. Debit cards may or may not be used for online transactions, depending on your card issuer.

Debit cards evolved from ATM cards.  ATM cards were originally used only at ATM machines to withdraw cash and to check account balances. The cards operate by using a magnetic stripe that contains your bank account information. When you “swipe” your card, the card reader reads your account information and electronically notifies your bank of money being subtracted or added to your account.  In most of the world, and increasingly in the United States, debit cards also come with a chip, which includes more security features thus increasing the difficulty of “stealing” your account information when you use your debit card. 

Advantages of Debit Cards

Debit cards were developed to make financial transactions easier than using checks.  The money comes directly from your linked account, usually a checking account, and you don’t need to carry around a checkbook and a pen.  Because the electronic transaction occurs almost instantly, the seller knows immediately that the funds were transferred or that the transaction was rejected due to lack of funds. This reduces the possibility that “check fraud” will occur, a positive outcome for retailers.  Since debit cards do not require a verification signature, a unique PIN number is used to verify that the individual using the card is the rightful owner of that card.  Without the correct pin number, the transaction will not go through.

Disadvantages of Debit Cards

Debit cards can be counterfeited.  Remember that the magnetic stripe stores your bank account information, so when you swipe your card, the data that describes your account can now be captured.  On the other hand, the chip on your chip debit card scrambles your data, making it extremely hard to “capture” your account information. 

Using a debit card frequently also makes it easy to over-spend, since it you do not see the money actually changing hands. This can make it possible to overdraw your account, which typically comes with heavy fees from your bank.

Prepaid Cards

Prepaid cards are usually issued by a credit card company or bank, and are often given as gifts. To use a prepaid card, you need to “Charge” it by adding value (either using cash at a kiosk for the card issuer, or sometimes online by transferring value from your bank account). Once it is stored, you can use a prepaid card any place you would use a credit card. The card issuer may charge a fee to use these services.

Advantages of prepaid cards

Prepaid cards can be a great way for people without a credit card to make online transactions, since you can make payments in the same way as you would with a credit card. They are also often used as gifts as a “use it anywhere” gift card. Generally speaking, prepaid cards work as a more flexible form as cash.

Disadvantages of prepaid cards

Like cash, prepaid cards can be easily lost or stolen. Since they are not tied to you in any way (and are normally given as gifts), whoever is currently holding the prepaid card controls all the value it has. This makes them very risky to use for large amounts of money.

The card issuer also usually charges a fee to use the card, and if you maintain a balance, they may charge “storage fees” as well.

Gift Cards

Amazon gift card

Gift Cards are another form of stored value. Many stores and online retailers will let you convert cash into a gift card which you can use in their store. Gift cards usually have no fees, so they retain their value longer than other prepaid cards.

As their name implies, a “Gift Card” is typically given a as a gift. Due to their limiting nature, it is very rare to purchase and use a gift card for yourself.

Advantages of Gift Cards

Gift cards are great to give as gifts. Because they can only be used in one location, they are less prone to theft and loss as other stored value cards.

Disadvantages of Gift Cards

Although you can purchase gift cards at many different retail locations, the card itself can only be used at the place of business identified on the card. For some businesses, like Amazon.com (AMZN) this is not really a limit, but for restaurants and individual retailers it might be.

Note about Credit Cards

Unlike these other items, credit cards are NOT a form of stored value, and do not act as money. This is because credit cards are a loan (or a form of “credit”). When you make a purchase using a credit card, no value is being transferred from you to the place where you are spending money. Instead, you are creating a debt that you must pay back later with interest.

In contrast, when you use any of the items of stored value, money is being directly transferred from you to the person you are paying. There is no loan or credit card company acting as a “middle man”. There is a direct transfer from one person or company to another.

Bitcoins and Other Virtual Currencies

Bitcoins and virtual currencies have become very popular in the last few years, but it is not always easy to tell if they are a form of money in and of themselves, or if they are just a stored value of money. Their actual definition shifts based on how you, the consumer, uses them.

For example, if you convert your dollars into bitcoins and then visit a shop that lists their prices in bitcoins and accepts bitcoins as payment, your bitcoins are acting as money. However, if that shop lists all their prices in dollars, but they also accept bitcoins as payment, then your bitcoins are just acting as a ‘stored value’ for dollars.

To make things more complicated, you can also buy bitcoin because you think its value will go up over time. This means that you are treating it not as stored value or as money but as an investment, and you are using “speculation” to try to gain a profit.

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[qsm quiz=58]

Challenge Questions

  1. As technology continues to evolve in our society, it is possible that the way we store our money and pay for transactions will change. What do you think that process might look like 15 years from now?
  2. What additional security measures do you see happening in the future in order to keep scammers from fraudulently stealing people’s money?
  3. Describe your experience with using the different financial tools you learned about in this lesson.

Definition of Wealth

“Wealth” means having an abundance of something desirable. This can be tangible, like money and property, or intangible, like good health or freedom.

Intangible Wealth

Just because something doesn’t have a monetary value does not mean it is worthless. Having strong connections with friends and family, freedom to make personal choices, and being known as trustworthy are often identified as part of a person’s wealth.  They are intangible, not capable of being bought or sold, but they add value to an individual’s life. Businesses can also have intangible wealth. If the public opinion about a company and its products is generally positive, this reputation is seen as adding value to the company’s value, even though it might not be possible to assign a specific dollar value to that goodwill.

Tangible Wealth

If you can buy and sell something, then it has a tangible value (meaning “can be obtained”). Tangible wealth includes things like cash, bank deposits, property, stocks, and bonds.

Monetary vs Non-Monetary Assets

When you are building wealth, you want to start building up your assets, both monetary and non-monetary.

Your “Monetary” assets are directly related to money. They will be part of your spending plan – how much cash you have in the bank, how much income you are going to get next month, and how much money you currently have in your emergency fund. Since we can spend these funds on a very short notice, they are also called “Liquid Assets”. Stocks and bonds, which are less liquid, are also considered “monetary assets” because you will almost always know their exact value in dollars.

Your “Non-Monetary Assets” are less liquid – you usually cannot spend them directly, and it takes time to convert them into cash. This includes things like property, furniture, machines, and vehicles. All of these items are useful and definitely have some value, but until you actually need to sell them you might not know exactly how much they are worth.

Both monetary and non-monetary assets are used to determine your total wealth.  For most individuals, the biggest portion of their total wealth will come from non-monetary assets such as cars, a home, and property.

Building Wealth

The idea of “building wealth” refers to investing in tangible assets. This includes financial steps to have cash reserves in bank accounts, investing in stocks, purchasing bonds, and buying property.  Building your wealth should occur throughout your lifetime as you learn to spend wisely, save regularly, and invest carefully.  These habits will allow you to “put your money to work” for you.

Financial Goals12345678

Setting and keeping financial goals is key to building wealth. For example, you might set a goal to save $300 for your first stock purchase.  You would first need to review your spending plan and identify areas where you could trim spending.  Those extra dollars could then be allocated to your savings goal.  Each month, as you followed your spending plan, you’d be able to see how close to your goal you were getting. 

Setting goals provides an incentive to maintain control of your spending, and reaching those goals will help you build your wealth.

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Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=55]

Challenge Questions

  1. What assets do you currently own? How could those assets help you accumulate wealth for your future?
  2. Setting goals to build wealth are truly key to helping you have a successful, happy future. You don’t have to be filthy rich. You just need enough money to support the lifestyle you’d like to live. Thinking about your future, what is one financial goal you’d like to have for yourself in your 20’s? What choices would help you reach that goal? (Students could choose from a goal for their 20’s, 30’s, 40’s, etc.)

As you begin working with financial institutions to secure your money and process your financial transactions, it is important that you learn to keep good financial records.  These records, both on paper and electronic, will allow you to know where your money and assets are and exactly how much you have at a given time. 

You may choose to print these documents and keep them in a binder or organize them in folders on your computer.  The method used does not matter.  What does matter is that you understand what is happening with your finances and know where to find the information when needed.

Financial Planning1212

When you are building or evolving your financial plans and setting new financial goals, you need to start with accurate financial records.  Your financial documents allow you to know exactly where you are today and they will help you see when you have reached your goals

Taxes

tax return
Pictured: the money you can’t get back because you didn’t save your receipt

Most people appreciate having good financial records when it comes time to file tax returns. Many thinks you spend money on throughout the year, like your car registration renewal, work uniforms, and certain types of interest on loans, can all be deducted from your taxes – but only if you have kept good records of all of those payments.

Types of Financial Records

Receipts

receipt
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In order to claim any deductions on your taxes, the IRS will want to see proof that specific purchases or payments were made.  And in order to show proof, you will need to provide a receipt.

You should always save the receipts for large purchases (like your car’s bill of sale). Many cities also provide tax breaks if you use public transit, so it is also a good idea to save those receipts.

Getting in the habit of keeping your receipts can help you in other areas of your life as well.  For example, utility bills and receipts are often required as a “proof of address” when you want to open a bank account. If you get in a conflict at a later date over a bill being paid, having a receipt can shut down the problem immediately, while proving otherwise can be a long and drawn-out process.

Bank Records

Your bank account will be one of your most important sources for financial records. Usually, your entire transaction history is saved for a few years (including every check you write), along with your current account balances. If you do not have a receipt for a payment (for example, if you write a rent check every month), you can still have a record of that transaction in your bank account.

The type of information contained in your bank records depends on the type of account you have. For example, if you have a savings account, you might have more records on deposit amounts and dates, with accumulated compound interest. If you have a checking (or “Current”) account, you will have your current available balances, along with your transaction history of your checks, debit card transactions, and ATM withdrawals. Your bank records will be an invaluable resource when you are building and changing your Spending Plan.

Income Reports

W-2 form, perhaps the most important financial record

Every time you get paid, your employer creates a paycheck transaction that shows how many hours you worked, how much you get paid per hour, and the amount of money deducted from your pay for various taxes.  At the end of the calendar year, your employer summarizes all of your pay information into a form known as a W-2 (or 1099, depending on your type of job) or Income Report. Outside the United States, the report has different names, but always has the same basic information.

Your income reports are statements showing how much money you’ve earned, usually along with how much income tax and social security you have paid, in a given year. These are necessary to file your taxes, but are also useful to see how your income evolves over time.

Investment Statements

If you have any stocks, bonds, or other investments, you will also get regular account statements from your broker. This will include your cash balances (available for withdrawal or purchasing more securities), the total net market value of your portfolio, the amount of any dividends you have received, and the total expenses of your investments (this is most important with mutual funds). Your investment statements are essential for tax purposes. You are legally required to report any investment income you receive, so having ready access to these documents will be essential.

Personal Property Inventory

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Unlike the other primary records, this is one you will make and maintain yourself. Your personal property inventory is basically a list of what you own, where it is located, and its estimated value. This seems fairly simple when you are still in school, but there are more than a few reported cases of large amounts of cash stashed and forgotten. Your personal property inventory is not used for taxes.

The main benefit of keeping and maintaining a personal property inventory is purely organization. Knowing exactly where your things are and how much they are worth can be very useful when your life circumstances change and you want to sell (or give away) things you no longer use or might have forgotten about. The self-service storage locker industry thrives on people making monthly payments to save things they do not regularly use!

Income Tax Returns

After you’ve filed your income tax return, keep a copy for later reference. Legally you should hold on to all tax returns and receipts for 7 years, but it can be useful to keep them for longer if you want to occasionally work on long-term financial planning.

Personal Expense Records

You might end up accumulating dozens of receipts in a relatively short period of time. Every few months, try to group them together and keep them in a safe place (for example, all receipts for “January – March 2016” kept in a folder in a fire-proof safe). While you do this, copy the amounts and the reason for the purchase into an excel spreadsheet. This will make it easy to know how much you spent and where you spent it. Plus, you can use your spreadsheet to quickly and easily find the original receipt later if you need it. By filing away all your receipts regularly, you make it less likely for any to get lost or accidentally thrown out. Making this a regular habit will also help you avoid having to spend an entire afternoon sorting through and organizing your receipts.

Keeping Your Records Secure

Now that you have all of this information, your main concern is keeping it safe. Identity theft is a major problem, and if someone were to get unauthorized access to just a few of your documents, they might be able to use that information to harm you.

Storing Paper Documents

For things like your tax returns, receipts, and investment statements, you might have paper copies that need to be both easy to find and secure. One possible route is to buy a small safe you can bolt to the floor, keeping your documents safe and all in one place. Banks offer safety deposit boxes where you can safely store documents and items.  Small boxes typically cost about $60 a year.  The inconvenience of having to visit the bank to get access to your documents may be offset by knowing the documents are in a secure location.

Storing Electronic Documents

Keeping your computer files safe from hackers and phishers is a much more challenging prospect. There are dozens of ways to keep your records safe, but these are the most common rules to follow:

Rule #1: Don’t Share Your Login Information

Despite what the movies show, most “hacking” is done not by forcing complex computer algorithms to hack a mainframe, but usually just because someone shares a password with someone they shouldn’t have. This goes not just for passwords, but other information as well. NEVER give your account numbers, credit card numbers, usernames, or passwords over the phone or by email. If you absolutely need to share a username and/or password (sharing an account with a group, for example), make sure it is a username and password you don’t use on any other websites.

Rule #2: Don’t Re-Use Your Password

When you are on the computer, you can’t tell which sites you use let the administrators see your password, and which use proper encryption. If you re-use the same usernames and passwords in many places, you’re increasing the chances that a disgruntled co-worker steals data and breaks into your other accounts.

Rule #3: Change Your Passwords Often

Even the most secure, unique password in the world is vulnerable to keyloggers – a type of virus software that records every key you press, and reports it back to the virus’s creator. Even if you don’t have a keylogger on your home computer (which can be hidden for months or years before “activated”), it is possible one might be installed on a computer in a computer lab or on a public computer. Changing your passwords every few months is a good way to keep them safe.

Rule #4: Pick Hard-To-Guess Passwords1234567

When you choose a password for an account, try to choose letter, symbol, and number combinations that are easy enough for you to remember but difficult for your best friend or a hacker using random letter combinations to guess.  Remember, you need to do your part to keep your passwords secure.

Other Financial Record Tips and Tricks

See What Account Management Services Some Financial Institutions Can Provide

If keeping track of everything is a daunting prospect, see what kinds of services your bank or other financial institution can “bundle together”. For example, it is extremely common for a person to have their savings and checking accounts, investment portfolio, home mortgage, and credit card all through the same bank, and so they are able to access all of those financial records through the bank’s online portal.

This has a strength of convenience, but there are also some serious drawbacks. For example, if you have your password stolen for this online banking service, you might lose access to everything all at once, causing a massive headache and potentially tens of thousands of dollars.

Visit Tax Professionals or Financial Advisers

Even if you do not do it every year, taking time to visit with a professional can save you time and money in the long run. Tax professionals and financial advisers understand tax codes, investment strategies, financial pitfalls, and red tape that you may not be familiar with.  Paying for their expertise may minimize how much time and research you need to spend trying to understand your financial records on your own. 

You might be able to remember the basics – if you have an expense that is used primarily for business, you can probably claim a tax credit on it. However, you might not know the exact process of claiming time you used your car while working, or if you can claim sales tax exemptions for new renovations on your home. Meeting with a tax professional or a financial adviser is the easiest way to navigate the seas of red tape and get the most out of your tax returns, and minimize how much time and research you need to spend on your financial records out of your own free time.

Pop Quiz

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These are the requirements for your semester project. Please ensure that you understand all components and work on your project throughout the semester. The complete project must be submitted by the end of week 14.

Objectives

  1. To acquaint students with sources of market and price information available for personal investment that will help to make better financial decisions.
  2. To assist students in understanding the role and operation of the financial markets.
  3. Develop an appreciation of how various forms of investment information can lead to better investing skills and returns.
  4. Apply the concepts and tools presented in the course to identify logical chains of causes and effects determining price changes in the financial markets.
  5. Describe an investment portfolio and how students would go about developing, monitoring, and managing a portfolio of securities.

Project Part 1

Research Your Investments!

Select a minimum of 5 (five) companies from different industries and provide information for points 1 through 9 and why or why not to invest in this company.

Investing involves making informed decisions, which means researching companies and industries before plunking down your hard-earned money! An excellent source of information about a company is the company itself, particularly its annual report to stockholders. In this project, you’ll examine the annual stockholders’ report of a company in which you are interested. (You can substitute an annual report for a current 10K filled to the SEC). The annual report is a document that provides financial and operating information about a company to its owners, the stockholders. Obtain a copy of the latest annual report of the company you are researching. The best research tool is the BB&T finance lab located at the HU Fort Myers campus room 330. Additional websites will be recommended by your instructor for online research. (Stocktrack, MorningStar, Finviz etc). Carefully study the annual report or 10K and then prepare a corporate profile of the firms you selected. Your profile should include the following elements: 1.Name of the company, its ticker symbol, and the exchange on which it trades 2.Current market price of the stock and its percentage change from 1, 3, and 5 years ago (try to find a chart of its stock price) 3.Location of its corporate headquarters, names of its officers, and percentage of inside ownership 4.Brief description of the company, including its major products or services 5.Brief history of the company 6.Major competitors 7.Sales and profit summaries 8.Other relevant financial ratios and measures 9.Recent developments and future plans

Project Part 2

You will want to approach the trading with the objective of making the greatest amount of money since this is the objective of speculators in the market. However, remember that the objective of the project is for you to learn about the role and operation of the financial markets. The focus of the evaluation of your term project will be on your research and analysis of the markets.

  1. Trade in the preferred financial market
  2. Select at least one Mutual Fund
  3. Create table of all trades (buy and sell date, shares, price per share, gain/loss)
  4. Provide detailed analysis for each trade (buy and sell)
    • Must include national and international economic/business events
    • Basic fundamental analysis of investment
    • Reason for transaction

Project Part 3

Summarize your trading results; particularly including the decision making process during the establishment of the portfolio. Your summary should include national and international events, gains and losses, and how specific events have impacted the value of the portfolio.

Finally, include what was learned during this project in terms of speculating in the financial market.

Your final report must include all three (3) project parts. The report must be in APA style, including a title and reference page, and intext citations.

TRADING INSTRUCTIONS

  1. You will have a password and account number. As instructor, I will have access to your trades and will be able to monitor your progress through the game.
  2. You are required to make a minimum of ten round turns. Trade as often as you like; five is just the minimum; the more you trade, the more comfortable you will become. You are to close all trades by week 14.
  3. The instructor will let you know when to start.
  4. You will have an initial capital level of $500,000 for trading. Out of this capital base you must pay commissions, post margin, and cover any losses.
  5. You are not allowed to buy more capital. You may hold up to 25% of your initial endowment in any security.
  6. You are NOT allowed to day trade for more than half of your trades, and if you are not familiar with markets, you may not want to trade with this strategy.
  7. Keep a record of all of your transactions for your personal use as you will be asked to report your trades in your written report