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Want to make money in stocks without losing your shirt? This practical guide gives you proven strategies for weathering the current economic crisis and for selecting and managing profitable investments in either a bear or bull market. You’ll navigate the new economic landscape and choose the right stocks for different situations — and you’ll find fresh real-world examples that show you how to maximize your returns. • Get started with the basics — understand stock value, assess your finances, set your investing goals, and know your investing style • Recognize the risks — explore different kinds of risk and weigh risk against return • Make informed investing decisions — research stocks, understand growth and income investing, and use basic economics to improve your stock strategy • Build a strong foundation for your portfolio — investigate industries, evaluate a company’s financial health, and understand the effect of politics/government on stock investing • Capitalize on emerging sector opportunities — from precious metals to alternative energy, discover the hot sectors that will make your portfolio thrive
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Paul Mladjenovic is a well-known Certified Financial Planner and national speaker on investing and financial matters. He is the owner of PM Financial Services and www.SuperMoneyLinks.com, and he has been quoted or referenced by media outlets, publications, and financial Web sites. Mladjenovic is the author of the first two editions of Stock Investing For Dummies as well as Precious Metals Investing For Dummies.
3rd Edition
3rd Edition
Stock Investing
Now updated! Your expert guide to building a profitable stock portfolio
g Easier! Making Everythin
ISBN 978-0-470-40114-9
Paul Mladjenovic Mladjenovic
Certified Financial Planner
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Stock Investing FOR
DUMmIES
‰
3RD
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EDITION
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Stock Investing FOR
DUMmIES
‰
3RD
EDITION
by Paul Mladjenovic
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Stock Investing For Dummies®, 3rd Edition Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2009 by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at http://www. wiley.com/go/permissions. Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com, Making Everything Easier, and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/ or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE. NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS. THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION. THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES. IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT. NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FURTHER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE. FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. For technical support, please visit www.wiley.com/techsupport. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Control Number: 2008942707 ISBN: 978-0-470-40114-9 Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1
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About the Author Paul Mladjenovic is a certified financial planner practitioner, writer, and public speaker. His business, PM Financial Services, has helped people with financial and business concerns since 1981. In 1985 he achieved his CFP designation. Since 1983, Paul has taught thousands of budding investors through popular national seminars such as “The $50 Wealthbuilder” and “Stock Investing Like a Pro.” Paul has been quoted or referenced by many media outlets, including Bloomberg, MarketWatch, Comcast, CNBC, and a variety of financial and business publications and Web sites. As an author, he has written the books The Unofficial Guide to Picking Stocks (Wiley, 2000) and ZeroCost Marketing (Todd Publications, 1995). In 2002, the first edition of Stock Investing For Dummies was ranked in the top 10 out of 300 books reviewed by Barron’s. In recent years, Paul accurately forecasted many economic events, such as the rise of gold, the decline of the U.S. dollar, and the housing crisis. At press time he had been warning his students and clients about the credit crisis on Wall Street. He edits the financial newsletter Prosperity Alert, available at no charge at www.supermoneylinks.com. Paul’s personal Web site can be found at www.mladjenovic.com.
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Dedication For my fantastic wife Fran, my wonderful boys Adam and Joshua, and a loving, supportive family, I thank God for you. I also dedicate this book to the millions of investors who deserve more knowledge and information to achieve lasting prosperity.
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Author’s Acknowledgments First and foremost, I offer my appreciation and gratitude to the wonderful people at Wiley. It has been a pleasure to work with such a top-notch organization that works so hard to create products that offer readers tremendous value and information. I wish all of you continued success! Wiley has some notables whom I want to single out. The first person is Georgette Beatty (my project editor). She has guided me from day one. Her patience, professionalism, and guidance have kept me sane and productive. Thanks for being great! Todd Lothery (my copy editor) is a pro who took my bundle of words and turned them into worthy messages, and I thank him. The technical editor, Juli Erhart-Graves, is a great financial pro whom I appreciate. She made sure that my logic is sound and my facts are straight. I wish her continued success. My gratitude again goes out to my fantastic acquisitions editor, Stacy Kennedy, for making this 3rd edition happen. For Dummies books don’t magically appear at the bookstore; they happen because of the foresight and efforts of people like Stacy. Wiley is fortunate to have her (and the others also mentioned)! Fran, Lipa Zyenska, I appreciate your great support during the writing and updating of this book. It’s not always easy dealing with the world, but with you by my side, I know that God has indeed blessed me. Te amo! Lastly, I want to acknowledge you, the reader. Over the years, you’ve made the For Dummies books what they are today. Your devotion to these wonderful books helped build a foundation that played a big part in the creation of this book and many more yet to come. Thank you!
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Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at http://dummies.custhelp.com. For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Senior Project Editor: Georgette Beatty
Composition Services Senior Project Coordinator: Kristie Rees
Acquisitions Editor: Stacy Kennedy
Layout and Graphics: Stacie Brooks, Reuben W. Davis, Shawn Frazier, Melissa K. Jester, Christine Williams
Copy Editor: Todd Lothery
Proofreader: C.M. Jones
(Previous Edition: Sarah Faulkner)
Indexer: Sherry Massey
(Previous Edition: Jennifer Connolly)
Assistant Editor: Erin Calligan Mooney Editorial Program Coordinator: Joe Niesen Technical Editor: Juli Erhart-Graves Editorial Manager: Michelle Hacker Editorial Assistant: Jennette ElNaggar Cover Photo: Image Farm Cartoons: Rich Tennant (www.the5thwave.com) Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Kristin Ferguson-Wagstaffe, Product Development Director, Consumer Dummies Ensley Eikenburg, Associate Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services
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Contents at a Glance Introduction ................................ 1 Par t I: The Essentials of Stock Investing ............ 9 Chapter 1: Welcome to the World of Stock Investing ......................... 11 Chapter 2: Taking Stock of Your Current Financial Situation and Goals ......... 19 Chapter 3: Defining Common Approaches to Stock Investing .................. 37 Chapter 4: Recognizing the Risks ......................................... 47 Chapter 5: Say Cheese: Getting a Snapshot of the Market with Indexes ......... 63
Par t II: Before You Start Buying ................. 75 Chapter 6: Gathering Information ......................................... 77 Chapter 7: Going for Brokers............................................. 97 Chapter 8: Investing for Growth.......................................... 109 Chapter 9: Investing for Income .......................................... 123 Chapter 10: Getting a Grip on Economics ................................. 137
Par t III: Picking Winners ..................... 149 Chapter 11: Using Basic Accounting to Choose Winning Stocks ............... 151 Chapter 12: Decoding Company Documents............................... 167 Chapter 13: Analyzing Industries ......................................... 179 Chapter 14: Emerging Sector Opportunities ............................... 189 Chapter 15: Money, Mayhem, and Votes .................................. 203
Par t IV: Investment Strategies and Tactics ........ 213 Chapter 16: Choosing between Investing and Trading ....................... 215 Chapter 17: Selecting a Strategy That’s Just Right for You ................... 225 Chapter 18: Understanding Brokerage Orders and Trading Techniques ........ 235 Chapter 19: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ ............... 251 Chapter 20: Corporate Skullduggery: Looking at Insider Activity .............. 261 Chapter 21: Keeping More of Your Money from the Taxman ................. 273
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Par t V: The Par t of Tens ...................... 285 Chapter 22: Ten Ways to Profit before the Crowd Does ...................... 287 Chapter 23: Ten (Or So) Ways to Protect Your Stock Market Profits .......... 293 Chapter 24: Ten Red Flags for Stock Investors ............................. 299 Chapter 25: Ten Challenges and Opportunities for Stock Investors ............ 305
Par t VI: Appendixes ......................... 311 Appendix A: Resources for Stock Investors ................................ 313 Appendix B: Financial Ratios ............................................ 329
Index ................................... 339
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Table of Contents Introduction ................................. 1 About This Book ............................................... 1 Conventions Used in This Book ................................... 2 What You’re Not to Read ........................................ 3 Foolish Assumptions ............................................ 3 How This Book Is Organized ..................................... 4 Part I: The Essentials of Stock Investing ....................... 4 Part II: Before You Start Buying .............................. 4 Part III: Picking Winners .................................... 5 Part IV: Investment Strategies and Tactics..................... 6 Part V: The Part of Tens .................................... 6 Part VI: Appendixes ........................................ 7 Icons Used in This Book ......................................... 7 Where to Go from Here .......................................... 8
Par t I: The Essentials of Stock Investing ............. 9 Chapter 1: Welcome to the World of Stock Investing . . . . . . . . . . . . . .11 Understanding the Basics....................................... 12 Preparing to Buy Stocks ........................................ 12 Knowing How to Pick Winners ................................... 13 Recognizing stock value ................................... 13 Understanding how market capitalization affects stock value ... 14 Sharpening your investment skills .......................... 15 Boning Up on Strategies and Tactics ............................. 17
Chapter 2: Taking Stock of Your Current Financial Situation and Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Establishing a Starting Point by Preparing a Balance Sheet .......... 20 Step 1: Make sure you have an emergency fund ............... 21 Step 2: List your assets in decreasing order of liquidity ........ 22 Step 3: List your liabilities ................................. 24 Step 4: Calculate your net worth............................ 26 Step 5: Analyze your balance sheet .......................... 27 Funding Your Stock Program .................................... 29 Step 1: Tally up your income ............................... 30 Step 2: Add up your outgo ................................. 31
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Stock Investing For Dummies, 3rd Edition Step 3: Create a cash flow statement......................... 32 Step 4: Analyze your cash flow.............................. 33 Another option: Finding investment money in tax savings ...... 33 Setting Your Sights on Your Financial Goals....................... 34
Chapter 3: Defining Common Approaches to Stock Investing . . . . . . .37 Matching Stocks and Strategies with Your Goals ................... 38 Investing for the Future ........................................ 39 Focusing on the short term ................................ 39 Considering intermediate-term goals ........................ 40 Preparing for the long term ................................ 41 Investing for a Purpose ......................................... 42 Making loads of money quickly: Growth investing............. 42 Steadily making money: Income investing.................... 43 Investing for Your Personal Style ................................ 45 Conservative investing .................................... 45 Aggressive investing ...................................... 46
Chapter 4: Recognizing the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 Exploring Different Kinds of Risk................................. 48 Financial risk ............................................ 48 Interest rate risk.......................................... 49 Market risk .............................................. 52 Inflation risk ............................................. 54 Tax risk ................................................. 54 Political and governmental risks ............................ 54 Personal risks ............................................ 55 Emotional risk ........................................... 56 Minimizing Your Risk .......................................... 58 Gaining knowledge ........................................ 58 Staying out until you get a little practice ..................... 59 Putting your financial house in order ........................ 59 Diversifying your investments .............................. 60 Weighing Risk against Return ................................... 61
Chapter 5: Say Cheese: Getting a Snapshot of the Market with Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63 Knowing How Indexes Are Measured ............................. 63 Checking Out the Indexes ....................................... 65 The Dow Jones Industrial Average .......................... 65 Standard & Poor’s 500 ..................................... 68 Wilshire Total Market Index ................................ 69 Nasdaq indexes .......................................... 69 Russell 3000 Index........................................ 70 International indexes ...................................... 70
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Using the Indexes Effectively .................................... 71 Tracking the indexes ...................................... 72 Investing in indexes ....................................... 72
Par t II: Before You Start Buying ................. 75 Chapter 6: Gathering Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .77 Looking to Stock Exchanges for Answers.......................... 78 Understanding Stocks and the Companies They Represent .......... 79 Accounting for taste and a whole lot more ................... 79 Understanding how economics affects stocks................. 80 Staying on Top of Financial News................................ 84 Figuring out what a company’s up to ........................ 84 Discovering what’s new with an industry..................... 85 Knowing what’s happening with the economy ................ 85 Seeing what politicians and government bureaucrats are doing... 86 Checking for trends in society, culture, and entertainment ..... 86 Reading (And Understanding) Stock Tables ....................... 87 52-week high ............................................. 88 52-week low.............................................. 88 Name and symbol ........................................ 89 Dividend ................................................ 89 Volume ................................................. 89 Yield .................................................... 91 P/E ..................................................... 91 Day last ................................................. 92 Net change .............................................. 92 Using News about Dividends .................................... 92 Looking at important dates ................................ 93 Understanding why these dates matter ...................... 94 Evaluating Investment Tips ..................................... 95
Chapter 7: Going for Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97 Defining the Broker’s Role ...................................... 97 Distinguishing between Full-Service and Discount Brokers .......... 99 Full-service brokers ....................................... 99 Discount brokers ........................................ 101 Choosing a Broker ............................................ 102 Discovering Various Types of Brokerage Accounts................ 103 Cash accounts .......................................... 103 Margin accounts......................................... 104 Option accounts ......................................... 105 Judging Brokers’ Recommendations............................. 105 Understanding basic recommendations ..................... 106 Asking a few important questions .......................... 106
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Stock Investing For Dummies, 3rd Edition Chapter 8: Investing for Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109 Becoming a Value-Oriented Growth Investor ..................... 110 Choosing Growth Stocks with a Few Handy Tips .................. 111 Looking for leaders in megatrends ......................... 112 Comparing a company’s growth to an industry’s growth ...... 113 Considering a company with a strong niche ................. 113 Checking out a company’s fundamentals .................... 114 Evaluating a company’s management ....................... 115 Noticing who’s buying and/or recommending a company’s stock..................................... 117 Making sure a company continues to do well ................ 118 Heeding investing lessons from history..................... 119 Exploring Small Caps and Speculative Stocks ..................... 119 Know when to avoid IPOs ................................. 120 Make sure a small cap stock is making money ............... 121 Analyze small cap stocks before you invest.................. 122
Chapter 9: Investing for Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123 Understanding the Basics of Income Stocks ...................... 123 Getting a grip on dividends and dividend rates............... 124 Recognizing who’s well-suited for income stocks ............. 124 Checking out the advantages of income stocks ............... 125 Watching out for the disadvantages of income stocks ......... 125 Analyzing Income Stocks ...................................... 127 Pinpointing your needs first ............................... 127 Checking out yield ....................................... 128 Looking at a stock’s payout ratio........................... 130 Examining a company’s bond rating ........................ 131 Diversifying your stocks .................................. 132 Exploring Some Typical Income Stocks .......................... 132 Utilities ................................................ 133 Real estate investment trusts (REITs)....................... 133 Royalty trusts ........................................... 135
Chapter 10: Getting a Grip on Economics . . . . . . . . . . . . . . . . . . . . . . .137 Breaking Down Microeconomics versus Macroeconomics .......... 138 Microeconomics......................................... 138 Macroeconomics........................................ 139 Understanding Important Concepts in Economic Logic ............ 139 Supply and demand ...................................... 140 Wants and needs ........................................ 140 Dynamic analysis versus static analysis ..................... 141 Cause and effect ......................................... 142 Surveying a Few Schools of Economic Thought ................... 142 The Marx school ........................................ 142 The Keynes school....................................... 143 The Austrian school ..................................... 145
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Understanding Some Current Economic Issues That Face Stock Investors .................................... 145 Inflation ................................................ 146 Government intervention ................................. 146
Par t III: Picking Winners ..................... 149 Chapter 11: Using Basic Accounting to Choose Winning Stocks . . .151 Recognizing Value When You See It ............................. 151 Understanding different types of value...................... 152 Putting the pieces together ............................... 154 Accounting for Value.......................................... 155 Breaking down the balance sheet .......................... 156 Looking at the income statement .......................... 159 Tooling around with ratios ................................ 162
Chapter 12: Decoding Company Documents . . . . . . . . . . . . . . . . . . . . .167 Getting a Message from the Bigwigs: The Annual Report ........... 167 Analyzing the annual report’s anatomy ..................... 168 Going through the proxy materials ......................... 172 Getting a Second Opinion ...................................... 172 Company documents filed with the SEC ..................... 172 Value Line .............................................. 174 Standard & Poor’s ....................................... 174 Moody’s Investment Service .............................. 175 Brokerage reports: The good, the bad, and the ugly .......... 175 Compiling Your Own Research Department ...................... 177
Chapter 13: Analyzing Industries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Interrogating the Industries .................................... 180 Which category does the industry fall into? ................. 180 Is the industry growing?.................................. 181 Are the industry’s products or services in demand? .......... 183 What does the industry’s growth rely on? ................... 183 Is the industry dependent on another industry? .............. 184 Who are the leading companies in the industry? ............. 184 Is the industry a target of government action? ............... 185 Outlining Key Industries ....................................... 185 Moving in: Real estate .................................... 186 Driving it home: Automotive .............................. 187 Talking tech: Computers and related electronics ............. 187 Banking on it: Financials .................................. 188
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Stock Investing For Dummies, 3rd Edition Chapter 14: Emerging Sector Opportunities . . . . . . . . . . . . . . . . . . . . .189 Bullish Opportunities ......................................... 190 Commodities ........................................... 191 Oil and gas ............................................. 192 Alternative energy ....................................... 193 Gold and other precious metals ........................... 194 Healthcare.............................................. 195 Defending the nation ..................................... 195 A Bearish Outlook............................................ 196 Avoiding consumer discretionary sectors ................... 196 A warning on real estate .................................. 197 The great credit monster ................................. 198 Cyclical stocks.......................................... 199 Important Considerations for Bulls and Bears .................... 199 Conservative and bullish ................................. 200 Aggressive and bullish ................................... 200 Conservative and bearish ................................. 201 Aggressive and bearish ................................... 201
Chapter 15: Money, Mayhem, and Votes . . . . . . . . . . . . . . . . . . . . . . . .203 Tying Together Politics and Stocks.............................. 204 Seeing the general effects of politics on stock investing ....... 204 Ascertaining the political climate .......................... 206 Distinguishing between nonsystemic and systemic effects ..... 207 Understanding price controls ............................. 209 Poking into Political Resources ................................. 209 Government reports to watch out for ....................... 210 Web sites to surf ........................................ 212
Par t IV: Investment Strategies and Tactics ......... 213 Chapter 16: Choosing between Investing and Trading . . . . . . . . . . . .215 The Differences between Investing and Trading ................... 215 The time factor .......................................... 216 The psychology factor ................................... 217 Checking out an example ................................. 217 Tools of the Trader ........................................... 220 Technical analysis ....................................... 220 Brokerage orders ........................................ 221 Advisory services ....................................... 221 The Basic Rules of Trading..................................... 222
Chapter 17: Selecting a Strategy That’s Just Right for You . . . . . . . .225 Laying Out Your Plans ........................................ 225 Living the bachelor life: Young single with no dependents ..... 226 Going together like a horse and carriage: Married with children .................................. 227
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Getting ready for retirement: Over 40 and either single or married................................. 227 Kicking back in the hammock: Already retired ............... 228 Allocating Your Assets ........................................ 228 Investors with less than $10,000 ........................... 229 Investors with $10,000 to $50,000 .......................... 230 Investors with $50,000 or more ............................ 230 Knowing When to Sell ......................................... 231
Chapter 18: Understanding Brokerage Orders and Trading Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .235 Checking Out Brokerage Orders ................................ 235 On the clock: Time-related orders .......................... 236 At your command: Condition-related orders ................. 238 The joys of technology: Advanced orders ................... 243 Buying on Margin............................................. 244 Examining marginal outcomes ............................. 245 Maintaining your balance ................................. 246 Striving for success on margin ............................. 246 Going Short and Coming Out Ahead ............................. 247 Setting up a short sale .................................... 248 Oops! Going short when prices grow taller .................. 249 Feeling the squeeze ...................................... 250
Chapter 19: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ. . . .251 Being Direct with DPPs ........................................ 252 Investing in a DPP ....................................... 252 Finding DPP alternatives .................................. 253 Recognizing the drawbacks ............................... 254 Dipping into DRPs............................................ 255 Getting a clue about compounding ......................... 255 Building wealth with optional cash payments ................ 256 Checking out the cost advantages .......................... 257 Weighing the pros with the cons ........................... 258 The One-Two Punch: Dollar Cost Averaging and DRPs ............. 258
Chapter 20: Corporate Skullduggery: Looking at Insider Activity . . .261 Tracking Insider Trading ...................................... 262 Looking at Insider Transactions ................................ 263 Breaking down insider buying............................. 264 Picking up tips from insider selling ......................... 265 Considering Corporate Stock Buybacks .......................... 266 Understanding why a company buys back shares ............ 267 Exploring the downside of buybacks ....................... 269 Stock Splits: Nothing to Go Bananas Over ........................ 269 Ordinary stock splits ..................................... 270 Reverse stock splits ...................................... 271
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Stock Investing For Dummies, 3rd Edition Chapter 21: Keeping More of Your Money from the Taxman . . . . . . .273 Paying through the Nose: The Tax Treatment of Different Investments ..................................... 274 Understanding ordinary income and capital gains ............ 274 Minimizing the tax on your capital gains .................... 275 Coping with capital losses ................................ 276 Evaluating gains and losses scenarios ...................... 277 Sharing Your Gains with the IRS ................................ 277 Filling out forms ......................................... 278 Playing by the rules ...................................... 279 Discovering the Softer Side of the IRS: Tax Deductions for Investors ... 279 Investment interest...................................... 280 Miscellaneous expenses.................................. 280 Donations of stock to charity .............................. 281 Knowing what you can’t deduct ........................... 281 Taking Advantage of Tax-Advantaged Retirement Investing ......... 281 IRAs ................................................... 282 401(k) plans ............................................ 283
Par t V: The Par t of Tens ...................... 285 Chapter 22: Ten Ways to Profit before the Crowd Does . . . . . . . . . . .287 Use Your Instincts ............................................ 287 Take Notice of Praise from Consumer Groups .................... 288 Check Out Powerful Demographics ............................. 288 Look for a Rise in Earnings ..................................... 289 Analyze Industries ............................................ 289 Stay Aware of Positive Publicity for Industries .................... 290 Watch Megatrends ........................................... 290 Keep Track of Politics ......................................... 290 Recognize Heavy Insider or Corporate Buying .................... 291 Follow Institutional Investors .................................. 292
Chapter 23: Ten (Or So) Ways to Protect Your Stock Market Profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293 Accrue Cash ................................................. 293 Spread Your Money across Several Stocks ....................... 293 Buy More of a Down (Yet Solid) Stock ........................... 294 Apply Long-Term Logic........................................ 294 Use the Almighty Stop-Loss Order .............................. 294 Use the Almighty Trailing Stop Order............................ 295 Place a Limit Order........................................... 295 Set Up Broker Triggers........................................ 296 Consider the Put Option ....................................... 296 Check Out the Covered Call Option ............................. 296 When All Else Fails, Sell ....................................... 297
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Chapter 24: Ten Red Flags for Stock Investors . . . . . . . . . . . . . . . . . . .299 Earnings Slow Down or Head South ............................. 299 Sales Slow Down ............................................. 300 Debt Is Too High or Unsustainable .............................. 301 Analysts Are Exuberant Despite Logic........................... 301 Insider Selling ................................................ 302 A Bond Rating Cut ............................................ 302 Increased Negative Coverage ................................... 302 Industry Problems ............................................ 303 Political Problems ............................................ 303 Funny Accounting: No Laughing Here!........................... 303
Chapter 25: Ten Challenges and Opportunities for Stock Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305 Debt, Debt, and More Debt ..................................... 305 Derivatives.................................................. 306 Real Estate .................................................. 307 Inflation ..................................................... 307 Pensions and Unfunded Liabilities .............................. 308 The Growth of Government .................................... 308 Recession/Depression......................................... 309 Commodities ................................................ 309 Energy ...................................................... 309 Dangers from Left Field........................................ 310
Par t VI: Appendixes ......................... 311 Appendix A: Resources for Stock Investors . . . . . . . . . . . . . . . . . . . . .313 Financial Planning Sources..................................... 313 The Language of Investing ..................................... 314 Textual Investment Resources ................................. 314 Periodicals and magazines ................................ 314 Books and pamphlets .................................... 315 Special books of interest to stock investors ................. 316 Investing Web Sites ........................................... 317 General investing Web sites ............................... 317 Stock investing Web sites ................................. 318 Investor Associations and Organizations ......................... 319 Stock Exchanges ............................................. 319 Finding Brokers .............................................. 319 Choosing brokers ........................................ 320 Brokers ................................................ 320 Fee-Based Investment Sources ................................. 321 Dividend Reinvestment Plans .................................. 322
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Stock Investing For Dummies, 3rd Edition Sources for Analysis .......................................... 323 Earnings and earnings estimates ........................... 323 Industry analysis ........................................ 323 Factors that affect market value ........................... 323 Technical analysis ....................................... 325 Insider trading .......................................... 325 Tax Benefits and Obligations ................................... 326 Fraud ....................................................... 326
Appendix B: Financial Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329 Liquidity Ratios .............................................. 330 Current ratio ............................................ 330 Quick ratio ............................................. 331 Operating Ratios ............................................. 331 Return on equity (ROE)................................... 331 Return on assets (ROA) .................................. 332 Sales to receivables ratio (SR) ............................. 332 Solvency Ratios .............................................. 333 Debt to net equity ratio ................................... 333 Working capital ......................................... 334 Common Size Ratios .......................................... 334 Valuation Ratios.............................................. 335 Price-to-earnings ratio (P/E) ............................... 335 Price to sales ratio (PSR) ................................. 336 Price to book ratio (PBR) ................................. 337
Index .................................... 339
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Introduction
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tock Investing For Dummies, 3rd Edition, has been an honor for me to write. I’m grateful that I can share my thoughts, information, and experience with such a large and devoted group of readers. I think that this edition is my most important edition so far because so much change, volatility, and uncertainty have become a part of the stock market. It’s not your parents’ stock market anymore. The opportunities for great gains (and even greater losses) have reached an extreme. In some ways, today’s market reminds me of Dickens’ famous novel opener: “It was the best of times, it was the worst of times . . . .” In terms of what faces us in today’s world — economic uncertainty, terrorism, war, political tensions, higher taxes, rising inflation, unemployment, and so on — these seem like the worst of times. Yet when I think of the tools, strategies, and investing vehicles available for you to build (and protect) wealth, these can be the best of times. Successful stock investing takes diligent work and knowledge, like any other meaningful pursuit. This book can definitely help you avoid the mistakes others have made and can point you in the right direction. It will give you a heads up about trends and conditions that are found in few other stock investing guides. Explore the pages of this book and find the topics that most interest you within the world of stock investing. Let me assure you that I’ve squeezed over a quarter century of experience, education, and expertise between these covers. My track record is as good (or better) as the track records of the experts who trumpet their successes. More important, I share information to avoid common mistakes (some of which I made myself!). Understanding what not to do can be just as important as figuring out what to do. In all the years that I’ve counseled and educated investors, the single difference between success and failure, between gain and loss, boils down to one word: knowledge. Take this book as your first step in a lifelong learning adventure.
About This Book The stock market has been a cornerstone of the investor’s passive wealthbuilding program for over a century and continues in this role. This decade has been one huge roller coaster ride for stock investors. Fortunes have been made and lost. With all the media attention, all the talking heads on radio and
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Stock Investing For Dummies, 3rd Edition television, and the books with titles like Dow at 36,000, the investing public still didn’t avoid losing trillions in a historic stock market debacle. Sadly, even the so-called experts who understand stocks didn’t see the economic and geopolitical forces that acted like a tsunami on the market. With just a little more knowledge and a few wealth-preserving techniques, more investors could have held onto their hard-earned stock market fortunes. Cheer up, though: This book gives you an early warning on those megatrends and events that will affect your stock portfolio. While other books may tell you about stocks, this book tells you about stocks and what affects them. This book is designed to give you a realistic approach to making money in stocks. It provides the essence of sound, practical stock investing strategies and insights that have been market-tested and proven from nearly 100 years of stock market history. I don’t expect you to read it cover to cover, although I’d be delighted if you read every word! Instead, this book is designed as a reference tool. Feel free to read the chapters in whatever order you choose. You can flip to the sections and chapters that interest you or those that include topics that you need to know more about. Stock Investing For Dummies, 3rd Edition, is also quite different from the “get rich with stocks” titles that have crammed the bookshelves in recent years. It doesn’t take a standard approach to the topic; it doesn’t assume that stocks are a sure thing and the be-all, end-all of wealth building. In fact, at times in this book, I tell you not to invest in stocks. This book can help you succeed not only in up markets but also in down markets. Bull markets and bear markets come and go, but the informed investor can keep making money no matter what. To give you an extra edge, I’ve tried to include information about the investing environment for stocks. Whether it’s politics or hurricanes (or both), you need to know how the big picture affects your stock investment decisions.
Conventions Used in This Book To make navigating through this book easier, I’ve established the following conventions: ✓ Boldface text points out keywords or the main parts of bulleted items. ✓ Italics highlight new terms that are defined. ✓ Monofont is used for Web addresses.
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Introduction
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When this book was printed, some Web addresses may have needed to break across two lines of text. If that happened, rest assured that I haven’t put in any extra characters (such as hyphens) to indicate the break. So when using one of these Web addresses, just type in exactly what you see in this book, pretending as though the line break doesn’t exist.
What You’re Not to Read Sidebars (gray boxes of text) in this book give you a more in-depth look at a certain topic. While they further illuminate a particular point, these sidebars aren’t crucial to your understanding of the rest of the book. Feel free to read them or skip them. Of course, I’d love for you to read them all, but my feelings won’t be hurt if you decide to skip them over. The text that accompanies the Technical Stuff icon (see the forthcoming section “Icons Used in This Book”) can be passed over as well. The text associated with this icon gives some technical details about stock investing that are certainly interesting and informative, but you can still come away with the information you need without reading this text.
Foolish Assumptions I figure you’ve picked up this book for one or more of the following reasons: ✓ You’re a beginner and want a crash course on stock investing that’s an easy read. ✓ You’re already a stock investor, and you need a book that allows you to read only those chapters that cover specific stock investing topics of interest to you. ✓ You need to review your own situation with the information in the book to see if you missed anything when you invested in that hot stock that your brother-in-law recommended. ✓ You need a great gift! When Uncle Mo is upset over his poor stock picks, you can give him this book so he can get back on his financial feet. Be sure to get a copy for his broker, too. (Odds are that the broker was the one who made those picks to begin with.)
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Stock Investing For Dummies, 3rd Edition
How This Book Is Organized The information is laid out in a straightforward format. The parts progress in a logical approach that any investor interested in stocks can follow very easily.
Part I: The Essentials of Stock Investing This part is for everyone. Understanding the essentials of stock investing and investing in general will only help you, especially in uncertain economic times. Stocks may even touch your finances in ways not readily apparent. For example, stocks aren’t only in individual accounts; they’re also in mutual funds and pension plans. An important point is that stocks are really financial tools that are a means to an end. Investors should be able to answer the question, “Why am I considering stocks at all?” Stocks are a great vehicle for wealth building, but only if investors realize what they can accomplish and how to use them. Chapter 2 explains how to take stock of your current financial situation and goals, and Chapter 3 defines common approaches to stock investing. One of the essentials of stock investing is understanding risk. Most people are clueless about risk. Chapter 4, on risk, is one of the most important chapters that serious stock investors should read. You can’t avoid every type of risk out there (life itself embodies risk). However, this chapter can help you recognize it and find ways to minimize it in your stock investing program.
Part II: Before You Start Buying When you’re ready to embark on your career as a stock investor, you need to use some resources to gather information about the stocks you’re interested in. Fortunately, you live in the information age. I pity the investors from the 1920s who didn’t have access to so many resources, but today’s investors are in an enviable position. This part tells you where to find information and how to use it to be a more knowledgeable investor (a rarity in recent years!). For example, I explain that stocks can be used for both growth and income purposes, and I discuss the characteristics of each; see Chapters 8 and 9 for more information.
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Chapter 6 is a great starting place for your information gathering; I show you how to stay on top of financial news and read stock tables, among other topics. When you’re ready to invest, you’ll invariably have to turn to a broker. Several types of brokers are out there, so you should know which is which. The wrong broker can make you . . . uh . . . broker. Chapter 7 helps you choose. New to this edition is Chapter 10, which gives you the lowdown on how a grasp of basic economics can make you more successful with your stock investing strategy.
Part III: Picking Winners Part III is about picking good stocks by using microeconomics, meaning that you look at the stocks of individual companies. I explain how to evaluate a company’s products, services, and other factors so that you can determine whether a company is strong and healthy. One of the major differences with this edition versus earlier editions is the emphasis on emerging sector opportunities. If I can steer you toward those segments of the stock market that show solid promise for the coming years, that alone would make your stock portfolio thrive. Putting your money into solid companies in thriving industries has been the hallmark of superior stock investing throughout history. It’s no different now. Check out Chapter 14 if you want to know more about emerging sector opportunities. Where do you turn to find out about a company’s financial health? In Chapters 11 and 12, I show you the documents you should review to make a more informed decision. When you find the information, you’ll discover how to make sense of that data as well. While you’re at it, check out Chapter 13 (on analyzing industries) and Chapter 15 (on how politics affects the art of stock picking). I compare buying stock to picking goldfish. If you look at a bunch of goldfish to choose which ones to buy, you want to make sure that you pick the healthiest ones. With stocks, you also need to pick companies that are healthy. Part III can help you do that.
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Stock Investing For Dummies, 3rd Edition
Part IV: Investment Strategies and Tactics Even the stocks of great companies can fall in a bad investing environment. This is where you should be aware of the “macro.” If stocks were goldfish, the macro would be the pond or goldfish bowl. In that case, even healthy goldfish can die if the water is toxic. Therefore, you should monitor the investing environment for stocks. Part IV reveals tips, strategies, and resources that you shouldn’t ignore. Investing is a long-term activity, but stocks can also be short-term opportunities, so I discuss stock trading in Chapter 16. In Chapter 17, I provide guidance on selecting an investing strategy that’s right for your personal and financial situations. After you understand stocks and the economic environment in which they operate, choose the strategy and the tactics to help steer you to your wealth-building objectives. Chapter 18 reveals some of my all-time favorite techniques for building wealth and holding onto your stock investment gains (definitely check it out). You may be an investor, but that doesn’t mean that you have deep pockets. Chapter 19 tells you how to buy stocks with low (or no) transaction costs. If you’re going to buy the stock anyway, why not save on commissions and other costs? As an investor, you must keep an eye on what company insiders are doing. In Chapter 20, I explain what it may mean if a company’s management is buying or selling the same stock that you’re considering. After you spend all your time, money, and effort to grow your money in the world of stocks, you have yet another concern: holding onto your hardearned gains. This challenge is summarized in one word: taxes. Sound tax planning is crucial for everyone who works hard. After all, taxes are the biggest expense in your lifetime (right after children!). See Chapter 21 for more information.
Part V: The Part of Tens I wrap up the book with a hallmark of For Dummies books — the Part of Tens. These chapters give you a mini crash course in stock investing, including ten ways to protect yourself from fraud.
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Introduction
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In this part, I offer some tips on how to profit with stocks before the crowd does (Chapter 22) and how to protect those profits (Chapter 23). I also provide a list of ten red flags for stock investors (Chapter 24), along with ten challenges and opportunities that face stock investors (Chapter 25).
Part VI: Appendixes Don’t overlook the appendixes. I pride myself on the resources I can provide my students and readers so that they can make informed investment decisions. Whether the topic is stock investing terminology, economics, or avoiding capital gains taxes, I include a treasure trove of resources to help you. Whether you go to a bookstore, the library, or the Internet, Appendix A gives you some great places to turn to for help. In Appendix B, I explain financial ratios. These important numbers help you better determine whether to invest in a particular company’s stock.
Icons Used in This Book When you see this icon, I’m reminding you about some information that you should always keep stashed in your memory, whether you’re new to investing or an old pro. The text attached to this icon may not be crucial to your success as an investor, but it may enable you to talk shop with investing gurus and better understand the financial pages of your favorite business publication or Web site.
This icon flags a particular bit of advice that just may give you an edge over other investors.
Pay special attention to this icon because the advice can prevent headaches, heartaches, and financial aches.
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Stock Investing For Dummies, 3rd Edition
Where to Go from Here You may not need to read every chapter to make you more confident as a stock investor, so feel free to jump around to suit your personal needs. Because every chapter is designed to be as self-contained as possible, it won’t do you any harm to cherry-pick what you really want to read. But if you’re like me, you may still want to check out every chapter because you never know when you may come across a new tip or resource that will make a profitable difference in your stock portfolio. I want you to be successful so that I can brag about you in the next edition!
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Part I
The Essentials of Stock Investing
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In this part . . .
he latest market turmoil and uncertainty tell investors to get back to square one. Your success is dependent on doing your homework before you invest your first dollar in stocks. Most investors don’t realize that they should be scrutinizing their own situations and financial goals at least as much as they scrutinize stocks. How else can you know which stocks are right for you? Too many people risk too much simply because they don’t take stock of their current needs, goals, and risk tolerance before they invest. The chapters in this part tell you what you need to know to choose the stocks that best suit you.
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Chapter 1
Welcome to the World of Stock Investing In This Chapter ▶ Knowing the essentials ▶ Doing your own research ▶ Recognizing winners ▶ Exploring investment strategies
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tock investing was the hot thing during the late 1990s — a trend just like the hula hoop and pet rocks. With the new millennium, however, a reversal of fortunes has occurred as the bear market of 2000–2002 rocked our world (a bear market is a prolonged period of falling prices — in this case, stock prices). This decade has been a wild roller coaster ride that saw the market hit new highs in 2007, although it’s down in ugly fashion in 2008. During this time, the public figured out that stock investing isn’t for wildeyed amateurs or dart-throwers (or the worst . . . wild-eyed amateur dartthrowers!). I wrote much of this 3rd Edition with current events and market conditions on my radar screen. The year 2008 witnessed some ominous events that will make stock investing very interesting (to say the least) for the time being. Don’t let that scare you, though; informed investors have made money in all sorts of markets — good, bad, and even ugly. As I write this, the conditions are in place for an inflationary depression, but selecting stocks that can benefit from these challenging times could indeed make you much wealthier. The purpose of this book is not only to tell you about the basics of stock investing but also to let you in on some solid strategies that can help you profit from the stock market. Before you invest your first dollar, you need to understand the basics of stock investing, which I introduce in this chapter.
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Part I: The Essentials of Stock Investing
Understanding the Basics The basics are so basic that few people are doing them. Perhaps the most basic (and therefore most important) thing to grasp is the risk you face whenever you do anything (like putting your hard-earned money in an investment like a stock). When you lose track of the basics, you lose track of why you invested to begin with. Find out more about risk (and the different kinds of risk) in Chapter 4. When the late comedian Henny Youngman was asked, “How is your wife?” he responded, “Compared to what?” This also applies to stocks. When you’re asked, “How is your stock?” you can very well respond that it’s doing well, especially when compared to an acceptable yardstick such as a stock index (like the S&P 500). Find out more about indexes in Chapter 5. The bottom line in stock investing is that you shouldn’t immediately send your money to a brokerage account or go to a Web site and click “buy stock.” The first thing you should do is find out as much as you can about what stocks are and how to use them to achieve your wealth-building goals. Chapters 2 and 3 help you take stock of your current financial situation and help you understand common approaches to stock investing. Before you continue, I want to get straight exactly what a stock is. Stock is a type of security that indicates ownership in a corporation and represents a claim on the part of that corporation’s assets and earnings. The two primary types of stocks are common and preferred. Common stock (what I cover throughout this book) entitles the owner to vote at shareholders’ meetings and receive any dividends that the company issues. Preferred stock doesn’t usually confer voting rights, but it does include some rights that exceed those of common stock. Preferred stockholders, for example, have priority in certain conditions, such as receiving dividends before common stockholders in the event that the corporation is going bankrupt.
Preparing to Buy Stocks Gathering information is critical in your stock-investing pursuits. You should gather information on your stock picks two times: before you invest and after. Obviously, you should become more informed before you invest your first dollar, but you also need to stay informed about what’s happening to the company whose stock you buy, and also about the industry and the general economy. To find the best information sources, check out Chapter 6.
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Chapter 1: Welcome to the World of Stock Investing
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When you’re ready to invest, you need a brokerage account. How do you know which broker to use? Chapter 7 provides some answers and resources to help you choose a broker.
Knowing How to Pick Winners When you get past the basics, you can get to the meat of stock picking. Successful stock picking isn’t mysterious, but it does take some time, effort, and analysis. And the effort is worthwhile because stocks are a convenient and important part of most investors’ portfolios. Read the following sections and be sure to leapfrog to the relevant chapters to get the inside scoop on hot stocks.
Recognizing stock value Imagine that you like eggs and you’re buying them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies’ stock. The grocery store is the stock market. What if two brands of eggs are similar, but one costs 50 cents a carton and the other costs 75 cents? Which would you choose? Odds are that you’d look at both brands, judge their quality, and if they’re indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same is true of stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side. What if the quality of the two brands of eggs is significantly different, but their prices are the same? If one brand of eggs is stale, of poor quality, and priced at 50 cents and the other brand is fresh, of superior quality, and also priced at 50 cents, which would you get? I’d take the good brand because they’re better eggs. Perhaps the lesser eggs are an acceptable purchase at 10 cents, but they’re definitely overpriced at 50 cents. The same example works with stocks. A poorly run company isn’t a good choice if you can buy a better company in the marketplace at the same — or a better — price. Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars. (Otherwise you get egg on your face. You saw that one coming, right?)
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Part I: The Essentials of Stock Investing
Understanding how market capitalization affects stock value You can determine a company’s value (and thus the value of its stock) in many ways. The most basic way is to look at the company’s market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share. Calculating the market cap is easy. If a company has 1 million shares outstanding and its share price is $10, the market cap is $10 million. Small cap, mid cap, and large cap aren’t references to headgear; they’re references to how large a company is as measured by its market value. Here are the five basic stock categories of market capitalization: ✓ Micro cap (under $250 million): These stocks are the smallest and hence the riskiest available. ✓ Small cap ($250 million to $1 billion): These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is “potential.” ✓ Mid cap ($1 billion to $10 billion): For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps. ✓ Large cap ($10 billion to $50 billion): This category is usually best reserved for conservative stock investors who want steady appreciation with greater safety. Stocks in this category are frequently referred to as blue chips. ✓ Ultra cap (over $50 billion): These stocks are also called mega caps and obviously refer to companies that are the biggest of the big. Stocks such as General Electric and Exxon Mobil are examples. From a safety point of view, a company’s size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees: Which tree is sturdier, a giant California redwood or a small oak tree that’s just a year old? In a great storm, the redwood holds up well, while the smaller tree has a rough time. But you also have to ask yourself which tree has more opportunity for growth. The redwood may not have much growth left, but the small oak tree has plenty of growth to look forward to.
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Chapter 1: Welcome to the World of Stock Investing
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For beginning investors, comparing market cap to trees isn’t so far-fetched. You want your money to branch out without becoming a sap. Although market capitalization is important to consider, don’t invest (or not invest) based solely on it. It’s just one measure of value. As a serious investor, you need to look at numerous factors that can help you determine whether any given stock is a good investment. Keep reading — this book is full of information to help you decide.
Sharpening your investment skills Investors who analyze a company can better judge the value of its stock and profit from buying and selling it. Your greatest asset in stock investing is knowledge (and a little common sense). To succeed in the world of stock investing, keep in mind these key success factors: ✓ Understand why you want to invest in stocks. Are you seeking appreciation (capital gains) or income (dividends)? Look at Chapters 8 and 9 for information on these topics. ✓ Get a good grounding in economics. It could save your financial life! In Chapter 10, I include some basic (but interesting) points on economics because I think that stock investors (as a group) are woefully undereducated in economics and are therefore at risk (translation: bad stock decisions!). Check it out — you’ll be glad you did. ✓ Do some research. Look at the company whose stock you’re considering to see whether it’s a profitable business worthy of your investment dollars. Chapters 11 and 12 help you scrutinize companies. ✓ Choosing a winning stock also means that you choose a winning industry. You’ll frequently see stock prices of mediocre companies in hot industries rise higher and faster than solid companies in floundering industries. Therefore, choosing the industry is very important. Find out more about analyzing industries in Chapter 13. ✓ Understand and identify megatrends. Doing so makes it easier for you to make money. This edition spends more time and provides more resources to help you see the opportunities in emerging sectors and avoid the problem areas (see Chapter 14 for details). ✓ Understand how the world affects your stock. Stocks succeed or fail in large part because of the environment in which they operate. Economics (see Chapter 10) and politics (see Chapter 15) make up that world, so you should know something about them.
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Part I: The Essentials of Stock Investing
Stock market insanity Have you ever noticed a stock going up even though the company is reporting terrible results? How about seeing a stock nosedive despite the fact that the company is doing well? What gives? Well, judging the direction of a stock in a short-term period — over the next few days or weeks — is almost impossible. Yes, in the short term, stock investing is irrational. The price of a stock and the value of its company seem disconnected and crazy. The key phrase to remember is “short term.” A stock’s price and the company’s value become more logical over an extended period of time.
The longer a stock is in the public’s view, the more rational the performance of the stock’s price. In other words, a good company continues to draw attention to itself; hence, more people want its stock, and the share price rises to better match the company’s value. Conversely, a bad company doesn’t hold up to continued scrutiny over time. As more and more people see that the company isn’t doing well, the share price declines. Over the long run, a stock’s share price and the company’s value eventually become equal for the most part.
✓ Use investing strategies like the pros do. In other words, how you go about investing can be just as important as what you invest in. Chapters 17, 18, and 19 highlight techniques for investing to help you make more money from your stocks. ✓ Keep more of the money you earn. After all your great work in getting the right stocks and making the big bucks, you should know about keeping more of the fruits of your investing. I cover taxes in stock investing in Chapter 21. ✓ Sometimes, what people tell you to do with stocks is not as revealing as what people are actually doing. This is why I like to look at company insiders before I buy or sell a particular stock. To find out more about insider buying and selling, read Chapter 20. Actually, every chapter in this book offers you valuable guidance on some essential aspect of the fantastic world of stocks. The knowledge you pick up and apply from these pages has been tested over nearly a century of stock picking. The investment experience of the past — the good, the bad, and some of the ugly — is here for your benefit. Use this information to make a lot of money (and make me proud!). And don’t forget to check out the appendixes, where I provide a wide variety of investing resources and financial ratios!
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Chapter 1: Welcome to the World of Stock Investing
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Boning Up on Strategies and Tactics Successful investing isn’t just what you invest in; it’s also the way you invest. I’m very big on strategies such as trailing stops and limit orders. You can find out more in Chapter 18. Buying stocks doesn’t always mean that you must buy through a broker and that it must be 100 shares. You can buy stock for as little as $25 using programs such as dividend reinvestment plans. Chapter 19 tells you more. While you’re at it, you may as well find out what the corporate insiders are doing. Why? Because corporate insiders are among the first to find out what’s really going on inside a company, and that knowledge is reflected in their investing decisions, which you should pay attention to. You can find out more about insider trading and other management doings in Chapter 20.
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Part I: The Essentials of Stock Investing
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Chapter 2
Taking Stock of Your Current Financial Situation and Goals In This Chapter ▶ Preparing your personal balance sheet ▶ Looking at your cash flow statement ▶ Determining your financial goals
Y
es, you want to make the big bucks. Or maybe you just want to get back the big bucks you lost in stocks during the bear market (a long period of falling prices) of 2000–2002, or perhaps in the tumultuous volatility of 2007 and early 2008. (Investors who followed the guidelines from the 1st and 2nd editions of this book did much better than the crowd!) Either way, you want your money to grow so that you can have a better life. But before you make reservations for that Caribbean cruise you’re dreaming about, you have to map out your action plan for getting there. Stocks can be a great component of most wealth-building programs, but you must first do some homework on a topic that you should be very familiar with — yourself. That’s right. Understanding your current financial situation and clearly defining your financial goals are the first steps in successful investing. Let me give you an example. I met an investor at one of my seminars who had a million dollars worth of Procter & Gamble (PG) stock, and he was nearing retirement. He asked me whether he should sell his stock and be more growth-oriented and invest in a batch of small cap stocks (stocks of a company worth $250 million to $1 billion; see Chapter 1 for more information). Because he already had enough assets to retire on at that time, I said that he didn’t need to get more aggressive. In fact, I told him that he had too much tied to a single stock, even though it was a solid, large company. What would happen to his assets if problems arose at PG? It seemed obvious to tell him to shrink his stock portfolio and put that money elsewhere, such as paying off debt or adding investment-grade bonds for diversification.
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Part I: The Essentials of Stock Investing This chapter is undoubtedly one of the most important chapters in this book. At first, you may think it’s a chapter more suitable for some general book on personal finance. Wrong! Unsuccessful investors’ greatest weakness is not understanding their financial situation and how stocks fit in. Often, I counsel people to stay out of the stock market if they aren’t prepared for the responsibilities of stock investing — they haven’t been regularly reviewing the company’s financial statements or tracking the company’s progress. Investing in stocks requires balance. Investors sometimes tie up too much money in stocks, putting themselves at risk of losing a significant portion of their wealth if the market plunges. Then again, other investors place little or no money in stocks and therefore miss out on excellent opportunities to grow their wealth. Investors should make stocks a part of their portfolios, but the operative word is part. You should let stocks take up only a portion of your money. A disciplined investor also has money in bank accounts, investmentgrade bonds, precious metals, and other assets that offer growth or income opportunities. Diversification is the key to minimizing risk. (For more on risk, see Chapter 4.)
Establishing a Starting Point by Preparing a Balance Sheet Whether you’re already in stocks or you’re looking to get into stocks, you need to find out about how much money you can afford to invest. No matter what you hope to accomplish with your stock investing plan, the first step you should take is to figure out how much you own and how much you owe. To do this, prepare and review your personal balance sheet. A balance sheet is simply a list of your assets, your liabilities, and what each item is currently worth so you can arrive at your net worth. Your net worth is total assets minus total liabilities. I know that these terms sound like accounting mumbo jumbo, but knowing your net worth is important to your future financial success, so just do it. Composing your balance sheet is simple. Pull out a pencil and a piece of paper. For the computer savvy, a spreadsheet software program accomplishes the same task. Gather all your financial documents, such as bank and brokerage statements and other such paperwork — you need figures from these documents. Then follow the steps that I outline in the following sections. Update your balance sheet at least once a year to monitor your financial progress (is your net worth going up or down?).
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Your personal balance sheet is really no different from balance sheets that giant companies prepare. (The main difference is a few zeros, but you can use my advice in this book to work on changing that.) In fact, the more you find out about your own balance sheet, the easier it is to understand the balance sheet of companies in which you’re seeking to invest. See Chapter 11 for details on reviewing company balance sheets.
Step 1: Make sure you have an emergency fund First, list cash on your balance sheet. Your goal is to have, in reserve, at least three to six months’ worth of your gross living expenses in cash and cash equivalents. The cash is important because it gives you a cushion. Three to six months is usually enough to get you through the most common forms of financial disruption, such as losing your job. If your monthly expenses (or outgo) are $2,000, you should have at least $6,000, and probably closer to $12,000, in a secure, FDIC-insured, interestbearing bank account (or other, relatively safe interest-bearing vehicle such as a money market fund). Consider this account an emergency fund and not an investment. Don’t use this money to buy stocks. Too many Americans don’t have an emergency fund, meaning that they put themselves at risk. Walking across a busy street while wearing a blindfold is a great example of putting yourself at risk, and in recent years, investors have done the financial equivalent. Investors piled on tremendous debt, put too much into investments (such as stocks) that they didn’t understand, and had little or no savings. One of the biggest problems during this past decade was that savings were sinking to record lows while debt levels were reaching new heights. People then sold many stocks because they needed funds for — you guessed it — paying bills and debt. Resist the urge to start thinking of your investment in stocks as a savings account generating over 20 percent per year. This is dangerous thinking! If your investments tank, or if you lose your job, you will have financial difficulty and that will affect your stock portfolio (you may have to sell some stocks in your account just to get money to pay the bills). An emergency fund helps you through a temporary cash crunch.
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Part I: The Essentials of Stock Investing
Step 2: List your assets in decreasing order of liquidity Liquid assets aren’t references to beer or cola (unless you’re AnheuserBusch). Instead, liquidity refers to how quickly you can convert a particular asset (something you own that has value) into cash. If you know the liquidity of your assets, including investments, you have some options when you need cash to buy some stock (or pay some bills). All too often, people are short on cash and have too much wealth tied up in illiquid investments such as real estate. Illiquid is just a fancy way of saying that you don’t have the immediate cash to meet a pressing need. (Hey, we’ve all had those moments!) Review your assets and take measures to ensure that enough of them are liquid (along with your illiquid assets). Listing your assets in order of liquidity on your balance sheet gives you an immediate picture of which assets you can quickly convert to cash and which ones you can’t. If you need money now, you can see that cash in hand, your checking account, and your savings account are at the top of the list. The items last in order of liquidity become obvious; they’re things like real estate and other assets that can take a long time to convert to cash. Selling real estate, even in a seller’s market, can take months. Investors who don’t have adequate liquid assets run the danger of selling assets quickly and possibly at a loss because they scramble to accumulate the cash for their short-term financial obligations. For stock investors, this scramble may include prematurely selling stocks that they originally intended to use as longterm investments. Table 2-1 shows a typical list of assets in order of liquidity. Use it as a guide for making your own asset list.
Table 2-1
John Q. Investor: Personal Assets as of December 31, 2008
Asset Item
Market Value
Annual Growth Rate %
$150
0
Current assets Cash on hand and in checking
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Bank savings accounts and certificates of deposit
$5,000
2%
Stocks
$2,000
11%
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Chapter 2: Taking Stock of Your Current Financial Situation and Goals Asset Item
Market Value
Annual Growth Rate %
Mutual funds
$2,400
9%
Total current assets
$9,790
23
Long-term assets Auto
$1,800
–10%
Residence
$150,000
5%
Real estate investment
$125,000
6%
Personal stuff (such as jewelry)
$4,000
Total long-term assets
$280,800
Total assets
$290,590
Here’s how to break down the information in Table 2-1: ✓ The first column describes the asset. You can quickly convert current assets to cash — they’re more liquid; long-term assets have value, but you can’t necessarily convert them to cash quickly — they aren’t very liquid. Please take note — I have stocks listed as short-term in the table. The reason is that this balance sheet is meant to list items in order of liquidity. Liquidity is best embodied in the question, “How quickly can I turn this asset into cash?” Because a stock can be sold and converted to cash very quickly, it’s a good example of a liquid asset. (However, that’s not the main purpose for buying stocks.) ✓ The second column gives the current market value for that item. Keep in mind that this value isn’t the purchase price or original value; it’s the amount you would realistically get if you sold the asset in the current market at that moment. ✓ The third column tells you how well that investment is doing, compared to one year ago. If the percentage rate is 5 percent, that item increased in value by 5 percent from a year ago. You need to know how well all your assets are doing. Why? To adjust your assets for maximum growth or to get rid of assets that are losing money. Assets that are doing well are kept (consider increasing your holdings in these assets), and assets that are down in value should be scrutinized to see whether they’re candidates for removal. Perhaps you can sell them and reinvest the money elsewhere. In addition, the realized loss has tax benefits (see Chapter 21).
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Part I: The Essentials of Stock Investing Figuring the annual growth rate (in the third column) as a percentage isn’t difficult. Say that you buy 100 shares of the stock Gro-A-Lot Corp. (GAL), and its market value on December 31, 2007, is $50 per share for a total market value of $5,000 (100 shares × $50 per share). When you check its value on December 31, 2008, you find out that the stock is at $60 per share for a total market value of $6,000 (100 shares × $60). The annual growth rate is 20 percent. You calculate this by taking the amount of the gain ($60 per share less $50 per share = $10 gain per share), which is $1,000 (100 shares times the $10 gain), and dividing it by the value at the beginning of the time period ($5,000). In this case, you get 20 percent ($1,000 ÷ $5,000). What if GAL also generates a dividend of $2 per share during that period — now what? In that case, GAL generates a total return of 24 percent. To calculate the total return, add the appreciation ($10 per share × 100 shares = $1,000) and the dividend income ($2 per share × 100 shares = $200) and divide that sum ($1,000 + $200, or $1,200) by the value at the beginning of the year ($50 per share × 100 shares, or $5,000). The total is $1,200 ÷ $5,000, or 24 percent. ✓ The last line lists the total for all the assets and their current market value.
Step 3: List your liabilities Liabilities are simply the bills that you’re obligated to pay. Whether it’s a credit card bill or a mortgage payment, a liability is an amount of money you have to pay back eventually (usually with interest). If you don’t keep track of your liabilities, you may end up thinking that you have more money than you really do. Table 2-2 lists some common liabilities. Use it as a model when you list your own. You should list the liabilities according to how soon you need to pay them. Credit card balances tend to be short-term obligations, while mortgages are long-term.
Table 2-2
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Listing Personal Liabilities
Liabilities
Amount
Paying Rate %
Credit cards
$4,000
15%
Personal loans
$13,000
10%
Mortgage
$100,000
8%
Total liabilities
$117,000
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Here’s a summary of the information in Table 2-2: ✓ The first column names the type of debt. Don’t forget to include student loans and auto loans if you have them. Never avoid listing a liability because you’re embarrassed to see how much you really owe. Be honest with yourself — doing so helps you improve your financial health. ✓ The second column shows the current value (or current balance) of your liabilities. List the most current balance to see where you stand with your creditors. ✓ The third column reflects how much interest you’re paying for carrying that debt. This information is an important reminder about how debt can be a wealth zapper. Credit card debt can have an interest rate of 18 percent or more, and to add insult to injury, it isn’t even tax-deductible. Using a credit card to make even a small purchase costs you if you don’t pay off the balance each month. Within a year, a $50 sweater at 18 percent costs $59 when you add in the potential interest you pay. If you compare your liabilities in Table 2-2 and your personal assets in Table 2-1, you may find opportunities to reduce the amount you pay for interest. Say, for example, that you pay 15 percent on a credit card balance of $4,000 but also have a personal asset of $5,000 in a bank savings account that’s earning 2 percent in interest. In that case, you may want to consider taking $4,000 out of the savings account to pay off the credit card balance. Doing so saves you $520; the $4,000 in the bank was earning only $80 (2 percent of $4,000), while you were paying $600 on the credit card balance (15 percent of $4,000). If you can’t pay off high-interest debt, at least look for ways to minimize the cost of carrying the debt. The most obvious ways include the following: ✓ Replace high-interest cards with low-interest cards. Many companies offer incentives to consumers, including signing up for cards with favorable rates (recently under 10 percent) that can be used to pay off highinterest cards (typically 12 to 18 percent or higher). ✓ Replace unsecured debt with secured debt. Credit cards and personal loans are unsecured (you haven’t put up any collateral or other asset to secure the debt); therefore, they have higher interest rates because this type of debt is considered riskier for the creditor. Sources of secured debt (such as home equity line accounts and brokerage accounts) provide you with a means to replace your high-interest debt with lowerinterest debt. You get lower interest rates with secured debt because it’s less risky for the creditor — the debt is backed up by collateral (your home or your stocks).
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Part I: The Essentials of Stock Investing ✓ Replace variable-interest debt with fixed-interest debt. Think about how homeowners got blindsided when their monthly payments on adjustable-rate mortgages went up drastically in the wake of the housing bubble that popped during 2005–2008. If you can’t lower your debt, at least make it fixed and predictable. The year 2007 was the 11th consecutive year that personal bankruptcies surpassed the million mark in the United States. Corporate bankruptcies were also at record levels. Due to the fallout of the housing bubble, it’s probably safe to say that by the time you read this, 2008 will also join the million-plus bankruptcies club, unfortunately. Make a diligent effort to control and reduce your debt; otherwise, the debt can become too burdensome. If you don’t control it, you may have to sell your stocks just to stay liquid. Remember, Murphy’s Law states that you will sell your stock at the worst possible moment! Don’t go there.
Step 4: Calculate your net worth Your net worth is an indication of your total wealth. You can calculate your net worth with this basic equation: total assets (Table 2-1) less total liabilities (Table 2-2) equal net worth (net assets or net equity). Table 2-3 shows this equation in action with a net worth of $173,590 — a very respectable number. For many investors, just being in a position where assets exceed liabilities (a positive net worth) is great news. Use Table 2-3 as a model to analyze your own financial situation. Your mission (if you choose to accept it — and you should) is to ensure that your net worth increases from year to year as you progress toward your financial goals (I discuss financial goals later in this chapter).
Table 2-3
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Figuring Your Personal Net Worth
Totals
Amounts ($)
Increase from Year Before
Total assets (from Table 2-1)
$290,590
+5%
Total liabilities (from Table 2-2)
($117,000)
–2%
Net worth (total assets less total liabilities)
$173,590
+3%
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I owe, I owe, so off to work I go One reason you continue to work is probably so that you can pay off your bills. But many people today are losing their jobs because their company owes, too! Debt is one of the biggest financial problems in America today. Companies and individuals holding excessive debt contributed to the stock market’s massive decline in 2000 and the U.S. recession in 2001. If individuals managed their personal liabilities more responsibly, the general economy would be much better off. One reason the U.S. appeared to be doing so well during the late 1990s was the fact that
individuals and organizations went on an unprecedented spending binge, financed mostly by excessive debt. The economy looked unstoppable. However, sooner or later you have to pay the piper. Stock prices may go up and down, but debt stays up until it’s either paid down or the debtor files for bankruptcy. As of the first quarter of 2008, U.S. debt has surpassed a mind-boggling $49 trillion, which means that consumers, businesses, and governments will continue dealing with challenging times through this decade and into the next. Yes, the stock market (and the stocks in your portfolio) will be affected!
Step 5: Analyze your balance sheet Create a balance sheet based on the prior steps in this chapter to illustrate your current finances. Take a close look at it and try to identify any changes you can make to increase your wealth. Sometimes, reaching your financial goals can be as simple as refocusing the items on your balance sheet (use Table 2-3 as a general guideline). Here are some brief points to consider: ✓ Is the money in your emergency (or rainy day) fund sitting in an ultrasafe account and earning the highest interest available? Bank money market accounts or money market funds are recommended. The safest type of account is a U.S. Treasury money market fund. Banks are backed by the Federal Deposit Insurance Corporation (FDIC), while U.S. treasury securities are backed by the “full faith and credit” of the federal government. Shop around for the best rates. ✓ Can you replace depreciating assets with appreciating assets? Say that you have two stereo systems. Why not sell one and invest the proceeds? You may say, “But I bought that unit two years ago for $500, and if I sell it now, I’ll get only $300.” That’s your choice. You need to decide what helps your financial situation more — a $500 item that keeps shrinking in value (a depreciating asset) or $300 that can grow in value when invested (an appreciating asset).
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Part I: The Essentials of Stock Investing ✓ Can you replace low-yield investments with high-yield investments? Maybe you have $5,000 in a bank certificate of deposit (CD) earning 3 percent. You can certainly shop around for a better rate at another bank, but you can also seek alternatives that can offer a higher yield, such as U.S. savings bonds or short-term bond funds. Just remember that if you already have a CD and you withdraw the funds before it matures, you may face a penalty (such as losing some interest). ✓ Can you pay off any high-interest debt with funds from low-interest assets? If, for example, you have $5,000 earning 2 percent in a taxable bank account, and you have $2,500 on a credit card charging 18 percent (nondeductible), you may as well pay off the credit card balance and save on the interest. ✓ If you’re carrying debt, are you using that money for an investment return that’s greater than the interest you’re paying? Carrying a loan with an interest rate of 8 percent is acceptable if that borrowed money is yielding more than 8 percent elsewhere. Suppose that you have $6,000 in cash in a brokerage account. If you qualify, you can actually make a stock purchase greater than $6,000 by using margin (essentially a loan from the broker). You can buy $12,000 of stock using your $6,000 in cash, with the remainder financed by the broker. Of course, you pay interest on that margin loan. But what if the interest rate is 6 percent and the stock you’re about to invest in has a dividend that yields 9 percent? In that case, the dividend can help you pay off the margin loan, and you keep the additional income. (For more on buying on margin, see Chapter 18.) ✓ Can you sell any personal stuff for cash? You can replace unproductive assets with cash from garage sales and auction Web sites. ✓ Can you use your home equity to pay off consumer debt? Borrowing against your home has more favorable interest rates, and this interest is still tax-deductible. (Be careful about your debt level. See Chapter 24 for warnings on debt and other concerns.) Paying off consumer debt by using funds borrowed against your home is a great way to wipe the slate clean. What a relief to get rid of your credit card balances! Just don’t turn around and run up the consumer debt again. You can get overburdened and experience financial ruin (not to mention homelessness). Not a pretty picture. The important point to remember is that you can take control of your finances with discipline (and with the advice I offer in this book).
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Funding Your Stock Program If you’re going to invest money in stocks, the first thing you need is . . . money! Where can you get that money? If you’re waiting for an inheritance to come through, you may have to wait a long time, considering all the advances being made in healthcare lately. What’s that? You were going to invest in healthcare stocks? How ironic. Yet, the challenge still comes down to how to fund your stock program. Many investors can reallocate their investments and assets to do the trick. Reallocating simply means selling some investments or other assets and reinvesting that money into something else (such as stocks). It boils down to deciding what investment or asset you can sell or liquidate. Generally, you want to consider those investments and assets that give you a low return on your money (or no return at all). If you have a complicated mix of investments and assets, you may want to consider reviewing your options with a financial planner. Reallocation is just part of the answer; your cash flow is the other part. Ever wonder why there’s so much month left at the end of the money? Consider your cash flow. Your cash flow refers to what money is coming in (income) and what money is being spent (outgo). The net result is either a positive cash flow or a negative cash flow, depending on your cash management skills. Maintaining a positive cash flow (more money coming in than going out) helps you increase your net worth. A negative cash flow ultimately depletes your wealth and wipes out your net worth if you don’t turn it around immediately. The following sections show you how to analyze your cash flow. The first step is to do a cash flow statement. With a cash flow statement, you ask yourself three questions: ✓ What money is coming in? In your cash flow statement, jot down all sources of income. Calculate income for the month and then for the year. Include everything: salary, wages, interest, dividends, and so on. Add them all up and get your grand total for income. ✓ What is your outgo? Write down all the things that you spend money on. List all your expenses. If possible, categorize them into essential and nonessential. You can get an idea of all the expenses that you can reduce without affecting your lifestyle. But before you do that, make as complete a list as possible of what you spend your money on. ✓ What’s left? If your income is greater than your outgo, you have money ready and available for stock investing. No matter how small the amount seems, it definitely helps. I’ve seen fortunes built when people started to diligently invest as little as $25 to $50 per week or per month. If your outgo is greater than your income, you better sharpen your pencil. Cut down on nonessential spending and/or increase your income. If your budget is a little tight, hold off on your stock investing until your cash flow improves.
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Part I: The Essentials of Stock Investing
Dot-com-and-go If you were publishing a book about negative cash flow, you could look for the employees of any one of 100 dot-com companies to write it. Their qualifications include working for a company that flew sky-high in 1999 and crashed in 2000 and 2001. Companies such as eToys.com, Pets.com, and DrKoop.com were given millions, yet they couldn’t turn a profit and eventually
closed for business. You may as well call them “dot-com-and-go.” You can learn from their mistakes. (Actually, they could have learned from you.) In the same way that profit is the most essential single element in a business, a positive cash flow is important for your finances in general and for funding your stock investment program in particular.
Don’t confuse a cash flow statement with an income statement (also called a profit and loss statement or an income and expense statement). A cash flow statement is simple to calculate because you can easily track what goes in and what goes out. Income statements are a little different (especially for businesses) because they take into account things that aren’t technically cash flow (such as depreciation or amortization). Find out more about income statements in Chapter 11.
Step 1: Tally up your income Using Table 2-4 as a worksheet, list and calculate the money you have coming in. The first column describes the source of the money, the second column indicates the monthly amount from each respective source, and the last column indicates the amount projected for a full year. Include all income, such as wages, business income, dividends, interest income, and so on. Then project these amounts for a year (multiply by 12) and enter those amounts in the third column.
Table 2-4 Item
Listing Your Income Monthly $ Amount
Yearly $ Amount
Salary and wages Interest income and dividends Business net (after taxes) income Other income Total income
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This is the amount of money you have to work with. To ensure your financial health, don’t spend more than this amount. Always be aware of and carefully manage your income.
Step 2: Add up your outgo Using Table 2-5 as a worksheet, list and calculate the money that’s going out. How much are you spending and on what? The first column describes the source of the expense, the second column indicates the monthly amount, and the third column shows the amount projected for a full year. Include all the money you spend: credit card and other debt payments; household expenses, such as food, utility bills, and medical expenses; and nonessential expenses such as video games and elephant-foot umbrella stands.
Table 2-5 Item
Listing Your Expenses (Outgo) Monthly $ Amount
Yearly $ Amount
Payroll taxes Rent or mortgage Utilities Food Clothing Insurance (medical, auto, homeowners, and so on) Telephone Real estate taxes Auto expenses Charity Recreation Credit card payments Loan payments Other Total Payroll taxes is just a category in which to lump all the various taxes that the government takes out of your paycheck. Feel free to put each individual tax on its own line if you prefer. The important thing is creating a comprehensive list that’s meaningful to you.
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Part I: The Essentials of Stock Investing You may notice that the outgo doesn’t include items such as payments to a 401(k) plan and other savings vehicles. Yes, these items do impact your cash flow, but they’re not expenses; the amounts that you invest (or your employer invests for you) are essentially assets that benefit your financial situation versus expenses that don’t help you build wealth. To account for the 401(k), simply deduct it from the gross pay before you calculate the preceding worksheet. If, for example, your gross pay is $2,000 and your 401(k) contribution is $300, then use $1,700 as your income figure.
Step 3: Create a cash flow statement Okay, you’re almost to the end. The last step is creating a cash flow statement so that you can see (all in one place) how your money moves — how much comes in and how much goes out and where it goes. Plug the amount of your total income (from Table 2-4) and the amount of your total expenses (from Table 2-5) into the Table 2-6 worksheet to see your cash flow. Do you have positive cash flow — more coming in than going out — so that you can start investing in stocks (or other investments), or are expenses overpowering your income? Doing a cash flow statement isn’t just about finding money in your financial situation to fund your stock program. First and foremost, it’s about your financial well-being. Are you managing your finances well or not?
Table 2-6 Item
Looking at Your Cash Flow Monthly $ Amount
Yearly $ Amount
Total income (from Table 2-4) Total outgo (from Table 2-5) Net inflow/outflow At the time of this writing, 2008 was shaping up to be yet another record year for personal and business bankruptcies. Personal debt and expenses far exceeded whatever income they generated. That announcement is another reminder to watch your cash flow; keep your income growing and your expenses and debt as low as possible.
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Step 4: Analyze your cash flow Use your cash flow statement in Table 2-6 to identify sources of funds for your investment program. The more you can increase your income and the more you can decrease your outgo, the better. Scrutinize your data. Where can you improve the results? Here are some questions to ask yourself: ✓ How can you increase your income? Do you have hobbies, interests, or skills that can generate extra cash for you? ✓ Can you get more paid overtime at work? How about a promotion or a job change? ✓ Where can you cut expenses? ✓ Have you categorized your expenses as either “necessary” or “nonessential”? ✓ Can you lower your debt payments by refinancing or consolidating loans and credit card balances? ✓ Have you shopped around for lower insurance or telephone rates? ✓ Have you analyzed your tax withholdings in your paycheck to make sure that you’re not overpaying your taxes (just to get your overpayment back next year as a refund)?
Another option: Finding investment money in tax savings According to the Tax Foundation, the average U.S. citizen pays more in taxes than in food, clothing, and shelter combined. Sit down with your tax advisor and try to find ways to reduce your taxes. A home-based business, for example, is a great way to gain new income and increase your tax deductions, resulting in a lower tax burden. Your tax advisor can make recommendations that work for you. One tax strategy to consider is doing your stock investing in a tax-sheltered account such as a traditional Individual Retirement Account (IRA) or a Roth Individual Retirement Account (Roth IRA). Again, check with your tax advisor for deductions and strategies available to you. For more on the tax implications of stock investing, see Chapter 21.
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Part I: The Essentials of Stock Investing
Setting Your Sights on Your Financial Goals Consider stocks as tools for living, just like any other investment — no more, no less. Stocks are the tools you use (one of many) to accomplish something — to achieve a goal. Yes, successfully investing in stocks is the goal that you’re probably shooting for if you’re reading this book. However, you must complete the following sentence: “I want to be successful in my stock investing program to accomplish _____.” You must consider stock investing as a means to an end. When people buy a computer, they don’t (or shouldn’t) think of buying a computer just to have a computer. People buy a computer because doing so helps them achieve a particular result, such as being more efficient in business, playing fun games, or having a nifty paperweight (tsk, tsk). Know the difference between long-term, intermediate-term, and short-term goals, and then set some of each (see Chapter 3 for more information). ✓ Long-term goals refer to projects or financial goals that need funding five or more years from now. ✓ Intermediate term refers to financial goals that need funding two to five years from now. ✓ Short-term goals need funding less than two years from now. Stocks, in general, are best suited for long-term goals such as these: ✓ Achieving financial independence (think retirement funding) ✓ Paying for future college costs ✓ Paying for any long-term expenditure or project Some categories of stock (such as conservative or large cap) may be suitable for intermediate-term financial goals. If, for example, you’ll retire four years from now, conservative stocks can be appropriate. If you’re optimistic (or bullish) about the stock market and confident that stock prices will rise, go ahead and invest. However, if you’re negative about the market (you’re bearish, or you believe that stock prices will decline), you may want to wait until the economy starts to forge a clear path. For more on investing in bull or bear markets, see Chapter 14. Stocks generally aren’t suitable for short-term investing goals because stock prices can behave irrationally in a short period of time. Stocks fluctuate from day to day, so you don’t know what the stock will be worth in the near future. You may end up with less money than you expected. For investors seeking to reliably accrue money for short-term needs, short-term bank certificates of deposit or money market funds are more appropriate.
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In recent years, investors have sought quick, short-term profits by trading and speculating in stocks. Lured by the fantastic returns generated by the stock market in the late 1990s, investors saw stocks as a get-rich-quick scheme. It’s very important for you to understand the difference between investing, saving, and speculating. Which one do you want to do? Knowing the answer to this question is crucial to your goals and aspirations. Investors who don’t know the difference tend to get burned. Here’s some information to help you distinguish among these three actions: ✓ Investing is the act of putting your current funds into securities or tangible assets for the purpose of gaining future appreciation, income, or both. You need time, knowledge, and discipline to invest. The investment can fluctuate in price, but it has been chosen for long-term potential. ✓ Saving is the safe accumulation of funds for a future use. Savings don’t fluctuate and are generally free of financial risk. The emphasis is on safety and liquidity. ✓ Speculating is the financial world’s equivalent of gambling. An investor who speculates is seeking quick profits gained from short-term price movements in a particular asset or investment. (In recent years, many folks are trading stocks, which is in the realm of short-term speculating. Find out more about trading in Chapter 16.) These distinctly different concepts are often confused, even among so-called financial experts. I know of one financial advisor who actually put a child’s college fund money into an Internet stock fund, only to lose over $17,000 in less than ten months! This advisor thought that she was investing, but in reality, she was speculating. I know of another advisor who told a client to avoid savings accounts altogether because the client had a 401(k) plan. This particular advisor didn’t catch the crucial difference between saving and investing. The client eventually found out the difference; his 401(k) fell by 40 percent when the bear market of 2000 arrived. Fortunately, we can learn from these situations and get back on track. That child who lost the $17,000? He’s my neighbor, and I helped the father reinvest the remaining funds. The portfolio doubled in value by the following year, and it’s still growing. The second fellow who lost 40 percent in his 401(k) account? He became my student, he has recouped his losses, and his 401(k) plan is up (this occurred within two years). As of 2008, both investors have portfolios that are out-performing the general stock market.
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Part I: The Essentials of Stock Investing
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Chapter 3
Defining Common Approaches to Stock Investing In This Chapter ▶ Pairing stock strategies with investing goals ▶ Deciding what time frame fits your investment strategy ▶ Looking at your purpose for investing: growth versus income ▶ Determining your investing style: conservative versus aggressive
“I
nvesting for the long term” isn’t just some perfunctory investment slogan. It’s a culmination of proven stock market experience that goes back many decades. Unfortunately, investor buying and selling habits have deteriorated in recent years due to impatience. Today’s investors think that short term is measured in days, intermediate term is measured in weeks, and long term is measured in months. Yeesh! It’s no wonder that so many folks are complaining about lousy investment returns. Investors have lost the profitable art of patience! What should you do? Become an investor with a time horizon greater than one year. Give your investments time to grow. Everybody dreams about emulating the success of someone like Warren Buffett, but few emulate his patience (a huge part of his investment success). Stocks are tools you can use to build your wealth. When used wisely, for the right purpose, and in the right environment, they do a great job. But when improperly applied, they can lead to disaster. In this chapter, I show you how to choose the right types of investments based on your short- and long-term financial goals. I also show you how to decide on your purpose for investing (growth or income investing) and your style of investing (conservative or aggressive).
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Part I: The Essentials of Stock Investing
Matching Stocks and Strategies with Your Goals Various stocks are out there, as well as various investment approaches. The key to success in the stock market is matching the right kind of stock with the right kind of investment situation. You have to choose the stock and the approach that match your goals. (Refer to Chapter 2 for more on defining your financial goals.) Before investing in a stock, ask yourself, “When do I want to reach my financial goal?” Stocks are a means to an end. Your job is to figure out what that end is — or, more important, when it is. Do you want to retire in ten years or next year? Must you pay for your kid’s college education next year or 18 years from now? The length of time you have before you need the money you hope to earn from stock investing determines what stocks you should buy. Table 3-1 gives you some guidelines for choosing the kind of stock best suited for the type of investor you are and the goals you have.
Table 3-1
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Stock Types, Financial Goals, and Investor Types
Type of Investor
Time Frame for Financial Goals
Type of Stock Most Suitable
Conservative (worries about risk)
Long term (over 5 years)
Large cap stocks and mid cap stocks
Aggressive (high tolerance to risk)
Long term (over 5 years)
Small cap stocks and mid cap stocks
Conservative (worries about risk)
Intermediate term (2 to 5 years)
Large cap stocks, preferably with dividends
Aggressive (high tolerance to risk)
Intermediate term (2 to 5 years)
Small cap stocks and mid cap stocks
Short term
1 to 2 years
Stocks are not suitable for the short term. Instead, look at vehicles such as savings accounts and money market funds.
Very short term
Less than 1 year
Stocks? Don’t even think about it! Well . . . you can invest in stocks for less than a year, but seriously, you’re not really investing — you’re either trading (see Chapter 16) or speculating (see Chapter 2). Instead, use savings accounts and money market funds.
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Chapter 3: Defining Common Approaches to Stock Investing
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Dividends are payments made to a stock owner (unlike interest, which is payment to a creditor). Dividends are a great form of income, and companies that issue dividends tend to have more stable stock prices as well. For more information on dividend-paying stocks, see the section “Steadily making money: Income investing,” later in this chapter, and also see Chapter 9. Table 3-1 gives you general guidelines, but not everyone fits into a particular profile. Every investor has a unique situation, set of goals, and level of risk tolerance. The terms large cap, mid cap, and small cap refer to the size (or market capitalization, also known as market cap) of the company. All factors being equal, large companies are safer (less risky) than small companies. For more on market caps, see the section “Investing for Your Personal Style,” later in this chapter.
Investing for the Future Are your goals long term or short term? Answering this question is important because individual stocks can be either great or horrible choices, depending on the time period you want to focus on. Generally, the length of time you plan to invest in stocks can be short term, intermediate term, or long term. The following sections outline what kinds of stocks are most appropriate for each term length. Investing in quality stocks becomes less risky as the time frame lengthens. Stock prices tend to fluctuate on a daily basis, but they have a tendency to trend up or down over an extended period of time. Even if you invest in a stock that goes down in the short term, you’re likely to see it rise and possibly exceed your investment if you have the patience to wait it out and let the stock price appreciate.
Focusing on the short term Short term generally means one year or less, although some people extend the period to two years or less. Short-term investing isn’t about making a quick buck on your stock choices — it refers to when you may need the money. Every person has short-term goals. Some are modest, such as setting aside money for a vacation next month or paying for medical bills. Other shortterm goals are more ambitious, such as accruing funds for a down payment to purchase a new home within six months. Whatever the expense or purchase, you need a predictable accumulation of cash soon. If this sounds like your situation, stay away from the stock market!
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Part I: The Essentials of Stock Investing Because stocks can be so unpredictable in the short term, they’re a bad choice for short-term considerations. I get a kick out of market analysts on TV saying things such as, “At $25 a share, XYZ is a solid investment, and we feel that its stock should hit our target price of $40 within six to nine months.” You know that an eager investor hears that and says, “Gee, why bother with 3 percent at the bank when this stock will rise by more than 50 percent? I better call my broker.” It may hit that target amount (or surpass it), or it may not. Most of the time, the stock doesn’t reach the target price, and the investor is disappointed. The stock could even go down! The reason that target prices are frequently missed is that it’s difficult to figure out what millions of investors will do in the short term. The short term can be irrational because so many investors have so many reasons for buying and selling that it can be difficult to analyze. If you invest for an important short-term need, you could lose very important cash quicker than you think. During the raging bull market (see more about bull markets in Chapter 14) of the late 1990s, investors watched as some high-profile stocks went up 20 to 50 percent in a matter of months. Hey, who needs a savings account earning a measly interest rate when stocks grow like that! Of course, when the bear market hit from 2000 to 2003 and those same stocks fell 50 to 85 percent, a savings account earning a measly interest rate suddenly didn’t seem so bad. Short-term stock investing is very unpredictable. Stocks — even the best ones — fluctuate in the short term. In a negative environment, they can be very volatile. No one can accurately predict the price movement (unless he or she has some inside information), so stocks are definitely inappropriate for any financial goal you need to reach within one year. You can better serve your short-term goals with stable, interest-bearing investments like certificates of deposit at your local bank. Check Table 3-1 for suggestions about your short-term strategies.
Considering intermediate-term goals Intermediate term refers to the financial goals you plan to reach within five years. For example, if you want to accumulate funds to put money down for investment in real estate four years from now, some growth-oriented investments may be suitable. (I discuss growth investing in more detail later in this chapter.) Although some stocks may be appropriate for a two- or three-year period, not all stocks are good intermediate-term investments. Some stocks are fairly stable and hold their value well, such as the stock of large or established dividend-paying companies. Other stocks have prices that jump all over the place, such as those of untested companies that haven’t been in existence long enough to develop a consistent track record.
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Short-term investing = speculating My case files are littered with examples of long-term stock investors who morphed into short-term speculators. I know of one fellow who had $80,000 and was set to get married within 12 months and then put a down payment on a new home for him and his bride. He wanted to surprise her by growing his nest egg quickly so they could have a glitzier wedding and a larger down payment. What happened? The money instead shrunk to $11,000 as his stock choices pulled back sharply. Ouch! How
does that go again? For better or for worse . . . uh . . . for richer or for poorer? I’m sure they had to adjust their plans accordingly. I recall some of the stocks he chose, and now, years later, those stocks have recovered and gone on to new highs. The bottom line is that investing in stocks for the short term is nothing more than speculating. Your only possible strategy is luck.
If you plan to invest in the stock market to meet intermediate-term goals, consider large, established companies or dividend-paying companies in industries that provide the necessities of life (like the food and beverage industry, or electric utilities). In today’s economic environment, I strongly believe that stocks attached to companies that serve basic human needs should have a major presence in most stock portfolios. They’re especially well-suited for intermediate investment goals. Just because a particular stock is labeled as being appropriate for the intermediate term doesn’t mean you should get rid of it by the stroke of midnight five years from now. After all, if the company is doing well and going strong, you can continue holding the stock indefinitely. The more time you give a wellpositioned, profitable company’s stock to grow, the better you’ll do.
Preparing for the long term Stock investing is best suited for making money over a long period of time. When you measure stocks against other investments in terms of five to (preferably) ten or more years, they excel. Even investors who bought stocks during the depths of the Great Depression saw profitable growth in their stock portfolios over a ten-year period. In fact, if you examine any ten-year period over the past fifty years, you see that stocks beat out other financial investments (such as bonds or bank investments) in almost every period when measured by total return (taking into account reinvesting and compounding of capital gains and dividends)! Of course, your work doesn’t stop at deciding on a long-term investment. You still have to do your homework and choose stocks wisely, because even in good times, you can lose money if you invest in companies that go out of
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Part I: The Essentials of Stock Investing business. Part III of this book shows you how to evaluate specific companies and industries and alerts you to factors in the general economy that can affect stock behavior. Appendix A provides plenty of resources you can turn to. Because so many different types and categories of stocks are available, virtually any investor with a long-term perspective should add stocks to his investment portfolio. Whether you want to save for a young child’s college fund or for future retirement goals, carefully selected stocks have proven to be a superior long-term investment.
Investing for a Purpose When someone asked the lady why she bungee jumped off the bridge that spanned a massive ravine, she answered, “Because it’s fun!” When someone asked the fellow why he dove into a pool chock-full of alligators and snakes, he responded, “Because someone pushed me.” You shouldn’t invest in stocks unless you have a purpose that you understand, like investing for growth or investing for income. Even if an advisor pushes you to invest, be sure that your advisor gives you an explanation of how each stock choice fits your purpose. I know of a very nice, elderly lady who had a portfolio brimming with aggressive-growth stocks because she had an overbearing broker. Her purpose should’ve been conservative, and she should’ve chosen investments that would preserve her wealth rather than grow it. Obviously, the broker’s agenda got in the way. Stocks are just a means to an end. Figure out your desired end and then match the means. To find out more about dealing with brokers, go to Chapter 7.
Making loads of money quickly: Growth investing When investors want their money to grow (versus just trying to preserve it), they look for investments that appreciate in value. Appreciate is just another way of saying grow. If you bought a stock for $8 per share and now its value is $30 per share, your investment has grown by $22 per share — that’s appreciation. I know I would appreciate it.
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Appreciation (also known as capital gain) is probably the number one reason people invest in stocks. Few investments have the potential to grow your wealth as conveniently as stocks. If you want the stock market to make you loads of money (and you can assume some risk), head to Chapter 8, which takes an in-depth look at investing for growth. Stocks are a great way to grow your wealth, but they’re not the only way. Many investors seek alternative ways to make money, but many of these alternative ways are more aggressive than stocks and carry significantly more risk. You may have heard about people who made quick fortunes in areas such as commodities (like wheat, pork bellies, or precious metals), options, and other more sophisticated investment vehicles. Keep in mind that you should limit these more risky investments to only a small portion of your portfolio, such as 10 percent of your investable funds. Experienced investors, however, can go as high as 20 percent.
Steadily making money: Income investing Not all investors want to take on the risk that comes with making a killing. (Hey . . . no guts, no glory!) Some people just want to invest in the stock market as a means of providing a steady income. They don’t need stock values to go through the ceiling. Instead, they need stocks that perform well consistently. If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record as of specific dates. How do you know if the dividend you’re being paid is higher (or lower) than other vehicles (such as bonds)? The next sections will help you figure it out.
Distinguishing between dividends and interest Don’t confuse dividends with interest. Most people are familiar with interest because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders — and if you own stock you’re a shareholder because shares of stock represent ownership in a publicly traded company). When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor, and as such, it must eventually pay your money back to you with interest.
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44
Part I: The Essentials of Stock Investing Recognizing the importance of an income stock’s yield When you invest for income, you have to consider your investment’s yield and compare it with the alternatives. The yield is an investment’s payout expressed as a percentage of the investment amount. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others. Table 3-2 shows some comparative yields.
Table 3-2
Comparing the Yields of Various Investments
Investment
Type
Amount
Pay Type
Payout
Yield
Smith Co.
Stock
$50/share
Dividend
$2.50
5.0%
Jones Co.
Stock
$100/share
Dividend
$4.00
4.0%
Acme Bank
Bank CD
$500
Interest
$25.00
5.0%
Acme Bank
Bank CD
$2,500
Interest
$131.25
5.25%
Acme Bank
Bank CD
$5,000
Interest
$287.50
5.75%
Brown Co.
Bond
$5,000
Interest
$300.00
6.0%
To calculate yield, use the following formula: Yield = Payout ÷ Investment amount For the sake of simplicity, the following exercise is based on an annual percentage yield basis (compounding would increase the yield). Jones Co. and Smith Co. are typical dividend-paying stocks. Looking at Table 3-2 and presuming that both companies are similar in most respects except for their differing dividends, how can you tell whether the $50 stock with a $2.50 annual dividend is better (or worse) than the $100 stock with a $4.00 dividend? The yield tells you. Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent). Therefore, if you had to choose between those two stocks as an income investor, you would choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate a lot, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent. Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but at the very least, they have a greater potential for capital gain than CDs or bonds. Dividend-paying stocks (investing for income) are covered in Chapter 9.
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Investing for Your Personal Style Your investing style isn’t a blue-jeans-versus-three-piece-suit debate. It refers to your approach to stock investing. Do you want to be conservative or aggressive? Would you rather be the tortoise or the hare? Your investment personality greatly depends on your purpose and the term over which you’re planning to invest (see the previous two sections in this chapter). The following sections outline the two most general investment styles.
Conservative investing Conservative investing means that you put your money in something proven, tried, and true. You invest your money in safe and secure places, such as banks and government-backed securities. But how does that apply to stocks? (Table 3-1 gives you suggestions.) If you’re a conservative stock investor, you want to place your money in companies that exhibit some of the following qualities: ✓ Proven performance: You want companies that have shown increasing sales and earnings year after year. You don’t demand anything spectacular — just a strong and steady performance. ✓ Large market size: You want to invest in large cap companies (short for large capitalization). In other words, they should have a market value exceeding $5–$25 billion. Conservative investors surmise that bigger is safer. ✓ Proven market leadership: Look for companies that are leaders in their industries. ✓ Perceived staying power: You want companies with the financial clout and market position to weather uncertain market and economic conditions. It shouldn’t matter what happens in the economy or who gets elected. As a conservative investor, you don’t mind if the companies’ share prices jump (who would?), but you’re more concerned with steady growth over the long term.
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Part I: The Essentials of Stock Investing
Aggressive investing Aggressive investors can plan long term or look over only the intermediate term, but in any case, they want stocks that resemble jack rabbits — those that show the potential to break out of the pack. If you’re an aggressive stock investor, you want to invest your money in companies that exhibit some of the following qualities: ✓ Great potential: Choose companies that have superior goods, services, ideas, or ways of doing business compared to the competition. ✓ Capital gains possibility: Don’t even consider dividends. If anything, you dislike dividends. You feel that the money dispensed in dividend form is better reinvested in the company. This, in turn, can spur greater growth. ✓ Innovation: Find companies that have innovative technologies, ideas, or methods that make them stand apart from other companies. Aggressive investors usually seek out small capitalization stocks, known as small caps, because they can have plenty of potential for growth. Take the tree example, for instance: A giant redwood may be strong, but it may not grow much more, whereas a brand-new sapling has plenty of growth to look forward to. Why invest in big, stodgy companies when you can invest in smaller enterprises that may become the leaders of tomorrow? Aggressive investors have no problem buying stock in obscure businesses because they hope that such companies will become another IBM or McDonald’s. Find out more about growth investing in Chapter 8.
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Chapter 4
Recognizing the Risks In This Chapter ▶ Considering different types of risk ▶ Taking steps to reduce your risk ▶ Balancing risk against return
I
nvestors face many risks, most of which I cover in this chapter. The simplest definition of risk for investors is “the possibility that your investment will lose some (or all) of its value.” Yet you don’t have to fear risk if you understand it and plan for it. You must understand the oldest equation in the world of investing — risk versus return. This equation states the following: If you want a greater return on your money, you need to tolerate more risk. If you don’t want to tolerate more risk, you must tolerate a lower rate of return. This point about risk is best illustrated from a moment in one of my investment seminars. One of the attendees told me that he had his money in the bank but was dissatisfied with the rate of return. He lamented, “The yield on my money is pitiful! I want to put my money somewhere where it can grow.” I asked him, “How about investing in common stocks? Or what about growth mutual funds? They have a solid, long-term growth track record.” He responded, “Stocks? I don’t want to put my money there. It’s too risky!” Okay, then. If you don’t want to tolerate more risk, then don’t complain about earning less on your money. Risk (in all its forms) has a bearing on all your money concerns and goals. That’s why it’s so important that you understand risk before you invest. This man — as well as the rest of us — needs to remember that risk is not a four-letter word. (Well, it is a four-letter word, but you know what I mean.) Risk is present no matter what you do with your money. Even if you simply stick your money in your mattress, risk is involved — several kinds of risk, in
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Part I: The Essentials of Stock Investing fact. You have the risk of fire. What if your house burns down? You have the risk of theft. What if burglars find your stash of cash? You also have relative risk. (In other words, what if your relatives find your money?) Be aware of the different kinds of risk that I describe in this chapter, and you can easily plan around them to keep your money growing.
Exploring Different Kinds of Risk Think about all the ways that an investment can lose money. You can list all sorts of possibilities. So many that you may think, “Holy cow! Why invest at all?” Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risk that I discuss in the following sections before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals.
Financial risk The financial risk of stock investing is that you can lose your money if the company whose stock you purchase loses money or goes belly up. This type of risk is the most obvious because companies do go bankrupt. You can greatly enhance the chances of your financial risk paying off by doing an adequate amount of research and choosing your stocks carefully (which this book helps you do — see Part III for details). Financial risk is a real concern even when the economy is doing well. Some diligent research, a little planning, and a dose of common sense help you reduce your financial risk. In the stock investing mania of the late 1990s, millions of investors (along with many well-known investment gurus) ignored some obvious financial risks of many then-popular stocks. Investors blindly plunked their money into stocks that were bad choices. Consider investors who put their money in DrKoop. com, a health information Web site, in 1999 and held on during 2000. This company had no profit and was over-indebted. DrKoop.com went into cardiac arrest as it collapsed from $45 per share to $2 per share by mid-2000. By the time the stock was DOA, investors lost millions. RIP (risky investment play!). Internet and tech stocks littered the graveyard of stock market catastrophes during 2000–2001 because investors didn’t see (or didn’t want to see?) the risks involved with companies that didn’t offer a solid record of results (profits, sales, and so on). When you invest in companies that don’t have a proven track record, you’re not investing, you’re speculating.
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Fast forward to 2007–2008. New risks abound as the headlines rail on about the credit crisis on Wall Street and the subprime fiasco in the wake of the housing bubble popping. Think about how this crisis impacted investors as the market went through its stomach-churning roller-coaster ride. A good example of a casualty you didn’t want to be a part of was Bear Stearns (BSC), which was caught in the subprime buzz saw. Bear Stearns was sky-high at $170 a share in early 2007, yet it crashed to $2 a share by March 2008. Yikes! Its problems arose from massive overexposure to bad debt, and investors could have done some research (the public data was revealing!) and avoided the stock entirely. Investors who did their homework regarding the financial conditions of companies such as the Internet stocks (and Bear Stearns, among others) would have discovered that these companies had the hallmarks of financial risk — high debt, low (or no) earnings, and plenty of competition. They steered clear, avoiding tremendous financial loss. Investors who didn’t do their homework were lured by the status of these companies and lost their shirts. Of course, the individual investors who lost money by investing in these trendy, high-profile companies don’t deserve all the responsibility for their tremendous financial losses; some high-profile analysts and media sources also should have known better. The late 1990s may someday be a case study of how euphoria and the herd mentality (rather than good, old-fashioned research and common sense) ruled the day (temporarily). The excitement of making potential fortunes gets the best of people sometimes, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” Achieving true wealth takes diligent work and careful analysis. In terms of financial risk, the bottom line is . . . well . . . the bottom line! A healthy bottom line means that a company is making money. And if a company is making money, then you can make money by investing in its stock. However, if a company isn’t making money, you won’t make money if you invest in it. Profit is the lifeblood of any company. See Chapter 11 for the scoop on determining whether a company’s bottom line is healthy.
Interest rate risk You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rates have changed.” Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers its interest rates, actions that, in turn, cause banks to raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.
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Part I: The Essentials of Stock Investing Here’s a generic introduction to the way fluctuating interest rate risk can affect investors in general: Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2 percent interest. The only way to get out of your 6 percent bond is to sell it at current market values and use the money to reinvest at the higher rate. The only problem with this scenario is that the 6 percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny (LM). According to the bond agreement, LM must pay 6 percent (called the face rate or nominal rate) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they’re issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however. Say that he decides to sell the bond long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6 percent bond if the market is offering bonds at 8 percent. What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bond. What has to change so that current investors get the equivalent yield of 8 percent? If you said, “The bond’s value has to go down,” . . . bingo! In this example, the bond’s market value needs to drop to $7,500 so that investors buying the bond get an equivalent yield of 8 percent. (For simplicity’s sake, I left out the time it takes for the bond to mature.) Here’s how that figures: New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500. In this example, little, if any, financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond, yet you still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss. (For more on the how and why of selling your stock, review Chapters 17 and 18.) Historically, rising interest rates have had an adverse effect on stock prices. I outline several reasons why in the following sections. Because our country is top-heavy in debt, rising interest rates are an obvious risk that threatens both stocks and fixed-income securities (such as bonds).
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Hurting a company’s financial condition Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt, because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.
Affecting a company’s customers A company’s success comes when it sells its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings. For a good example, consider Home Depot (HD) during 2005–2008. The company had soaring sales and earnings during 2005 and into early 2006 as the housing boom hit its high point (record sales, construction, and so on). As the housing bubble popped and the housing and construction industries went into an agonizing decline, the fortunes of Home Depot followed suit because its success is directly tied to home building, repair, and improvement. By late 2006, HD’s sales were slipping and earnings were dropping as the housing industry sunk deeper into its depression. This was bad news for stock investors. HD’s stock went from over $44 in 2005 to $21 by October 2008 (a drop of about 52 percent). Ouch! No “home improvement” there.
Impacting investors’ decision-making considerations When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes: ✓ Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others. ✓ Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher yield. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.
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Part I: The Essentials of Stock Investing Hurting stock prices indirectly High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices. As this book goes to press, the stock market and the U.S. economy face perhaps the greatest challenge since the Great Depression — debt. In terms of Gross Domestic Product (GDP), the size of the economy is about $14 trillion (give or take $100 billion), but the debt level is about $49 trillion (this includes personal, corporate, mortgage, and government debt). This already enormous amount doesn’t include $53 trillion of liabilities such as Social Security and Medicare. Additionally (Yikes! There’s more?), some of our financial institutions hold over $100 trillion worth of derivatives. These can be very complicated and sophisticated investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron and Bear Stearns), and investors should be aware of them. Just check out the company’s financial reports. (Find out more in Chapter 12.) Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles. A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (series I), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio. (I discuss diversification in more detail later in this chapter.)
Market risk People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is — a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand.
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Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth. A good example of market risk with a stock is Apple (AAPL). Had you bought AAPL in early 2007, you could have gotten it for about $75 a share in January 2007 and watched it rise joyfully upward to hit $205 a share by December 2007. At that point some giddy investor may be thinking, “It’s time to pop the champagne! I’ll be able to buy Rhode Island!” Hold on a second! Within three months of that top, AAPL had a dizzying plunge to under $120 by March 2008. It’s typical for stocks to take a relatively long time to climb, but they can fall in a relatively short time. In that example, a long-term patient investor would still be up, but some short-term folks that “jump in” and “jump out” would have been burned. I’m sure that some of them lived in Rhode Island (but probably renting). Markets are volatile by nature; they go up and down, and investments need time to grow. Market volatility is an increasingly common condition that we have to live with. Investors should be aware of the fact that stocks in general (especially in today’s marketplace) aren’t suitable for short-term (one year or less) goals (see Chapters 2 and 3 for more on short-term goals). Despite the fact that companies you’re invested in may be fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward. Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there! Consider the married couple nearing retirement who decided to play with their money to see about making their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.) What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money. Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks, or similar aggressive investment vehicles). Remember, you can lose everything.
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Inflation risk Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a stock that doesn’t appreciate much, for example) may not keep up with inflation. Say that you have money in a bank savings account currently earning 4 percent. This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money. At the time of this writing, inflation is a very real and a very serious concern and it should not be ignored. I deal more with inflation in Chapter 10.
Tax risk Taxes (such as income tax or capital gains tax) don’t affect your stock investment directly. Taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that you’re trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions. Chapter 21 covers in greater detail the impact of taxes.
Political and governmental risks If companies were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies can kill companies. Of course, if you own stock in a company exposed to political and governmental risks, you need to be aware of these risks. For some companies, a single new regulation or law is enough to send them into bankruptcy. For other companies, a new law could help them increase sales and profits.
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What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop-loss orders on the stock (see Chapter 18). For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?” (See Chapter 15 for more on how politics can affect the stock market.) Taking the preceding point a step further, I’d like to remind you that politics and government have a direct and often negative impact on the economic environment. And one major pitfall for investors is that many misunderstand even basic economics. Considering all the examples I could find in recent years, I could write a book! Or . . . uh . . . simply add it to this book. Chapter 10 goes into greater detail to help you make (and keep) stock market profits just by understanding rudimentary (and quite interesting) economics. (Don’t worry; the dry stuff will be kept to a minimum!)
Personal risks Frequently, the risk involved with investing in the stock market may not be directly involved with the investment or factors directly related to the investment; sometimes the risk is with the investor’s circumstances. Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week and Ralph’s stocks drop to a market value of $14,000. Because stocks are good for the long term, this type of decrease is usually not an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price. (Chapter 18 covers orders you can place with your broker to help you do that.) Over the long term, Ralph would probably see the value of his investment grow substantially. But what if during a period when his stocks are declining, Ralph experiences financial difficulty and needs quick cash? He may have to sell his stock to get some money. This problem occurs frequently for investors who don’t have an emergency fund or a rainy day fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone.
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Part I: The Essentials of Stock Investing You probably won’t get much comfort from knowing that stock losses are tax deductible — a loss is a loss (see Chapter 21 for more on taxes). However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund. A good place for your emergency cash fund is in either a bank savings account or a money market fund. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills. (Chapter 2 provides more guidance on having liquid assets for emergencies.)
Emotional risk What does emotional risk have to do with stocks? Emotions are important risk considerations because the main decision makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to. If you get too attached to a sinking stock, then you don’t need a stock investing book — you need Dr. Phil!
Paying the price for greed In 1998–2000, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes (just like slot machines) when they saw that easy street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios and earnings when you can just buy stock, make a fortune, and get out with millions? (Of course, you care about making money with stocks, so you can flip to Chapter 11 and Appendix B to find out more about P/E ratios.) Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense (such as investing for quick short-term gains in dubious hot stocks rather than doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus, as I explain in Part III).
Recognizing the role of fear Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss.
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Investment lessons from September 11 September 11, 2001, was a horrific day that is burned in our minds and won’t be forgotten in our lifetime. The acts of terrorism that day took over 3,000 lives and caused untold pain and grief. A much less important aftereffect was the hard lessons that investors learned that day. Terrorism reminds us that risk is more real than ever and that we should never let our guard down. What lessons can investors learn from the worst acts of terrorism to ever happen on U.S. soil? Here are a few pointers: ✓ Diversify your portfolio. Of course, the events of September 11 were certainly surreal and unexpected. But before the events occurred, investors should have made it a habit to assess their situations and see whether they had any vulnerabilities. Stock investors with no money outside the stock market are always more at risk. Keeping your portfolio diversified is a time-tested strategy that is more relevant than ever before. (I discuss diversification later in this chapter.)
✓ Review and re-allocate. September 11 triggered declines in the overall market, but specific industries, such as airlines and hotels, were hit particularly hard. In addition, some industries, such as defense and food, saw stock prices rise. Monitor your portfolio and ask yourself whether it’s overly reliant on or exposed to events in specific sectors. If so, reallocate your investments to decrease your risk exposure. ✓ Check for signs of trouble. Techniques such as trailing stops (which I explain in Chapter 18) come in very handy when your stocks plummet because of unexpected events. Even if you don’t use these techniques, you can make it a regular habit to analyze your stocks and check for signs of trouble, such as debts or P/E ratios that are too high. If you see signs of trouble (check out Chapter 24), consider selling anyway.
Also, keep in mind that fear is frequently a symptom of lack of knowledge about what’s going on. If you see your stocks falling and don’t understand why, fear will take over and you may act irrationally. When stock investors are affected by fear, the tendency is to sell their stocks and head for the exits and the life boats. When an investor sees his stock go down 20 percent, what goes through his head? Experienced, knowledgeable investors see that no bull market goes straight up. Even the strongest bull goes up in a zigzag fashion. Conversely, even bear markets don’t go straight down, they zigzag down. Out of fear, inexperienced investors will sell good stocks if they see them go down temporarily (the “correction”) while experienced investors see that temporary down move as a good buying opportunity to add to their positions. (Flip to Chapter 14 for details on dealing with bull and bear markets.)
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Part I: The Essentials of Stock Investing Looking for love in all the wrong places Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell it, even when the stock is plummeting and shows all the symptoms of getting worse. Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends. Love and attachment are great in relationships with people but can be horrible with investments. To deal with this emotion, investors have to deploy techniques that take the emotion out. For example, you can use brokerage orders (such as trailing stops and limit orders), which can automatically trigger buy and sell transactions and leave some of the agonizing out. Hey, disciplined investing may just become your new passion!
Minimizing Your Risk Now, before you go crazy thinking that stock investing carries so much risk that you may as well not get out of bed, take a breath. Minimizing your risk in stock investing is easier than you think. Although wealth building through the stock market doesn’t take place without some amount of risk, you can practice the following tips to maximize your profits and still keep your money secure.
Gaining knowledge Some people spend more time analyzing a restaurant menu to choose a $10 entrée than analyzing where to put their next $5,000. Lack of knowledge constitutes the greatest risk for new investors, but diminishing that risk starts with gaining knowledge. The more familiar you are with the stock market — how it works, factors that affect stock value, and so on — the better you can navigate around its pitfalls and maximize your profits. The same knowledge that enables you to grow your wealth also enables you to minimize your risk. Before you put your money anywhere, you want to know as much as you can. This book is a great place to start — check out Chapter 6 for a rundown of the kinds of information you want to know before you buy stocks, as well as the resources that can give you the information you need to invest successfully.
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Staying out until you get a little practice If you don’t understand stocks, don’t invest! Yeah, I know this book is about stock investing, and I think that some measure of stock investing is a good idea for most people. But that doesn’t mean you should be 100 percent invested 100 percent of the time. If you don’t understand a particular stock (or don’t understand stocks, period), stay away until you do understand. Instead, give yourself an imaginary sum of money, such as $100,000, give yourself reasons to invest, and just make believe (“simulated stock investing or trading”). Pick a few stocks that you think will increase in value, track them for a while, and see how they perform. Begin to understand how the price of a stock goes up and down, and watch what happens to the stocks you choose when various events take place. As you find out more and more about stock investing, you get better and better at picking individual stocks, and you haven’t risked — or lost — any money during your learning period. A good place to do your imaginary investing is at Web sites such as Marketocracy (www.marketocracy.com) and Investopedia’s simulator (http://simulator.investopedia.com). You can design a stock portfolio and track its performance with thousands of other investors to see how well you do.
Putting your financial house in order Advice on what to do before you invest could be a whole book all by itself. The bottom line is that you want to make sure that you are, first and foremost, financially secure before you take the plunge into the stock market. If you’re not sure about your financial security, look over your situation with a financial planner. (You can find more on financial planners in Appendix A.) Before you buy your first stock, here are a few things you can do to get your finances in order: ✓ Have a cushion of money. Set aside three to six months’ worth of your gross living expenses somewhere safe, such as in a bank account or treasury money market fund, in case you suddenly need cash for an emergency (see Chapter 2 for details). ✓ Reduce your debt. Overindulging in debt was the worst personal economic problem for many Americans in the late 1990s, and this has continued in recent years. The year 2001 was a record year for bankruptcy,
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Part I: The Essentials of Stock Investing with nearly 1.5 million people filing for bankruptcy. When the housing bubble popped, millions of foreclosures were the result as homeowners piled on too much debt. ✓ Make sure that your job is as secure as you can make it. Are you keeping your skills up to date? Is the company you work for strong and growing? Is the industry that you work in strong and growing? ✓ Make sure that you have adequate insurance. You need enough insurance to cover you and your family’s needs in case of illness, death, disability, and so on.
Diversifying your investments Diversification is a strategy for reducing risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments? The easiest way to understand proper diversification may be to look at what you shouldn’t do: ✓ Don’t put all your money in one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks. As a general rule, the money you tie up in a single stock should be money you can do without. ✓ Don’t put all your money in one industry. I know people who own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it could work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt. ✓ Don’t put all your money in one type of investment. Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio. Some of these alternatives can be found in mutual funds or exchange-traded funds (ETFs). An exchange-traded fund is a fund with a fixed portfolio of stocks or other securities that tracks a particular index but is traded like a stock. By the way, I love ETFs and I think that every serious investor should consider them; see Chapter 14 for more information.
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Better luck next time! A little knowledge can be very risky. Consider the true story of one “lucky” fellow who played the California lottery in 1987. He discovered that he had a winning ticket, with the first prize of $412,000. He immediately ordered a Porsche, booked a lavish trip to Hawaii for his family, and treated his wife and friends to a champagne dinner at a posh Hollywood restaurant. When
he finally went to collect his prize, he found out that he had to share first prize with over 9,000 other lottery players who also had the same winning numbers. His share of the prize was actually only $45! Hopefully, he invested that tidy sum based on his increased knowledge about risk.
Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice: ✓ Keep only 10 percent (or less) of your investment money in a single stock. ✓ Invest in four or five (and no more than ten) different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand. To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities. See Chapter 13 for more information about analyzing industries.
Weighing Risk against Return How much risk is appropriate for you, and how do you handle it? Before you try to figure out what risks accompany your investment choices, analyze yourself. Here are some points to keep in mind when weighing risk versus return in your situation: ✓ Your financial goal: In five minutes with a financial calculator, you can easily see how much money you’re going to need to become financially independent (presuming financial independence is your goal). Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that’s a relatively low rate of return.
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Part I: The Essentials of Stock Investing The important point is that you don’t have to knock yourself out trying to double your money with risky, high-flying investments; some runof-the-mill bank investments will do just fine. All too often, investors take on more risk than is necessary. Figure out what your financial goal is so that you know what kind of return you realistically need. Flip to Chapters 2 and 3 for details on determining your financial goals. ✓ Your investor profile: Are you nearing retirement, or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return. • If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. Even if you lose big time, you still have a long time to recoup your money and get back on track. • However, if you’re within five years of retirement, risky or aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and the odds are that you’ll need the investment money (and its income-generating capacity) to cover your living expenses after you’re no longer employed. ✓ Asset allocation: I never tell retirees to put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, I don’t see a problem as long as they limit such investments to 5 percent of their total assets. As long as the bulk of their money is safe and sound in secure investments (such as U.S. treasury bonds), I know I can sleep well (knowing that they can sleep well!). Asset allocation beckons back to diversification, which I discuss earlier in this chapter. For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid cap and small cap stocks; see Chapter 1) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (mid caps and large caps are preferable). Check with your financial advisor to find the right mix for your particular situation.
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Chapter 5
Say Cheese: Getting a Snapshot of the Market with Indexes In This Chapter ▶ Defining index basics ▶ Looking at the Dow and other indexes ▶ Exploring indexes for practical use
“H
ow’s the market doing today?” is the most common question that interested parties ask about the stock market. “What did the Dow do?” “How about Nasdaq?” Invariably, people asking those questions expect an answer regarding how well the market performed that day. “Well, the Dow fell 157 points to 12,500, while Nasdaq was unchanged at 2,449.” The Dow and Nasdaq are indexes, which are statistical measures that represent the value of a batch of stocks. You can use indexes as general gauges of stock market activity. From them, you get a basic idea of how well (or how poorly) the overall market (or a portion of it) is doing. In this chapter, I focus my attention on the major stock market indexes and how to use them.
Knowing How Indexes Are Measured The oldest stock market index is the Dow Jones Industrial Average (DJIA or simply “The Dow”), which was created by Charles Dow (of Dow Jones fame) in 1896. The Dow covered only 12 stocks then, but the number increased to 30 stocks in 1928, and it remains the same to this day. Because Dow worked long before the age of computers, he kept the calculations of his stock market index simple and did them arithmetically by hand. Dow added up the stock prices of the 12 companies and then divided the sum by 12. Technically, this number is an average and not an index (hence the word “average” in the name). For simplicity’s sake, I refer to it as an index. Besides, the number gets tweaked nowadays to account for things such as stock splits. (For more on stock splits, see Chapter 20.)
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Part I: The Essentials of Stock Investing However, indexes and averages get calculated differently. The primary difference is the concept of weighting. Weighting refers to the relative importance of the items when they’re computed within the index. Several kinds of indexes exist, including: ✓ Price-weighted index: This index tracks changes based on the change in the individual stock’s price per share. For example, suppose you own two stocks: Stock A, worth $20 per share, and Stock B, worth $40 per share. A price-weighted index allocates a greater proportion of the index to the stock at $40 than to the one at $20. If the index contained only these two stocks, the index number would reflect the $40 stock as being 67 percent (two-thirds of the total), while the $20 stock would be 33 percent (one-third of the total). The Dow is a good example of a priceweighted index. ✓ Market-value weighted index: This index, also known as a capitalizationweighted index, tracks the proportion of a stock based on its market capitalization (or market value, also called market cap). Say that in your portfolio, you have 10 million shares of a $20 stock (Stock A) and 1 million shares of a $40 stock (Stock B). Stock A’s market cap is $200 million, while Stock B’s market cap is $40 million. Therefore, in a market-value weighted index, Stock A represents 83 percent of the index’s value because of its much larger market cap. An example of a market-value weighted index is the Nasdaq Composite Index. ✓ Broad-based index: The sample portfolios in the preceding bullets show only two stocks — obviously not a good representative index. Most investing professionals (especially money managers and mutual fund firms) use a broad-based index as a benchmark to compare their progress. A broad-based index provides a snapshot of the entire market. The S&P 500 and the Wilshire 5000 are good examples of broad-based indexes (they also happen to be market-value weighted indexes; see descriptions of both indexes later in this chapter.) ✓ Composite index: This index is a combination of several averages or indexes. An example is the New York Stock Exchange (NYSE) Composite, which tracks all the stocks on the NYSE. Another example is the Nasdaq Composite Index, which is a market-capitalization composite index of 3,000 companies on Nasdaq. (I discuss Nasdaq later in this chapter.) ✓ Performance-based index: This index includes not only the appreciation of the stocks represented in the index but also the dividends (and other cash payouts) issued to stockholders. The DAX (the most widely followed German index, composed of 30 major German companies) is a performance-based index.
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Checking Out the Indexes Although most people consider the Dow, Nasdaq, and Standard & Poor’s 500 to be the stars of the financial press, you may find other indexes equally important to follow because they cover other significant facets of the market, such as small cap and mid cap stocks, or specific sectors and industries. For example, if you invest in an Internet stock, you should check the Internet Stock Index to compare how your stock is doing when measured against the index. You can find indexes that cover industries such as transportation, brokerage firms, retailers, computer companies, and real estate firms. For a comprehensive list of indexes, go to www.djindexes.com (a Dow Jones & Co. Web site). The most reliable and most widely respected indexes are produced not only by Dow Jones but also Standard & Poor’s and the major exchanges/ markets themselves, such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and Nasdaq. Smaller exchanges also issue or provide indexes (such as the Philadelphia Exchange). Web sites for different exchanges can be found in Appendix A.
The Dow Jones Industrial Average The most famous stock market barometer is my first example in the previous section — the Dow Jones Industrial Average (DJIA). When someone asks how the market is doing, most investors quote the DJIA (simply referred to as “the Dow”). The Dow is price weighted and tracks a basket of 30 of the largest and most influential public companies in the stock market. I list the stocks tracked on the Dow and discuss the Dow’s drawbacks in the following sections.
The companies of the Dow The following list shows the current roster of 30 stocks tracked on the DJIA (in alphabetical order by company, with their stock symbols in parentheses).
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Alcoa (AA)
Caterpillar (CAT)
American Express Co. (AXP)
Chevron (CVX)
AT&T (T)
Citigroup (C)
Bank of America (BAC)
Coca-Cola Co. (KO)
Boeing (BA)
Disney & Co (DIS)
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Part I: The Essentials of Stock Investing DuPont (DD)
Kraft Food Inc. (KFT)
Exxon Mobil (XOM)
McDonald’s (MCD)
General Electric (GE)
Merck (MRK)
General Motors (GM)
Microsoft (MSFT)
Hewlett-Packard (HPQ) Home Depot (HD)
Minnesota Mining and Manufacturing (also known as 3M) (MMM)
Intel (INTC)
Pfizer (PFE)
International Business Machines (IBM)
Procter & Gamble (PG) United Technologies (UTX)
Johnson & Johnson (JNJ) Verizon (VZ) J.P. Morgan Chase (JPM) Wal-Mart Stores (WMT)
The drawbacks of the Dow The Dow has survived as a popular gauge of stock market activity for over a century because it was the first such statistical snapshot of the stock market, which helped it become quickly entrenched as a widely followed and quoted barometer. Although it’s an important indicator of the market’s progress, the Dow does have one major drawback: It tracks only 30 companies. Regardless of their status in the market, the companies in the Dow represent a limited sampling, so they don’t communicate the true pulse of the market. For example, when the Dow surpassed the record 10,000 and 11,000 milestones during 1999 and 2000, the majority of (nonindex) companies showed lackluster or declining stock price movement. (See the “Dow Jones milestones” sidebar, later in this chapter, for more information.) The roster of the Dow has changed many times during the 100-plus years of its existence. The only original company from 1896 is General Electric. Dow Jones made most of the changes because of company mergers and bankruptcy. However, Dow Jones also made some changes simply to reflect the changing times. In September 2008, as AIG Corp.’s stock was plummeting because of the credit crisis on Wall Street, it was quickly removed from the Dow and replaced with Kraft Foods. At that time, AIG fell from $25 per share to $3 per share within days. Had AIG stayed in the Dow, the Dow would have shown a larger drop, but it maintained a higher level because of the quick replacement. Investors unaware of such moves can be fooled regarding the market’s health — another drawback of the Dow.
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Dow Jones milestones This table shows when the Dow Jones Industrial Average reached each of 14 1,000-point milestones and how long it took to reach that point: Milestone
Date
How long it took
1,000
Nov. 14, 1972
76 years
2,000
Jan. 8, 1987
14 years
3,000
April 17, 1991
4 years
4,000
Feb. 23, 1995
4 years
5,000
Nov. 21, 1995
9 months
6,000
Oct. 14, 1996
11 months
7,000
Feb. 13, 1997
4 months
8,000
July 16, 1997
5 months
9,000
April 6, 1998
9 months
10,000
March 29, 1999
1 year
11,000
May 3, 1999
1 month
12,000
Oct. 19, 2006
7 years and 5 months
13,000
April 25, 2007
6 months
14,000
July 19, 2007
3 months
As you can see, the Dow took 76 years to hit its first milestone. But it took less and less time to hit each succeeding milestone because the higher the Dow is in a relative sense, the easier it is to jump 1,000 points. For example, it went from 6,000 to 7,000 in only four months. As the table indicates, most of the milestones happened during the 1982–1999 bull market. But the Dow didn’t reach a new milestone from 2000–2004. After the Dow hit a peak of 11,722 in January 2000, it entered a bear market that lasted three years. A new bull market started in 2003, and the Dow regained its traction and started an ascent to new highs. It finally hit the 12,000 mark in late 2006 (nearly 71/2 years after hitting the 11,000 level). Despite hitting the 14,000 plateau in July 2007, it spent the subsequent 12-month period trading sideways in the 11,000–13,000 range. The Dow hit an alltime closing high of 14,164.53 on October 9, 2007 (Hey! That’s my wedding anniversary!), although it is considerably lower a year later (under 9,300). Oh well . . . .
The Dow isn’t a pure gauge of industrial activity because it also includes a hodgepodge of nonindustrial companies such as J.P. Morgan Chase and Citigroup (banks), Home Depot (retailing), and Microsoft (software). During this decade, true industrial sectors like manufacturing had difficult times, yet the Dow rose to record levels. Given the Dow’s shortcomings, serious investors also look at the following indexes: ✓ Broad-based indexes: The S&P 500 and the Wilshire 5000 are more realistic gauges of the stock market’s performance than the Dow. (I discuss these indexes later in this chapter.)
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Part I: The Essentials of Stock Investing ✓ Industry or sector indexes: These indexes are better gauges of the growth (or lack of growth) of specific industries and sectors. If you buy a gold stock, for example, you should track the index for the precious metals industry. Dow Jones has several averages, including the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). Dow Jones manages both of these indexes more strictly than the Dow, so they tend to be a more accurate barometer of the market they represent. Find out more about the Dow Jones indexes at www.djindexes.com.
Standard & Poor’s 500 The Standard & Poor’s 500 (S&P 500) tracks 500 leading publicly traded companies considered to be widely held. The publishing firm Standard & Poor’s created this index (I bet you could’ve guessed that). Because it contains 500 companies, the S&P 500 more accurately represents overall market performance than the DJIA, with its 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the Dow. Most mutual funds especially like to measure their performance against the S&P 500 rather than any other index, although mutual funds that concentrate on small cap stocks usually prefer an index that has more small cap stocks in it, such as the Russell 2000 (which I discuss later in this chapter). The S&P 500 doesn’t attempt to cover the 500 biggest companies. Instead, it includes companies that are widely held and widely followed. The companies are also industry leaders in a variety of industries, including energy, technology, healthcare, and finance. Although it’s a reliable indicator of the market’s overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies make up 50 percent of the index’s market value. This situation can be a drawback, because those 50 companies have a greater influence on the index’s price movement than any other segment of companies. In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DIJA, it doesn’t give a perfectly accurate representation of the general market. Standard & Poor’s doesn’t set the 500 companies it tracks in stone — S&P can add or remove companies when market conditions change, removing a company if it isn’t doing well or goes bankrupt, for instance, and replacing it
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with a company that’s doing better. You can find out more at www.standard andpoors.com.
Wilshire Total Market Index The Wilshire 5000 Equity Index, often referred to as the Wilshire Total Market Index, is probably the largest stock index in the world. Wilshire Associates started out in 1980 tracking 5,000 stocks. Since then, the Wilshire 5000 has ballooned to cover more than 7,500 stocks. The advantage of the Wilshire 5000 is that it’s very comprehensive, covering nearly the entire market (at the very least, the Wilshire 5000 tracks the largest publicly traded stocks). It includes all the stocks on the major stock exchanges (NYSE, AMEX, and the largest issues on Nasdaq), which by default also includes all the stocks covered by the S&P 500. Investors and analysts who seek the greatest representation/performance of the general market look to the Wilshire 5000. The Wilshire 5000 is a market-value weighted index that also performs as a broad-based index. The Wilshire indexes are maintained by Wilshire Associates Incorporated, and you can find out more at www.wilshire.com.
Nasdaq indexes Nasdaq became a formalized market in 1971. The name used to stand for “National Association of Securities Dealers Automated Quote” system, but now it’s simply “Nasdaq” (as if it’s a name like Ralph or Eddie). Nasdaq indexes are similar to other indexes in style and structure. The only difference is that, well, they cover companies traded on the Nasdaq (www. nasdaq.com). The Nasdaq has two indexes, both of which are reported in the financial pages: ✓ Nasdaq Composite Index: Most frequently quoted on the news, the Nasdaq Composite Index covers about 3,000 companies that trade on Nasdaq. The companies encompass a variety of industries, but the index’s concentration is primarily technology, telecommunications, and related sectors. The Nasdaq Composite Index hit an all-time high of 5,048 in March 2000 before the worst bear market in its history occurred. The index dropped a whopping 77 percent by 2002 to bottom out at 1,114 in October 2002. As of early October 2008, the Nasdaq was at approximately 1,740 (still way below its all-time high, but higher than its bottom six years earlier).
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Part I: The Essentials of Stock Investing ✓ Nasdaq 100 Index: The Nasdaq 100 tracks the 100 largest companies in Nasdaq based on size in terms of market capitalization. This index is for investors who want to concentrate on the largest companies, which tend to be especially weighted in technology. It provides extra representation of technology-related companies such as Microsoft, Adobe, and Symantec. Although these indexes track growth-oriented companies, the stocks of these companies are also very volatile and carry commensurate risk. The indexes themselves bear this risk out; in the bear market of 2000 and 2001 (and even extending into 2002), they fell more than 60 percent. You can find out more about Nasdaq’s indexes at www.nasdaq.com.
Russell 3000 Index The Russell 3000 Index is a great example of an index that seeks more comprehensive inclusion of U.S. companies. It’s a performance-based index that includes the 3,000 largest publicly traded companies (nearly 98 percent of publicly traded stocks). The Russell 3000 is important because it includes many mid cap and small cap stocks. Most companies covered in the Russell 3000 have an average market value of a billion dollars or less. Russell Investments Group created and maintains the Russell 3000 Index, as well as the Russell 1000 and the Russell 2000. The Russell 2000 contains the smallest 2,000 companies from the Russell 3000, while the Russell 1000 contains the largest 1,000 companies. The Russell indexes don’t cover micro cap stocks (companies with a market capitalization under $250 million). You can find out more at www.russell.com.
International indexes Investors need to remember that the whole world is a vast marketplace that interacts with and exerts tremendous influence on individual national economies and markets. Whether you have one stock or one mutual fund, keep tabs on how world markets affect your portfolio. The best way to get a snapshot of international markets is, of course, with indexes. Here are some of the more widely followed international indexes: ✓ BSE SENSEX (India): The most widely followed index of Indian stocks is also referred to as the “BSE 30 Index” and is a value-weighted index maintained by the Bombay Stock Exchange (www.bseindia.com).
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✓ CAC-40 (France): This market-capitalization weighted index tracks 40 of the largest public stocks that trade on Paris’s stock exchange, the Euronext Paris. ✓ DAX (Germany): This index is similar to our DJIA in that it tracks 30 blue chip stocks (the largest and most active that trade on the Frankfurt Exchange). ✓ FTSE-100 (Great Britain): Usually referred to as the “footsie,” this market-value weighted index includes the top 100 public companies in the United Kingdom. ✓ Halter USX China Index (China): This index tracks a basket of 50 market-value weighted U.S. public companies that derive most of their revenues from China. ✓ Hang Seng Index (Hong Kong): This market-value weighted index tracks the top 45 companies on the Hong Kong Stock Exchange. ✓ Nikkei (Japan): This index is considered Japan’s version of the Dow. If you’re invested in Japanese stocks or in stocks that do business with Japan, you want to know what’s up with the Nikkei. ✓ SSE Composite Index (Shanghai): This is an index of all the stocks that trade on the Shanghai Stock Exchange. You can track these international indexes (among others) at major financial Web sites such as www.bloomberg.com and www.marketwatch.com. You may find international indexes useful in your analysis as you watch your stocks’ progress. What if you have stock in a company that has most of its customers in Japan? Then the Nikkei can help you get a general snapshot of how well the major companies are doing in Japan, which in turn can be a general barometer of Japan’s economic health. If your company’s business partners or customers are in the Nikkei and it’s plunging, you know it’s probably “sayonara” for the company’s stock price. As for me, I’m still waiting for the “Galaxy 1 Million Index” — no point in being overweight with Earth stocks, you know.
Using the Indexes Effectively You may be wondering which indexes you should be checking out and exactly what you should do with them. The sections that follow give you some idea of how to put all the pieces together.
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Part I: The Essentials of Stock Investing
Tracking the indexes The bottom line is that indexes give investors an instant snapshot of how well the market is doing. Indexes offer a quick way to compare the performance of one investor’s portfolio with the rest of the market. If the Dow goes up 10 percent in a year and your portfolio shows a cumulative gain of 12 percent, then you know you’re doing well. Appendix A lists resources to help you keep up with various indexes. The problem with indexes is that they can be misleading if you take them too literally as an accurate barometer of stock success. For example, the Dow has changed its roster of companies many times since 1896. Had it not, the Dow’s general upward trajectory in the past few decades would have been much different. Laggard stocks have been dropped and replaced with stocks that have shown more promise. Many of the original companies that were in the DJIA in 1896 went out of business or were bought by other companies that aren’t reflected in the index.
Investing in indexes If the market is doing well but your specific stock isn’t, can you find a way to invest in the index itself? Yes, and with investments based on indexes, you can invest in the general market or a particular industry. Say you want to invest in the DJIA. After all, why try to beat the market if just matching it is sufficient to grow your wealth? Why not have a portfolio that directly mirrors the DJIA? Well, it’s too impractical and expensive to invest in all 30 stocks in the DJIA. Fortunately, alternatives can accomplish the act of investing in indexes. Here are the best ways: ✓ Index mutual funds: An index mutual fund is much like a regular mutual fund except that it only invests in securities (in this case, stocks) that match as closely as possible the basket of stocks in that particular index. For example, you can find index mutual funds that track the DJIA and the S&P 500. Find out more about index mutual funds at places such as Morningstar (www.morningstar.com). ✓ Exchange-traded funds (ETFs): This is a particular favorite of mine. ETFs have similar characteristics to mutual funds except for a few key differences. An ETF can reflect a basket of stocks that mirror a particular index, but you can trade the ETF like a stock itself. You can transact ETFs like stocks in that you can buy, sell, or go short. You can put
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stop losses on them, and you can even purchase them on margin (see Chapter 18 for more on stop losses and buying on margin). ETFs can give you the diversification of mutual funds coupled with the versatility of stocks. Examples of ETFs that track indexes are the DJIA ETF (symbol DIA) and the ETF for Nasdaq (QQQ). You can find out more about ETFs at the American Stock Exchange (www.amex.com).
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Part I: The Essentials of Stock Investing
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Part II
Before You Start Buying
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In this part . . .
hen you’re about to begin investing in stocks, you should know that different types of stocks exist for different objectives. If you can at least get a stock that fits your situation, you’re that much ahead in the game. In this part, you can find out where to start gathering information and discover what stockbrokers can do for you. In addition, you’ll find a fun chapter on the basics of economics (really!) that will keep you ahead of the curve because stock choices are made more intelligently when you know the economic environment.
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Chapter 6
Gathering Information In This Chapter ▶ Using stock exchanges to get investment information ▶ Applying accounting and economic know-how to your investments ▶ Exploring financial issues ▶ Deciphering stock tables ▶ Interpreting dividend news ▶ Recognizing good (and bad) investing advice
K
nowledge and information are two critical success factors in stock investing. (Isn’t that true about most things in life?) People who plunge headlong into stocks without sufficient knowledge of the stock market in general, and current information in particular, quickly learn the lesson of the eager diver who didn’t find out ahead of time that the pool was only an inch deep (ouch!). In their haste to avoid missing so-called golden investment opportunities, investors too often end up losing money.
Opportunities to make money in the stock market will always be there, no matter how well or how poorly the economy and the market are performing in general. There’s no such thing as a single (and fleeting) magical moment, so don’t feel that if you let an opportunity pass you by, you’ll always regret that you missed your one big chance. For the best approach to stock investing, you want to build your knowledge and find quality information first. Then buy stocks and make your fortunes more assuredly. Basically, before you buy stock, you need to know that the company you’re investing in is ✓ Financially sound and growing ✓ Offering products and services that are in demand by consumers ✓ In a strong and growing industry (and general economy) Where do you start and what kind of information do you want to acquire? Keep reading.
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Part II: Before You Start Buying
Looking to Stock Exchanges for Answers Before you invest in stocks, you need to be completely familiar with the basics of stock investing. At its most fundamental, stock investing is about using your money to buy a piece of a company that will give you value in the form of appreciation or income. Fortunately, many resources are available to help you find out about stock investing. Some of my favorite places are the stock exchanges themselves. Stock exchanges are organized marketplaces for the buying and selling of stocks (and other securities). The New York Stock Exchange (NYSE), the premier stock exchange, provides a framework for stock buyers and sellers to make their transactions. The NYSE makes money not only from a piece of every transaction but also from fees (such as listing fees) charged to companies and brokers that are members of its exchanges. In 2007, the NYSE merged with Euronext, a major European exchange, but no material differences exist for stock investors. The main exchanges for most stock investors are the NYSE and the American Stock Exchange (AMEX). Nasdaq is technically not an exchange, but it is a formal market that effectively acts as an exchange. These three encourage and inform people about stock investing. Because these exchanges/markets benefit from increased popularity of stock investing and continued demand for stocks, they offer a wealth of free (or low-cost) resources and information for stock investors. Go to their Web sites and you find useful resources such as: ✓ Tutorials on how to invest in stocks, common investment strategies, and so on ✓ Glossaries and free information to help you understand the language, practice, and purpose of stock investing ✓ A wealth of news, press releases, financial data, and other information about companies listed on the exchange or market, usually accessed through an on-site search engine ✓ Industry analysis and news ✓ Stock quotes and other market information related to the daily market movements of stocks, including data such as volume, new highs, new lows, and so on ✓ Free tracking of your stock selections (you can input a sample portfolio, or the stocks you’re following, to see how well you’re doing)
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What each exchange/market offers keeps changing and is often updated, so go explore them at their Web sites: ✓ New York Stock Exchange: www.nyse.com ✓ American Stock Exchange: www.amex.com ✓ Nasdaq: www.nasdaq.com
Understanding Stocks and the Companies They Represent Stocks represent ownership in companies. Before you buy individual stocks, you want to understand the companies whose stock you’re considering and find out about their operations. It may sound like a daunting task, but you’ll digest the point more easily when you realize that companies work very similarly to how you work. They make decisions on a day-to-day basis just as you do. Think about how you grow and prosper as an individual or as a family, and you see the same issues with businesses and how they grow and prosper. Low earnings and high debt are examples of financial difficulties that can affect both people and companies. You’ll understand companies’ finances when you take the time to pick up some information in two basic disciplines: accounting and economics. These two disciplines play a significant role in understanding the performance of a firm’s stock.
Accounting for taste and a whole lot more Accounting. Ugh! But face it: Accounting is the language of business, and believe it or not, you’re already familiar with the most important accounting concepts! Just look at the following three essential principles: ✓ Assets minus liabilities equal net worth. In other words, take what you own (your assets), subtract what you owe (your liabilities), and the rest is yours (net worth)! Your own personal finances work the same way as Microsoft’s (except yours have fewer zeros at the end). See Chapter 2 to figure out how to calculate your own net worth.
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Part II: Before You Start Buying A company’s balance sheet shows you its net worth at a specific point in time (such as December 31). The net worth of a company is the bottom line of its asset and liability picture, and it tells you whether the company is solvent (has the ability to pay its debts without going out of business). The net worth of a successful company is regularly growing. To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier. A firm that has a $4 million net worth on December 31, 2007, and a $5 million net worth on December 31, 2008, is doing well; its net worth has gone up 25 percent ($1 million) in one year. ✓ Income less expenses equal net income. In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain). A company’s profitability is the whole point of investing in its stock. As it profits, the business becomes more valuable, and in turn, its stock price becomes more valuable. To discover a firm’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either reinvesting them for continued growth or paying down debt. ✓ Do a comparative financial analysis. That’s a mouthful, but it’s just a fancy way of saying how a company is doing now compared with something else (like a prior period or a similar company). If you know that the company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else. If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid that company or see what went wrong (if anything) with it. Accounting can be this simple. If you understand these three basic points, you’re ahead of the curve (in stock investing as well as in your personal finances). For more information on how to use a company’s financial statements to pick good stocks, see Chapters 11 and 12.
Understanding how economics affects stocks Economics. Double ugh! No, you aren’t required to understand “the inelasticity of demand aggregates” (thank heavens!) or “marginal utility” (say what?). But a working knowledge of basic economics is crucial (and I mean crucial)
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to your success and proficiency as a stock investor. The stock market and the economy are joined at the hip. The good (or bad) things that happen to one have a direct effect on the other.
Getting the hang of the basic concepts Alas, many investors get lost on basic economic concepts (as do some socalled experts that you see on TV). I owe my personal investing success to my status as a student of economics. Understanding basic economics helps me (and will help you) filter the financial news to separate relevant information from the irrelevant in order to make better investment decisions. Be aware of these important economic concepts: ✓ Supply and demand: How can anyone possibly think about economics without thinking of the ageless concept of supply and demand? Supply and demand can be simply stated as the relationship between what’s available (the supply) and what people want and are willing to pay for (the demand). This equation is the main engine of economic activity and is extremely important for your stock investing analysis and decisionmaking process. I mean, do you really want to buy stock in a company that makes elephant-foot umbrella stands if you find out that the company has an oversupply and nobody wants to buy them anyway? (I discuss supply and demand in more detail in Chapter 10.) ✓ Cause and effect: If you pick up a prominent news report and read, “Companies in the table industry are expecting plummeting sales,” do you rush out and invest in companies that sell chairs or manufacture tablecloths? Considering cause and effect is an exercise in logical thinking, and believe you me, logic is a major component of sound economic thought. When you read business news, play it out in your mind. What good (or bad) can logically be expected given a certain event or situation? If you’re looking for an effect (“I want a stock price that keeps increasing”), you also want to understand the cause. Here are some typical events that can cause a stock’s price to rise (see Chapter 10 for additional info on cause and effect): • Positive news reports about a company: The news may report that the company is enjoying success with increased sales or a new product. • Positive news reports about a company’s industry: The media may be highlighting that the industry is poised to do well. • Positive news reports about a company’s customers: Maybe your company is in industry A, but its customers are in industry B. If you see good news about industry B, that may be good news for your stock.
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Part II: Before You Start Buying • Negative news reports about a company’s competitors: If the competitors are in trouble, their customers may seek alternatives to buy from, including your company. ✓ Economic effects from government actions: Political and governmental actions have economic consequences. As a matter of fact, nothing (and I mean nothing!) has a greater effect on investing and economics than government. Government actions usually manifest themselves as taxes, laws, or regulations. They also can take on a more ominous appearance, such as war or the threat of war. Government can willfully (or even accidentally) cause a company to go bankrupt, disrupt an entire industry, or even cause a depression. It controls the money supply, credit, and all public securities markets. For more information on political effects, see Chapter 15.
Gaining insight from past mistakes Because most investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios. During 2000–2008, the U.S. experienced the greatest expansion of total debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing. This activity hyperstimulated the stock market and caused stocks to rise 25 percent per year for five straight years during the late 1990s. When the stock market bubble popped during 2000–2002, it was soon replaced with the housing bubble, which popped during 2005–2006 and is still hurting the economy in 2008. Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. This artificial stimulation by the Fed resulted in the following: ✓ More and more people depleted their savings. After all, why settle for 3 percent in the bank when you can get 25 percent in the stock market? ✓ More and more people bought on credit. If the economy is booming, why not buy now and pay later? Consumer credit hit record highs. ✓ More and more people borrowed against their homes. Why not borrow and get rich now? I can pay off my debt later. ✓ More and more companies sold more goods as consumers took more vacations and bought SUVs, electronics, and so on. Companies then borrowed to finance expansion, open new stores, and so on. ✓ More and more companies went public and offered stock to take advantage of more money that was flowing to the markets from banks and other financial institutions.
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Know thyself before you invest in stocks If you’re reading this book, you’re probably doing so because you want to become a successful investor. Granted, to be a successful investor, you have to select great stocks, but having a realistic understanding of your own financial situation and goals is equally important. I recall one investor who lost $10,000 in a speculative stock. The loss wasn’t that bad because he had most of his money safely tucked away elsewhere. He also understood
that his overall financial situation was secure and that the money he lost was “play” money — the loss wouldn’t have a drastic effect on his life. But many investors often lose even more money, and the loss does have a major, negative effect on their lives. You may not be like the investor who can afford to lose $10,000. Take time to understand yourself, your own financial picture, and your personal investment goals before you decide to buy stocks.
In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. However, companies had too much overhead, capacity, and debt because they expanded too eagerly. At this point, businesses were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. Companies, to stay in business, had to do the logical thing — cut expenses. What’s usually the biggest expense for companies? People! To stay in business, many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security. As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell. The lessons from the 1990s are important ones for investors today: ✓ Stocks are not a replacement for savings accounts. Always have some money in the bank. ✓ Stocks should never occupy 100 percent of your investment funds. ✓ When anyone (including an expert) tells you that the economy will keep growing indefinitely, be skeptical and read diverse sources of information. ✓ If stocks do well in your portfolio, consider protecting your stocks (both your original investment and any gains) with stop-loss orders. (See Chapter 18 for more on these strategies.)
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Part II: Before You Start Buying ✓ Keep debt and expenses to a minimum. ✓ If the economy is booming, a decline is sure to follow as the ebb and flow of the economy’s business cycle continues.
Staying on Top of Financial News Reading the financial news can help you decide where or where not to invest. Many newspapers, magazines, and Web sites offer great coverage of the financial world. Obviously, the more informed you are, the better, but you don’t have to read everything that’s written. The information explosion in recent years has gone beyond overload, and you can easily spend so much time reading that you have little time left for investing. In the following sections, I describe the types of information you need to get from the financial news. Appendix A of this book provides more information on the following resources, along with a treasure trove of some of the best publications, resources, and Web sites to assist you: ✓ The most obvious publications of interest to stock investors are The Wall Street Journal and Investor’s Business Daily. These excellent publications report the news and stock data as of the prior trading day. ✓ Some of the more obvious Web sites are MarketWatch (www.market watch.com) and Bloomberg (www.bloomberg.com). These Web sites can actually give you news and stock data within 15 to 20 minutes after an event occurs. ✓ Don’t forget the exchanges’ Web sites that I list in the earlier section, “Looking to Stock Exchanges for Answers”!
Figuring out what a company’s up to Before you invest, you need to know what’s going on with the company. When you read about the company, either from the firm’s literature (its annual report, for example) or from media sources, be sure to get answers to some pertinent questions: ✓ Is the company making more net income than it did last year? You want to invest in a company that’s growing. ✓ Are the company’s sales greater than they were the year before? Remember, you won’t make money if the company isn’t making money.
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✓ Is the company issuing press releases on new products, services, inventions, or business deals? All these achievements indicate a strong, vital company. Knowing how the company is doing, no matter what’s happening with the general economy, is obviously important. To better understand how companies tick, see Chapters 11 and 12.
Discovering what’s new with an industry As you consider investing in a stock, make it a point to know what’s going on in that company’s industry. If the industry is doing well, your stock is likely to do well, too. But then again, the reverse is also true. Yes, I’ve seen investors pick successful stocks in a failing industry, but those cases are exceptional. By and large, it’s easier to succeed with a stock when the entire industry is doing well. As you’re watching the news, reading the financial pages, or viewing financial Web sites, check out the industry to see that it’s strong and dynamic. See Chapter 13 for information on analyzing industries.
Knowing what’s happening with the economy No matter how well or how poorly the overall economy is performing, you want to stay informed about its general progress. It’s easier for the value of stock to keep going up when the economy is stable or growing. The reverse is also true; if the economy is contracting or declining, the stock has a tougher time keeping its value. Some basic items to keep tabs on include the following: ✓ Gross domestic product (GDP): This is roughly the total value of output for a particular nation, measured in the dollar amount of goods and services. The GDP is reported quarterly, and a rising GDP bodes well for your stock. When the GDP is rising 3 percent or more on an annual basis, that’s solid growth. If it rises at more than zero but less than 3 percent, that’s generally considered less than stellar (or mediocre). A GDP under zero (or negative) means that the economy is shrinking (heading into recession).
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Part II: Before You Start Buying ✓ The index of leading economic indicators (LEI): The LEI is a snapshot of a set of economic statistics covering activity that precedes what’s happening in the economy. Each statistic helps you understand the economy in much the same way that barometers (and windows!) help you understand what’s happening with the weather. Economists don’t just look at an individual statistic; they look at a set of statistics to get a more complete picture of what’s happening with the economy. Chapter 10 goes into greater detail on economics and its effect on stock prices.
Seeing what politicians and government bureaucrats are doing Being informed about what public officials are doing is vital to your success as a stock investor. Because federal, state, and local governments pass literally thousands of laws every year, monitoring the political landscape is critical to your success. The news media report what the president and Congress are doing, so always ask yourself, “How does a new law, tax, or regulation affect my stock investment?” Because government actions have a significant effect on your investments, it’s a good idea to see what’s going on. Laws being proposed or enacted by the federal government can be found through the Thomas legislative search engine, which is run by the Library of Congress (www.loc.gov). Also, some great organizations inform the public about tax laws and their impact, such as the National Taxpayers Union (www.ntu.org). Chapter 15 gives you more insights into politics and its effect on the stock market.
Checking for trends in society, culture, and entertainment As odd as it sounds, trends in society, popular culture, and entertainment affect your investments, directly or indirectly. For example, a headline such as, “The Graying of America — More People Than Ever Before Will Be Senior Citizens” gives you some important information that can make or break your stock portfolio. With that particular headline, you know that as more and more people age, companies that are well positioned to cater to that growing market’s wants and needs will do well — meaning a successful stock for you.
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Keep your eyes open to emerging trends in society at large. What trends are evident now? Can you anticipate the wants and needs of tomorrow’s society? Being alert, staying a step ahead of the public, and choosing stocks appropriately gives you a profitable edge over other investors. If you own stock in a solid company with growing sales and earnings, other investors eventually notice. As more investors buy up your company’s stocks, you’re rewarded as the stock price increases.
Reading (And Understanding) Stock Tables The stock tables in major business publications such as The Wall Street Journal and Investor’s Business Daily are loaded with information that can help you become a savvy investor — if you know how to interpret them. You need the information in the stock tables for more than selecting promising investment opportunities. You also need to consult the tables after you invest to monitor how your stocks are doing. Looking at the stock tables without knowing what you’re looking for or why you’re looking is the equivalent of reading War and Peace backwards through a kaleidoscope — nothing makes sense. But I can help you make sense of it all (well, at least the stock tables!). Table 6-1 shows a sample stock table for you to refer to as you read the sections that follow.
Table 6-1
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A Sample Stock Table
52Wk High 21.50
52Wk Low 8.00
Name (Symbol)
Div
Vol
SkyHighCorp (SHC)
47.00
31.75
LowDownInc (LDI)
2.35
2,735
25.00
21.00
ValueNowInc (VNI)
1.00
1,894
83.00
33.00
DoinBadly Corp (DBC)
Yld
P/E
Day Last
Net Chg
76
21.25
+.25
5.9
18
41.00
–.50
4.5
12
22.00
+.10
33.50
–.75
3,143
7,601
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Part II: Before You Start Buying Every newspaper’s financial tables are a little different, but they give you basically the same information. Updated daily, this section is not the place to start your search for a good stock; it’s usually where your search ends. The stock tables are the place to look when you own a stock or know what you want to buy and you’re just checking to see the most recent price. Each item gives you some clues about the current state of affairs for that particular company. The sections that follow describe each column to help you understand what you’re looking at.
52-week high The column in Table 6-1 labeled “52-Wk High” gives you the highest price that particular stock has reached in the most recent 52-week period. Knowing this price lets you gauge where the stock is now versus where it has been recently. SkyHighCorp’s (SHC) stock has been as high as $21.50, while its last (most recent) price is $21.25, the number listed in the “Day Last” column. (Flip to the “Day last” section for more on understanding this information.) SkyHighCorp’s stock is trading very high right now because it’s hovering right near its overall 52-week high figure. Now, take a look at DoinBadlyCorp’s (DBC) stock price. It seems to have tumbled big time. Its stock price has had a high in the past 52 weeks of $83, but it’s currently trading at $33.50. Something just doesn’t seem right here. During the past 52 weeks, DBC’s stock price fell dramatically. If you’re thinking about investing in DBC, find out why the stock price fell. If the company is strong, it may be a good opportunity to buy stock at a lower price. If the company is having tough times, avoid it. In any case, research the firm and find out why its stock has declined.
52-week low The column labeled “52-Wk Low” gives you the lowest price that particular stock reached in the most recent 52-week period. Again, this information is crucial to your ability to analyze stock over a period of time. Look at DBC in Table 6-1, and you can see that its current trading price of $33.50 is close to its 52-week low of $33. Keep in mind that the high and low prices just give you a range of how far that particular stock’s price has moved within the past 52 weeks. They could alert you that a stock has problems, or they could tell you that a stock’s price has fallen enough to make it a bargain. Simply reading the 52-Wk High and 52-Wk Low columns isn’t enough to determine which of those two scenarios is happening. They basically tell you to get more information before you commit your money.
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Name and symbol The “Name (Symbol)” column is the simplest in Table 6-1. It tells you the company name (usually abbreviated) and the stock symbol assigned to the company. When you have your eye on a stock for potential purchase, get familiar with its symbol. Knowing the symbol makes it easier for you to find your stock in the financial tables, which list stocks in alphabetical order by the company’s name. Stock symbols are the language of stock investing, and you need to use them in all stock communications, from getting a stock quote at your broker’s office to buying stock over the Internet.
Dividend Dividends (shown under the “Div” column in Table 6-1) are basically payments to owners (stockholders). If a company pays a dividend, it’s shown in the dividend column. The amount you see is the annual dividend quoted for one share of that stock. If you look at LowDownInc (LDI) in Table 6-1, you can see that you get $2.35 as an annual dividend for each share of stock that you own. Companies usually pay the dividend in quarterly amounts. If I own 100 shares of LDI, the company pays me a quarterly dividend of $58.75 ($235 total per year). A healthy company strives to maintain or upgrade the dividend for stockholders from year to year. (I discuss additional dividend details later in this chapter.) The dividend is very important to investors seeking income from their stock investment. For more about investing for income, see Chapter 9. Investors buy stock in companies that don’t pay dividends primarily for growth. For more information on growth stocks, see Chapter 8.
Volume Normally, when you hear the word “volume” on the news, it refers to how much stock is bought and sold for the entire market: “Well, stocks were very active today. Trading volume at the New York Stock Exchange hit 2 billion shares.” Volume is certainly important to watch because the stocks that you’re investing in are somewhere in that activity. For the “Vol” column in Table 6-1, though, the volume refers to the individual stock.
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Part II: Before You Start Buying Volume tells you how many shares of that particular stock were traded that day. If only 100 shares are traded in a day, then the trading volume is 100. SHC had 3,143 shares change hands on the trading day represented in Table 6-1. Is that good or bad? Neither, really. Usually the business news media only mention volume for a particular stock when it’s unusually large. If a stock normally has volume in the 5,000 to 10,000 range and all of a sudden has a trading volume of 87,000, then it’s time to sit up and take notice. Keep in mind that a low trading volume for one stock may be a high trading volume for another stock. You can’t necessarily compare one stock’s volume against that of any other company. The large cap stocks like IBM or Microsoft typically have trading volumes in the millions of shares almost every day, while less active, smaller stocks may have average trading volumes in far, far smaller numbers. The main point to remember is that trading volume that is far in excess of that stock’s normal range is a sign that something is going on with that stock. It may be negative or positive, but something newsworthy is happening with that company. If the news is positive, the increased volume is a result of more people buying the stock. If the news is negative, the increased volume is probably a result of more people selling the stock. What are typical events that cause increased trading volume? Some positive reasons include the following: ✓ Good earnings reports: The company announces good (or better-thanexpected) earnings. ✓ A new business deal: The firm announces a favorable business deal, such as a joint venture, or lands a big client. ✓ A new product or service: The company’s research and development department creates a potentially profitable new product. ✓ Indirect benefits: The business may benefit from a new development in the economy or from a new law passed by Congress. Some negative reasons for an unusually large fluctuation in trading volume for a particular stock include the following: ✓ Bad earnings reports: Profit is the lifeblood of a company. When its profits fall or disappear, you see more volume. ✓ Governmental problems: The stock is being targeted by government action, such as a lawsuit or a Securities and Exchange Commission (SEC) probe.
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✓ Liability issues: The media report that the company has a defective product or similar problem. ✓ Financial problems: Independent analysts report that the company’s financial health is deteriorating. Check out what’s happening when you hear about heavier than usual volume (especially if you already own the stock).
Yield In general, yield is a return on the money you invest. However, in the stock tables, yield (“Yld” in Table 6-1) is a reference to what percentage that particular dividend is to the stock price. Yield is most important to income investors. It’s calculated by dividing the annual dividend by the current stock price. In Table 6-1, you can see that the yield du jour of ValueNowInc (VNI) is 4.5 percent (a dividend of $1 divided by the company’s stock price of $22). Notice that many companies report no yield; because they have no dividends, their yield is zero. Keep in mind that the yield reported in the financial pages changes daily as the stock price changes. Yield is always reported as if you’re buying the stock that day. If you buy VNI on the day represented in Table 6-1, your yield is 4.5 percent. But what if VNI’s stock price rises to $30 the following day? Investors who buy stock at $30 per share obtain a yield of just 3.3 percent. (The dividend of $1 divided by the new stock price, $30.) Of course, because you bought the stock at $22, you essentially locked in the prior yield of 4.5 percent. Lucky you. Pat yourself on the back.
P/E The P/E ratio is the ratio between the price of the stock and the company’s earnings. P/E ratios are widely followed and are important barometers of value in the world of stock investing. The P/E ratio (also called the “earnings multiple” or just “multiple”) is frequently used to determine whether a stock is expensive (a good value). Value investors (such as yours truly) find P/E ratios to be essential to analyzing a stock as a potential investment. As a general rule, the P/E should be 10 to 20 for large cap or income stocks. For growth stocks, a P/E no greater than 30 to 40 is preferable. (See Chapter 11 for full details on P/E ratios.)
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Part II: Before You Start Buying In the P/E ratios reported in stock tables, price refers to the cost of a single share of stock. Earnings refers to the company’s reported earnings per share as of the most recent four quarters. The P/E ratio is the price divided by the earnings. In Table 6-1, VNI has a reported P/E of 12, which is considered a low P/E. Notice how SHC has a relatively high P/E (76). This stock is considered too pricey because you’re paying a price equivalent to 76 times earnings. Also notice that DBC has no available P/E ratio. Usually this lack of a P/E ratio indicates that the company reported a loss in the most recent four quarters.
Day last The “Day Last” column tells you how trading ended for a particular stock on the day represented by the table. In Table 6-1, LDI ended the most recent day of trading at $41. Some newspapers report the high and low for that day in addition to the stock’s ending price for the day.
Net change The information in the “Net Chg” column answers the question, “How did the stock price end today compared with its price at the end of the prior trading day?” Table 6-1 shows that SHC stock ended the trading day up 25 cents (at $21.25). This column tells you that SHC ended the prior day at $21. VNI ended the day at $22 (up 10 cents), so you can tell that the prior trading day it ended at $21.90.
Using News about Dividends Reading and understanding the news about dividends is essential if you’re an income investor (someone who invests in stocks as a means of generating regular income; see Chapter 9 for details). The following sections explain some basics about dividends you should know. You can find news and information on dividends in newspapers such as The Wall Street Journal, Investor’s Business Daily, and Barron’s (you can find their Web sites online with your favorite search engine, or just check out Appendix A).
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Looking at important dates In order to understand how buying stocks that pay dividends can benefit you as an investor, you need to know how companies report and pay dividends. Some important dates in the life of a dividend are as follows: ✓ Date of declaration: This is the date when a company reports a quarterly dividend and the subsequent payment dates. On January 15, for example, a company may report that it “is pleased to announce a quarterly dividend of 50 cents per share to shareholders of record as of February 10.” That was easy. The date of declaration is really just the announcement date. If you buy the stock before, on, or after the date of declaration, it won’t matter in regard to receiving the stock’s quarterly dividend. The date that matters is the date of record (see that bullet later in this list). ✓ Date of execution: This is the day you actually initiate the stock transaction (buying or selling). If you call up a broker (or contact her online) today to buy a particular stock, then today is the date of execution, or the date on which you execute the trade. You don’t own the stock on the date of execution; it’s just the day you put in the order. For an example, skip to the following section. ✓ Closing date (settlement date): This is the date on which the trade is finalized, which usually happens three business days after the date of execution. The closing date for stock is similar in concept to a real estate closing. On the closing date, you’re officially the proud new owner (or happy seller) of the stock. ✓ Date of record: This is used to identify which stockholders qualify to receive the declared dividend. Because stock is bought and sold every day, how does the company know which investors to pay? The company establishes a cut-off date by declaring a date of record. All investors who are official stockholders as of the declared date of record receive the dividend on the payment date, even if they plan to sell the stock any time between the date of declaration and the date of record. ✓ Ex-dividend date: Ex-dividend means without dividend. Because it takes three days to process a stock purchase before you become an official owner of the stock, you have to qualify (that is, you have to own or buy the stock) before the three-day period. That three-day period is referred to as the “ex-dividend period.” When you buy stock during this short time frame, you aren’t on the books of record, because the closing (or settlement) date falls after the date of record. See the next section to see the effect that the ex-dividend date can have on an investor. ✓ Payment date: The date on which a company issues and mails its dividend checks to shareholders. Finally!
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Part II: Before You Start Buying For typical dividends, the events in Table 6-2 happen four times per year.
Table 6-2
The Life of the Quarterly Dividend
Event
Sample Date
Comments
Date of declaration
January 15
The date that the company declares the quarterly dividend
Ex-dividend date
February 7
Starts the three-day period during which, if you buy the stock, you don’t qualify for the dividend
Record date
February 10
The date by which you must be on the books of record to qualify for the dividend
Payment date
February 27
The date that payment is made (a dividend check is issued and mailed to stockholders who were on the books of record as of February 10)
Understanding why these dates matter Three business days pass between the date of execution and the closing date. Three business days also pass between the ex-dividend date and the date of record. This information is important to know if you want to qualify to receive an upcoming dividend. Timing is important, and if you understand these dates, you know when to purchase stock and whether you qualify for a dividend. As an example, say that you want to buy ValueNowInc (VNI) in time to qualify for the quarterly dividend of 25 cents per share. Assume that the date of record (the date by which you have to be an official owner of the stock) is February 10. You have to execute the trade (buy the stock) no later than February 7 to be assured of the dividend. If you execute the trade right on February 7, the closing date occurs three days later, on February 10 — just in time for the date of record. But w
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Paul Mladjenovic is a well-known Certified Financial Planner and national speaker on investing and financial matters. He is the owner of PM Financial Services and www.SuperMoneyLinks.com, and he has been quoted or referenced by media outlets, publications, and financial Web sites. Mladjenovic is the author of the first two editions of Stock Investing For Dummies as well as Precious Metals Investing For Dummies.
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Stock Investing FOR
DUMmIES
‰
3RD
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EDITION
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Stock Investing FOR
DUMmIES
‰
3RD
EDITION
by Paul Mladjenovic
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Stock Investing For Dummies®, 3rd Edition Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2009 by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at http://www. wiley.com/go/permissions. Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com, Making Everything Easier, and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/ or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE. NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS. THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION. THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES. IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT. NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FURTHER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE. FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. For technical support, please visit www.wiley.com/techsupport. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Control Number: 2008942707 ISBN: 978-0-470-40114-9 Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1
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About the Author Paul Mladjenovic is a certified financial planner practitioner, writer, and public speaker. His business, PM Financial Services, has helped people with financial and business concerns since 1981. In 1985 he achieved his CFP designation. Since 1983, Paul has taught thousands of budding investors through popular national seminars such as “The $50 Wealthbuilder” and “Stock Investing Like a Pro.” Paul has been quoted or referenced by many media outlets, including Bloomberg, MarketWatch, Comcast, CNBC, and a variety of financial and business publications and Web sites. As an author, he has written the books The Unofficial Guide to Picking Stocks (Wiley, 2000) and ZeroCost Marketing (Todd Publications, 1995). In 2002, the first edition of Stock Investing For Dummies was ranked in the top 10 out of 300 books reviewed by Barron’s. In recent years, Paul accurately forecasted many economic events, such as the rise of gold, the decline of the U.S. dollar, and the housing crisis. At press time he had been warning his students and clients about the credit crisis on Wall Street. He edits the financial newsletter Prosperity Alert, available at no charge at www.supermoneylinks.com. Paul’s personal Web site can be found at www.mladjenovic.com.
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Dedication For my fantastic wife Fran, my wonderful boys Adam and Joshua, and a loving, supportive family, I thank God for you. I also dedicate this book to the millions of investors who deserve more knowledge and information to achieve lasting prosperity.
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Author’s Acknowledgments First and foremost, I offer my appreciation and gratitude to the wonderful people at Wiley. It has been a pleasure to work with such a top-notch organization that works so hard to create products that offer readers tremendous value and information. I wish all of you continued success! Wiley has some notables whom I want to single out. The first person is Georgette Beatty (my project editor). She has guided me from day one. Her patience, professionalism, and guidance have kept me sane and productive. Thanks for being great! Todd Lothery (my copy editor) is a pro who took my bundle of words and turned them into worthy messages, and I thank him. The technical editor, Juli Erhart-Graves, is a great financial pro whom I appreciate. She made sure that my logic is sound and my facts are straight. I wish her continued success. My gratitude again goes out to my fantastic acquisitions editor, Stacy Kennedy, for making this 3rd edition happen. For Dummies books don’t magically appear at the bookstore; they happen because of the foresight and efforts of people like Stacy. Wiley is fortunate to have her (and the others also mentioned)! Fran, Lipa Zyenska, I appreciate your great support during the writing and updating of this book. It’s not always easy dealing with the world, but with you by my side, I know that God has indeed blessed me. Te amo! Lastly, I want to acknowledge you, the reader. Over the years, you’ve made the For Dummies books what they are today. Your devotion to these wonderful books helped build a foundation that played a big part in the creation of this book and many more yet to come. Thank you!
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Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at http://dummies.custhelp.com. For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Senior Project Editor: Georgette Beatty
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Assistant Editor: Erin Calligan Mooney Editorial Program Coordinator: Joe Niesen Technical Editor: Juli Erhart-Graves Editorial Manager: Michelle Hacker Editorial Assistant: Jennette ElNaggar Cover Photo: Image Farm Cartoons: Rich Tennant (www.the5thwave.com) Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Kristin Ferguson-Wagstaffe, Product Development Director, Consumer Dummies Ensley Eikenburg, Associate Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services
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Contents at a Glance Introduction ................................ 1 Par t I: The Essentials of Stock Investing ............ 9 Chapter 1: Welcome to the World of Stock Investing ......................... 11 Chapter 2: Taking Stock of Your Current Financial Situation and Goals ......... 19 Chapter 3: Defining Common Approaches to Stock Investing .................. 37 Chapter 4: Recognizing the Risks ......................................... 47 Chapter 5: Say Cheese: Getting a Snapshot of the Market with Indexes ......... 63
Par t II: Before You Start Buying ................. 75 Chapter 6: Gathering Information ......................................... 77 Chapter 7: Going for Brokers............................................. 97 Chapter 8: Investing for Growth.......................................... 109 Chapter 9: Investing for Income .......................................... 123 Chapter 10: Getting a Grip on Economics ................................. 137
Par t III: Picking Winners ..................... 149 Chapter 11: Using Basic Accounting to Choose Winning Stocks ............... 151 Chapter 12: Decoding Company Documents............................... 167 Chapter 13: Analyzing Industries ......................................... 179 Chapter 14: Emerging Sector Opportunities ............................... 189 Chapter 15: Money, Mayhem, and Votes .................................. 203
Par t IV: Investment Strategies and Tactics ........ 213 Chapter 16: Choosing between Investing and Trading ....................... 215 Chapter 17: Selecting a Strategy That’s Just Right for You ................... 225 Chapter 18: Understanding Brokerage Orders and Trading Techniques ........ 235 Chapter 19: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ ............... 251 Chapter 20: Corporate Skullduggery: Looking at Insider Activity .............. 261 Chapter 21: Keeping More of Your Money from the Taxman ................. 273
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Par t V: The Par t of Tens ...................... 285 Chapter 22: Ten Ways to Profit before the Crowd Does ...................... 287 Chapter 23: Ten (Or So) Ways to Protect Your Stock Market Profits .......... 293 Chapter 24: Ten Red Flags for Stock Investors ............................. 299 Chapter 25: Ten Challenges and Opportunities for Stock Investors ............ 305
Par t VI: Appendixes ......................... 311 Appendix A: Resources for Stock Investors ................................ 313 Appendix B: Financial Ratios ............................................ 329
Index ................................... 339
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Table of Contents Introduction ................................. 1 About This Book ............................................... 1 Conventions Used in This Book ................................... 2 What You’re Not to Read ........................................ 3 Foolish Assumptions ............................................ 3 How This Book Is Organized ..................................... 4 Part I: The Essentials of Stock Investing ....................... 4 Part II: Before You Start Buying .............................. 4 Part III: Picking Winners .................................... 5 Part IV: Investment Strategies and Tactics..................... 6 Part V: The Part of Tens .................................... 6 Part VI: Appendixes ........................................ 7 Icons Used in This Book ......................................... 7 Where to Go from Here .......................................... 8
Par t I: The Essentials of Stock Investing ............. 9 Chapter 1: Welcome to the World of Stock Investing . . . . . . . . . . . . . .11 Understanding the Basics....................................... 12 Preparing to Buy Stocks ........................................ 12 Knowing How to Pick Winners ................................... 13 Recognizing stock value ................................... 13 Understanding how market capitalization affects stock value ... 14 Sharpening your investment skills .......................... 15 Boning Up on Strategies and Tactics ............................. 17
Chapter 2: Taking Stock of Your Current Financial Situation and Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Establishing a Starting Point by Preparing a Balance Sheet .......... 20 Step 1: Make sure you have an emergency fund ............... 21 Step 2: List your assets in decreasing order of liquidity ........ 22 Step 3: List your liabilities ................................. 24 Step 4: Calculate your net worth............................ 26 Step 5: Analyze your balance sheet .......................... 27 Funding Your Stock Program .................................... 29 Step 1: Tally up your income ............................... 30 Step 2: Add up your outgo ................................. 31
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Stock Investing For Dummies, 3rd Edition Step 3: Create a cash flow statement......................... 32 Step 4: Analyze your cash flow.............................. 33 Another option: Finding investment money in tax savings ...... 33 Setting Your Sights on Your Financial Goals....................... 34
Chapter 3: Defining Common Approaches to Stock Investing . . . . . . .37 Matching Stocks and Strategies with Your Goals ................... 38 Investing for the Future ........................................ 39 Focusing on the short term ................................ 39 Considering intermediate-term goals ........................ 40 Preparing for the long term ................................ 41 Investing for a Purpose ......................................... 42 Making loads of money quickly: Growth investing............. 42 Steadily making money: Income investing.................... 43 Investing for Your Personal Style ................................ 45 Conservative investing .................................... 45 Aggressive investing ...................................... 46
Chapter 4: Recognizing the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 Exploring Different Kinds of Risk................................. 48 Financial risk ............................................ 48 Interest rate risk.......................................... 49 Market risk .............................................. 52 Inflation risk ............................................. 54 Tax risk ................................................. 54 Political and governmental risks ............................ 54 Personal risks ............................................ 55 Emotional risk ........................................... 56 Minimizing Your Risk .......................................... 58 Gaining knowledge ........................................ 58 Staying out until you get a little practice ..................... 59 Putting your financial house in order ........................ 59 Diversifying your investments .............................. 60 Weighing Risk against Return ................................... 61
Chapter 5: Say Cheese: Getting a Snapshot of the Market with Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63 Knowing How Indexes Are Measured ............................. 63 Checking Out the Indexes ....................................... 65 The Dow Jones Industrial Average .......................... 65 Standard & Poor’s 500 ..................................... 68 Wilshire Total Market Index ................................ 69 Nasdaq indexes .......................................... 69 Russell 3000 Index........................................ 70 International indexes ...................................... 70
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Using the Indexes Effectively .................................... 71 Tracking the indexes ...................................... 72 Investing in indexes ....................................... 72
Par t II: Before You Start Buying ................. 75 Chapter 6: Gathering Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .77 Looking to Stock Exchanges for Answers.......................... 78 Understanding Stocks and the Companies They Represent .......... 79 Accounting for taste and a whole lot more ................... 79 Understanding how economics affects stocks................. 80 Staying on Top of Financial News................................ 84 Figuring out what a company’s up to ........................ 84 Discovering what’s new with an industry..................... 85 Knowing what’s happening with the economy ................ 85 Seeing what politicians and government bureaucrats are doing... 86 Checking for trends in society, culture, and entertainment ..... 86 Reading (And Understanding) Stock Tables ....................... 87 52-week high ............................................. 88 52-week low.............................................. 88 Name and symbol ........................................ 89 Dividend ................................................ 89 Volume ................................................. 89 Yield .................................................... 91 P/E ..................................................... 91 Day last ................................................. 92 Net change .............................................. 92 Using News about Dividends .................................... 92 Looking at important dates ................................ 93 Understanding why these dates matter ...................... 94 Evaluating Investment Tips ..................................... 95
Chapter 7: Going for Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .97 Defining the Broker’s Role ...................................... 97 Distinguishing between Full-Service and Discount Brokers .......... 99 Full-service brokers ....................................... 99 Discount brokers ........................................ 101 Choosing a Broker ............................................ 102 Discovering Various Types of Brokerage Accounts................ 103 Cash accounts .......................................... 103 Margin accounts......................................... 104 Option accounts ......................................... 105 Judging Brokers’ Recommendations............................. 105 Understanding basic recommendations ..................... 106 Asking a few important questions .......................... 106
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Stock Investing For Dummies, 3rd Edition Chapter 8: Investing for Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109 Becoming a Value-Oriented Growth Investor ..................... 110 Choosing Growth Stocks with a Few Handy Tips .................. 111 Looking for leaders in megatrends ......................... 112 Comparing a company’s growth to an industry’s growth ...... 113 Considering a company with a strong niche ................. 113 Checking out a company’s fundamentals .................... 114 Evaluating a company’s management ....................... 115 Noticing who’s buying and/or recommending a company’s stock..................................... 117 Making sure a company continues to do well ................ 118 Heeding investing lessons from history..................... 119 Exploring Small Caps and Speculative Stocks ..................... 119 Know when to avoid IPOs ................................. 120 Make sure a small cap stock is making money ............... 121 Analyze small cap stocks before you invest.................. 122
Chapter 9: Investing for Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123 Understanding the Basics of Income Stocks ...................... 123 Getting a grip on dividends and dividend rates............... 124 Recognizing who’s well-suited for income stocks ............. 124 Checking out the advantages of income stocks ............... 125 Watching out for the disadvantages of income stocks ......... 125 Analyzing Income Stocks ...................................... 127 Pinpointing your needs first ............................... 127 Checking out yield ....................................... 128 Looking at a stock’s payout ratio........................... 130 Examining a company’s bond rating ........................ 131 Diversifying your stocks .................................. 132 Exploring Some Typical Income Stocks .......................... 132 Utilities ................................................ 133 Real estate investment trusts (REITs)....................... 133 Royalty trusts ........................................... 135
Chapter 10: Getting a Grip on Economics . . . . . . . . . . . . . . . . . . . . . . .137 Breaking Down Microeconomics versus Macroeconomics .......... 138 Microeconomics......................................... 138 Macroeconomics........................................ 139 Understanding Important Concepts in Economic Logic ............ 139 Supply and demand ...................................... 140 Wants and needs ........................................ 140 Dynamic analysis versus static analysis ..................... 141 Cause and effect ......................................... 142 Surveying a Few Schools of Economic Thought ................... 142 The Marx school ........................................ 142 The Keynes school....................................... 143 The Austrian school ..................................... 145
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Understanding Some Current Economic Issues That Face Stock Investors .................................... 145 Inflation ................................................ 146 Government intervention ................................. 146
Par t III: Picking Winners ..................... 149 Chapter 11: Using Basic Accounting to Choose Winning Stocks . . .151 Recognizing Value When You See It ............................. 151 Understanding different types of value...................... 152 Putting the pieces together ............................... 154 Accounting for Value.......................................... 155 Breaking down the balance sheet .......................... 156 Looking at the income statement .......................... 159 Tooling around with ratios ................................ 162
Chapter 12: Decoding Company Documents . . . . . . . . . . . . . . . . . . . . .167 Getting a Message from the Bigwigs: The Annual Report ........... 167 Analyzing the annual report’s anatomy ..................... 168 Going through the proxy materials ......................... 172 Getting a Second Opinion ...................................... 172 Company documents filed with the SEC ..................... 172 Value Line .............................................. 174 Standard & Poor’s ....................................... 174 Moody’s Investment Service .............................. 175 Brokerage reports: The good, the bad, and the ugly .......... 175 Compiling Your Own Research Department ...................... 177
Chapter 13: Analyzing Industries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Interrogating the Industries .................................... 180 Which category does the industry fall into? ................. 180 Is the industry growing?.................................. 181 Are the industry’s products or services in demand? .......... 183 What does the industry’s growth rely on? ................... 183 Is the industry dependent on another industry? .............. 184 Who are the leading companies in the industry? ............. 184 Is the industry a target of government action? ............... 185 Outlining Key Industries ....................................... 185 Moving in: Real estate .................................... 186 Driving it home: Automotive .............................. 187 Talking tech: Computers and related electronics ............. 187 Banking on it: Financials .................................. 188
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Stock Investing For Dummies, 3rd Edition Chapter 14: Emerging Sector Opportunities . . . . . . . . . . . . . . . . . . . . .189 Bullish Opportunities ......................................... 190 Commodities ........................................... 191 Oil and gas ............................................. 192 Alternative energy ....................................... 193 Gold and other precious metals ........................... 194 Healthcare.............................................. 195 Defending the nation ..................................... 195 A Bearish Outlook............................................ 196 Avoiding consumer discretionary sectors ................... 196 A warning on real estate .................................. 197 The great credit monster ................................. 198 Cyclical stocks.......................................... 199 Important Considerations for Bulls and Bears .................... 199 Conservative and bullish ................................. 200 Aggressive and bullish ................................... 200 Conservative and bearish ................................. 201 Aggressive and bearish ................................... 201
Chapter 15: Money, Mayhem, and Votes . . . . . . . . . . . . . . . . . . . . . . . .203 Tying Together Politics and Stocks.............................. 204 Seeing the general effects of politics on stock investing ....... 204 Ascertaining the political climate .......................... 206 Distinguishing between nonsystemic and systemic effects ..... 207 Understanding price controls ............................. 209 Poking into Political Resources ................................. 209 Government reports to watch out for ....................... 210 Web sites to surf ........................................ 212
Par t IV: Investment Strategies and Tactics ......... 213 Chapter 16: Choosing between Investing and Trading . . . . . . . . . . . .215 The Differences between Investing and Trading ................... 215 The time factor .......................................... 216 The psychology factor ................................... 217 Checking out an example ................................. 217 Tools of the Trader ........................................... 220 Technical analysis ....................................... 220 Brokerage orders ........................................ 221 Advisory services ....................................... 221 The Basic Rules of Trading..................................... 222
Chapter 17: Selecting a Strategy That’s Just Right for You . . . . . . . .225 Laying Out Your Plans ........................................ 225 Living the bachelor life: Young single with no dependents ..... 226 Going together like a horse and carriage: Married with children .................................. 227
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Getting ready for retirement: Over 40 and either single or married................................. 227 Kicking back in the hammock: Already retired ............... 228 Allocating Your Assets ........................................ 228 Investors with less than $10,000 ........................... 229 Investors with $10,000 to $50,000 .......................... 230 Investors with $50,000 or more ............................ 230 Knowing When to Sell ......................................... 231
Chapter 18: Understanding Brokerage Orders and Trading Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .235 Checking Out Brokerage Orders ................................ 235 On the clock: Time-related orders .......................... 236 At your command: Condition-related orders ................. 238 The joys of technology: Advanced orders ................... 243 Buying on Margin............................................. 244 Examining marginal outcomes ............................. 245 Maintaining your balance ................................. 246 Striving for success on margin ............................. 246 Going Short and Coming Out Ahead ............................. 247 Setting up a short sale .................................... 248 Oops! Going short when prices grow taller .................. 249 Feeling the squeeze ...................................... 250
Chapter 19: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ. . . .251 Being Direct with DPPs ........................................ 252 Investing in a DPP ....................................... 252 Finding DPP alternatives .................................. 253 Recognizing the drawbacks ............................... 254 Dipping into DRPs............................................ 255 Getting a clue about compounding ......................... 255 Building wealth with optional cash payments ................ 256 Checking out the cost advantages .......................... 257 Weighing the pros with the cons ........................... 258 The One-Two Punch: Dollar Cost Averaging and DRPs ............. 258
Chapter 20: Corporate Skullduggery: Looking at Insider Activity . . .261 Tracking Insider Trading ...................................... 262 Looking at Insider Transactions ................................ 263 Breaking down insider buying............................. 264 Picking up tips from insider selling ......................... 265 Considering Corporate Stock Buybacks .......................... 266 Understanding why a company buys back shares ............ 267 Exploring the downside of buybacks ....................... 269 Stock Splits: Nothing to Go Bananas Over ........................ 269 Ordinary stock splits ..................................... 270 Reverse stock splits ...................................... 271
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Stock Investing For Dummies, 3rd Edition Chapter 21: Keeping More of Your Money from the Taxman . . . . . . .273 Paying through the Nose: The Tax Treatment of Different Investments ..................................... 274 Understanding ordinary income and capital gains ............ 274 Minimizing the tax on your capital gains .................... 275 Coping with capital losses ................................ 276 Evaluating gains and losses scenarios ...................... 277 Sharing Your Gains with the IRS ................................ 277 Filling out forms ......................................... 278 Playing by the rules ...................................... 279 Discovering the Softer Side of the IRS: Tax Deductions for Investors ... 279 Investment interest...................................... 280 Miscellaneous expenses.................................. 280 Donations of stock to charity .............................. 281 Knowing what you can’t deduct ........................... 281 Taking Advantage of Tax-Advantaged Retirement Investing ......... 281 IRAs ................................................... 282 401(k) plans ............................................ 283
Par t V: The Par t of Tens ...................... 285 Chapter 22: Ten Ways to Profit before the Crowd Does . . . . . . . . . . .287 Use Your Instincts ............................................ 287 Take Notice of Praise from Consumer Groups .................... 288 Check Out Powerful Demographics ............................. 288 Look for a Rise in Earnings ..................................... 289 Analyze Industries ............................................ 289 Stay Aware of Positive Publicity for Industries .................... 290 Watch Megatrends ........................................... 290 Keep Track of Politics ......................................... 290 Recognize Heavy Insider or Corporate Buying .................... 291 Follow Institutional Investors .................................. 292
Chapter 23: Ten (Or So) Ways to Protect Your Stock Market Profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293 Accrue Cash ................................................. 293 Spread Your Money across Several Stocks ....................... 293 Buy More of a Down (Yet Solid) Stock ........................... 294 Apply Long-Term Logic........................................ 294 Use the Almighty Stop-Loss Order .............................. 294 Use the Almighty Trailing Stop Order............................ 295 Place a Limit Order........................................... 295 Set Up Broker Triggers........................................ 296 Consider the Put Option ....................................... 296 Check Out the Covered Call Option ............................. 296 When All Else Fails, Sell ....................................... 297
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Chapter 24: Ten Red Flags for Stock Investors . . . . . . . . . . . . . . . . . . .299 Earnings Slow Down or Head South ............................. 299 Sales Slow Down ............................................. 300 Debt Is Too High or Unsustainable .............................. 301 Analysts Are Exuberant Despite Logic........................... 301 Insider Selling ................................................ 302 A Bond Rating Cut ............................................ 302 Increased Negative Coverage ................................... 302 Industry Problems ............................................ 303 Political Problems ............................................ 303 Funny Accounting: No Laughing Here!........................... 303
Chapter 25: Ten Challenges and Opportunities for Stock Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305 Debt, Debt, and More Debt ..................................... 305 Derivatives.................................................. 306 Real Estate .................................................. 307 Inflation ..................................................... 307 Pensions and Unfunded Liabilities .............................. 308 The Growth of Government .................................... 308 Recession/Depression......................................... 309 Commodities ................................................ 309 Energy ...................................................... 309 Dangers from Left Field........................................ 310
Par t VI: Appendixes ......................... 311 Appendix A: Resources for Stock Investors . . . . . . . . . . . . . . . . . . . . .313 Financial Planning Sources..................................... 313 The Language of Investing ..................................... 314 Textual Investment Resources ................................. 314 Periodicals and magazines ................................ 314 Books and pamphlets .................................... 315 Special books of interest to stock investors ................. 316 Investing Web Sites ........................................... 317 General investing Web sites ............................... 317 Stock investing Web sites ................................. 318 Investor Associations and Organizations ......................... 319 Stock Exchanges ............................................. 319 Finding Brokers .............................................. 319 Choosing brokers ........................................ 320 Brokers ................................................ 320 Fee-Based Investment Sources ................................. 321 Dividend Reinvestment Plans .................................. 322
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Stock Investing For Dummies, 3rd Edition Sources for Analysis .......................................... 323 Earnings and earnings estimates ........................... 323 Industry analysis ........................................ 323 Factors that affect market value ........................... 323 Technical analysis ....................................... 325 Insider trading .......................................... 325 Tax Benefits and Obligations ................................... 326 Fraud ....................................................... 326
Appendix B: Financial Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329 Liquidity Ratios .............................................. 330 Current ratio ............................................ 330 Quick ratio ............................................. 331 Operating Ratios ............................................. 331 Return on equity (ROE)................................... 331 Return on assets (ROA) .................................. 332 Sales to receivables ratio (SR) ............................. 332 Solvency Ratios .............................................. 333 Debt to net equity ratio ................................... 333 Working capital ......................................... 334 Common Size Ratios .......................................... 334 Valuation Ratios.............................................. 335 Price-to-earnings ratio (P/E) ............................... 335 Price to sales ratio (PSR) ................................. 336 Price to book ratio (PBR) ................................. 337
Index .................................... 339
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Introduction
S
tock Investing For Dummies, 3rd Edition, has been an honor for me to write. I’m grateful that I can share my thoughts, information, and experience with such a large and devoted group of readers. I think that this edition is my most important edition so far because so much change, volatility, and uncertainty have become a part of the stock market. It’s not your parents’ stock market anymore. The opportunities for great gains (and even greater losses) have reached an extreme. In some ways, today’s market reminds me of Dickens’ famous novel opener: “It was the best of times, it was the worst of times . . . .” In terms of what faces us in today’s world — economic uncertainty, terrorism, war, political tensions, higher taxes, rising inflation, unemployment, and so on — these seem like the worst of times. Yet when I think of the tools, strategies, and investing vehicles available for you to build (and protect) wealth, these can be the best of times. Successful stock investing takes diligent work and knowledge, like any other meaningful pursuit. This book can definitely help you avoid the mistakes others have made and can point you in the right direction. It will give you a heads up about trends and conditions that are found in few other stock investing guides. Explore the pages of this book and find the topics that most interest you within the world of stock investing. Let me assure you that I’ve squeezed over a quarter century of experience, education, and expertise between these covers. My track record is as good (or better) as the track records of the experts who trumpet their successes. More important, I share information to avoid common mistakes (some of which I made myself!). Understanding what not to do can be just as important as figuring out what to do. In all the years that I’ve counseled and educated investors, the single difference between success and failure, between gain and loss, boils down to one word: knowledge. Take this book as your first step in a lifelong learning adventure.
About This Book The stock market has been a cornerstone of the investor’s passive wealthbuilding program for over a century and continues in this role. This decade has been one huge roller coaster ride for stock investors. Fortunes have been made and lost. With all the media attention, all the talking heads on radio and
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Stock Investing For Dummies, 3rd Edition television, and the books with titles like Dow at 36,000, the investing public still didn’t avoid losing trillions in a historic stock market debacle. Sadly, even the so-called experts who understand stocks didn’t see the economic and geopolitical forces that acted like a tsunami on the market. With just a little more knowledge and a few wealth-preserving techniques, more investors could have held onto their hard-earned stock market fortunes. Cheer up, though: This book gives you an early warning on those megatrends and events that will affect your stock portfolio. While other books may tell you about stocks, this book tells you about stocks and what affects them. This book is designed to give you a realistic approach to making money in stocks. It provides the essence of sound, practical stock investing strategies and insights that have been market-tested and proven from nearly 100 years of stock market history. I don’t expect you to read it cover to cover, although I’d be delighted if you read every word! Instead, this book is designed as a reference tool. Feel free to read the chapters in whatever order you choose. You can flip to the sections and chapters that interest you or those that include topics that you need to know more about. Stock Investing For Dummies, 3rd Edition, is also quite different from the “get rich with stocks” titles that have crammed the bookshelves in recent years. It doesn’t take a standard approach to the topic; it doesn’t assume that stocks are a sure thing and the be-all, end-all of wealth building. In fact, at times in this book, I tell you not to invest in stocks. This book can help you succeed not only in up markets but also in down markets. Bull markets and bear markets come and go, but the informed investor can keep making money no matter what. To give you an extra edge, I’ve tried to include information about the investing environment for stocks. Whether it’s politics or hurricanes (or both), you need to know how the big picture affects your stock investment decisions.
Conventions Used in This Book To make navigating through this book easier, I’ve established the following conventions: ✓ Boldface text points out keywords or the main parts of bulleted items. ✓ Italics highlight new terms that are defined. ✓ Monofont is used for Web addresses.
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Introduction
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When this book was printed, some Web addresses may have needed to break across two lines of text. If that happened, rest assured that I haven’t put in any extra characters (such as hyphens) to indicate the break. So when using one of these Web addresses, just type in exactly what you see in this book, pretending as though the line break doesn’t exist.
What You’re Not to Read Sidebars (gray boxes of text) in this book give you a more in-depth look at a certain topic. While they further illuminate a particular point, these sidebars aren’t crucial to your understanding of the rest of the book. Feel free to read them or skip them. Of course, I’d love for you to read them all, but my feelings won’t be hurt if you decide to skip them over. The text that accompanies the Technical Stuff icon (see the forthcoming section “Icons Used in This Book”) can be passed over as well. The text associated with this icon gives some technical details about stock investing that are certainly interesting and informative, but you can still come away with the information you need without reading this text.
Foolish Assumptions I figure you’ve picked up this book for one or more of the following reasons: ✓ You’re a beginner and want a crash course on stock investing that’s an easy read. ✓ You’re already a stock investor, and you need a book that allows you to read only those chapters that cover specific stock investing topics of interest to you. ✓ You need to review your own situation with the information in the book to see if you missed anything when you invested in that hot stock that your brother-in-law recommended. ✓ You need a great gift! When Uncle Mo is upset over his poor stock picks, you can give him this book so he can get back on his financial feet. Be sure to get a copy for his broker, too. (Odds are that the broker was the one who made those picks to begin with.)
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Stock Investing For Dummies, 3rd Edition
How This Book Is Organized The information is laid out in a straightforward format. The parts progress in a logical approach that any investor interested in stocks can follow very easily.
Part I: The Essentials of Stock Investing This part is for everyone. Understanding the essentials of stock investing and investing in general will only help you, especially in uncertain economic times. Stocks may even touch your finances in ways not readily apparent. For example, stocks aren’t only in individual accounts; they’re also in mutual funds and pension plans. An important point is that stocks are really financial tools that are a means to an end. Investors should be able to answer the question, “Why am I considering stocks at all?” Stocks are a great vehicle for wealth building, but only if investors realize what they can accomplish and how to use them. Chapter 2 explains how to take stock of your current financial situation and goals, and Chapter 3 defines common approaches to stock investing. One of the essentials of stock investing is understanding risk. Most people are clueless about risk. Chapter 4, on risk, is one of the most important chapters that serious stock investors should read. You can’t avoid every type of risk out there (life itself embodies risk). However, this chapter can help you recognize it and find ways to minimize it in your stock investing program.
Part II: Before You Start Buying When you’re ready to embark on your career as a stock investor, you need to use some resources to gather information about the stocks you’re interested in. Fortunately, you live in the information age. I pity the investors from the 1920s who didn’t have access to so many resources, but today’s investors are in an enviable position. This part tells you where to find information and how to use it to be a more knowledgeable investor (a rarity in recent years!). For example, I explain that stocks can be used for both growth and income purposes, and I discuss the characteristics of each; see Chapters 8 and 9 for more information.
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Introduction
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Chapter 6 is a great starting place for your information gathering; I show you how to stay on top of financial news and read stock tables, among other topics. When you’re ready to invest, you’ll invariably have to turn to a broker. Several types of brokers are out there, so you should know which is which. The wrong broker can make you . . . uh . . . broker. Chapter 7 helps you choose. New to this edition is Chapter 10, which gives you the lowdown on how a grasp of basic economics can make you more successful with your stock investing strategy.
Part III: Picking Winners Part III is about picking good stocks by using microeconomics, meaning that you look at the stocks of individual companies. I explain how to evaluate a company’s products, services, and other factors so that you can determine whether a company is strong and healthy. One of the major differences with this edition versus earlier editions is the emphasis on emerging sector opportunities. If I can steer you toward those segments of the stock market that show solid promise for the coming years, that alone would make your stock portfolio thrive. Putting your money into solid companies in thriving industries has been the hallmark of superior stock investing throughout history. It’s no different now. Check out Chapter 14 if you want to know more about emerging sector opportunities. Where do you turn to find out about a company’s financial health? In Chapters 11 and 12, I show you the documents you should review to make a more informed decision. When you find the information, you’ll discover how to make sense of that data as well. While you’re at it, check out Chapter 13 (on analyzing industries) and Chapter 15 (on how politics affects the art of stock picking). I compare buying stock to picking goldfish. If you look at a bunch of goldfish to choose which ones to buy, you want to make sure that you pick the healthiest ones. With stocks, you also need to pick companies that are healthy. Part III can help you do that.
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Stock Investing For Dummies, 3rd Edition
Part IV: Investment Strategies and Tactics Even the stocks of great companies can fall in a bad investing environment. This is where you should be aware of the “macro.” If stocks were goldfish, the macro would be the pond or goldfish bowl. In that case, even healthy goldfish can die if the water is toxic. Therefore, you should monitor the investing environment for stocks. Part IV reveals tips, strategies, and resources that you shouldn’t ignore. Investing is a long-term activity, but stocks can also be short-term opportunities, so I discuss stock trading in Chapter 16. In Chapter 17, I provide guidance on selecting an investing strategy that’s right for your personal and financial situations. After you understand stocks and the economic environment in which they operate, choose the strategy and the tactics to help steer you to your wealth-building objectives. Chapter 18 reveals some of my all-time favorite techniques for building wealth and holding onto your stock investment gains (definitely check it out). You may be an investor, but that doesn’t mean that you have deep pockets. Chapter 19 tells you how to buy stocks with low (or no) transaction costs. If you’re going to buy the stock anyway, why not save on commissions and other costs? As an investor, you must keep an eye on what company insiders are doing. In Chapter 20, I explain what it may mean if a company’s management is buying or selling the same stock that you’re considering. After you spend all your time, money, and effort to grow your money in the world of stocks, you have yet another concern: holding onto your hardearned gains. This challenge is summarized in one word: taxes. Sound tax planning is crucial for everyone who works hard. After all, taxes are the biggest expense in your lifetime (right after children!). See Chapter 21 for more information.
Part V: The Part of Tens I wrap up the book with a hallmark of For Dummies books — the Part of Tens. These chapters give you a mini crash course in stock investing, including ten ways to protect yourself from fraud.
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Introduction
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In this part, I offer some tips on how to profit with stocks before the crowd does (Chapter 22) and how to protect those profits (Chapter 23). I also provide a list of ten red flags for stock investors (Chapter 24), along with ten challenges and opportunities that face stock investors (Chapter 25).
Part VI: Appendixes Don’t overlook the appendixes. I pride myself on the resources I can provide my students and readers so that they can make informed investment decisions. Whether the topic is stock investing terminology, economics, or avoiding capital gains taxes, I include a treasure trove of resources to help you. Whether you go to a bookstore, the library, or the Internet, Appendix A gives you some great places to turn to for help. In Appendix B, I explain financial ratios. These important numbers help you better determine whether to invest in a particular company’s stock.
Icons Used in This Book When you see this icon, I’m reminding you about some information that you should always keep stashed in your memory, whether you’re new to investing or an old pro. The text attached to this icon may not be crucial to your success as an investor, but it may enable you to talk shop with investing gurus and better understand the financial pages of your favorite business publication or Web site.
This icon flags a particular bit of advice that just may give you an edge over other investors.
Pay special attention to this icon because the advice can prevent headaches, heartaches, and financial aches.
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Stock Investing For Dummies, 3rd Edition
Where to Go from Here You may not need to read every chapter to make you more confident as a stock investor, so feel free to jump around to suit your personal needs. Because every chapter is designed to be as self-contained as possible, it won’t do you any harm to cherry-pick what you really want to read. But if you’re like me, you may still want to check out every chapter because you never know when you may come across a new tip or resource that will make a profitable difference in your stock portfolio. I want you to be successful so that I can brag about you in the next edition!
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Part I
The Essentials of Stock Investing
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In this part . . .
he latest market turmoil and uncertainty tell investors to get back to square one. Your success is dependent on doing your homework before you invest your first dollar in stocks. Most investors don’t realize that they should be scrutinizing their own situations and financial goals at least as much as they scrutinize stocks. How else can you know which stocks are right for you? Too many people risk too much simply because they don’t take stock of their current needs, goals, and risk tolerance before they invest. The chapters in this part tell you what you need to know to choose the stocks that best suit you.
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Chapter 1
Welcome to the World of Stock Investing In This Chapter ▶ Knowing the essentials ▶ Doing your own research ▶ Recognizing winners ▶ Exploring investment strategies
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tock investing was the hot thing during the late 1990s — a trend just like the hula hoop and pet rocks. With the new millennium, however, a reversal of fortunes has occurred as the bear market of 2000–2002 rocked our world (a bear market is a prolonged period of falling prices — in this case, stock prices). This decade has been a wild roller coaster ride that saw the market hit new highs in 2007, although it’s down in ugly fashion in 2008. During this time, the public figured out that stock investing isn’t for wildeyed amateurs or dart-throwers (or the worst . . . wild-eyed amateur dartthrowers!). I wrote much of this 3rd Edition with current events and market conditions on my radar screen. The year 2008 witnessed some ominous events that will make stock investing very interesting (to say the least) for the time being. Don’t let that scare you, though; informed investors have made money in all sorts of markets — good, bad, and even ugly. As I write this, the conditions are in place for an inflationary depression, but selecting stocks that can benefit from these challenging times could indeed make you much wealthier. The purpose of this book is not only to tell you about the basics of stock investing but also to let you in on some solid strategies that can help you profit from the stock market. Before you invest your first dollar, you need to understand the basics of stock investing, which I introduce in this chapter.
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Part I: The Essentials of Stock Investing
Understanding the Basics The basics are so basic that few people are doing them. Perhaps the most basic (and therefore most important) thing to grasp is the risk you face whenever you do anything (like putting your hard-earned money in an investment like a stock). When you lose track of the basics, you lose track of why you invested to begin with. Find out more about risk (and the different kinds of risk) in Chapter 4. When the late comedian Henny Youngman was asked, “How is your wife?” he responded, “Compared to what?” This also applies to stocks. When you’re asked, “How is your stock?” you can very well respond that it’s doing well, especially when compared to an acceptable yardstick such as a stock index (like the S&P 500). Find out more about indexes in Chapter 5. The bottom line in stock investing is that you shouldn’t immediately send your money to a brokerage account or go to a Web site and click “buy stock.” The first thing you should do is find out as much as you can about what stocks are and how to use them to achieve your wealth-building goals. Chapters 2 and 3 help you take stock of your current financial situation and help you understand common approaches to stock investing. Before you continue, I want to get straight exactly what a stock is. Stock is a type of security that indicates ownership in a corporation and represents a claim on the part of that corporation’s assets and earnings. The two primary types of stocks are common and preferred. Common stock (what I cover throughout this book) entitles the owner to vote at shareholders’ meetings and receive any dividends that the company issues. Preferred stock doesn’t usually confer voting rights, but it does include some rights that exceed those of common stock. Preferred stockholders, for example, have priority in certain conditions, such as receiving dividends before common stockholders in the event that the corporation is going bankrupt.
Preparing to Buy Stocks Gathering information is critical in your stock-investing pursuits. You should gather information on your stock picks two times: before you invest and after. Obviously, you should become more informed before you invest your first dollar, but you also need to stay informed about what’s happening to the company whose stock you buy, and also about the industry and the general economy. To find the best information sources, check out Chapter 6.
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Chapter 1: Welcome to the World of Stock Investing
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When you’re ready to invest, you need a brokerage account. How do you know which broker to use? Chapter 7 provides some answers and resources to help you choose a broker.
Knowing How to Pick Winners When you get past the basics, you can get to the meat of stock picking. Successful stock picking isn’t mysterious, but it does take some time, effort, and analysis. And the effort is worthwhile because stocks are a convenient and important part of most investors’ portfolios. Read the following sections and be sure to leapfrog to the relevant chapters to get the inside scoop on hot stocks.
Recognizing stock value Imagine that you like eggs and you’re buying them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies’ stock. The grocery store is the stock market. What if two brands of eggs are similar, but one costs 50 cents a carton and the other costs 75 cents? Which would you choose? Odds are that you’d look at both brands, judge their quality, and if they’re indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same is true of stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side. What if the quality of the two brands of eggs is significantly different, but their prices are the same? If one brand of eggs is stale, of poor quality, and priced at 50 cents and the other brand is fresh, of superior quality, and also priced at 50 cents, which would you get? I’d take the good brand because they’re better eggs. Perhaps the lesser eggs are an acceptable purchase at 10 cents, but they’re definitely overpriced at 50 cents. The same example works with stocks. A poorly run company isn’t a good choice if you can buy a better company in the marketplace at the same — or a better — price. Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars. (Otherwise you get egg on your face. You saw that one coming, right?)
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Part I: The Essentials of Stock Investing
Understanding how market capitalization affects stock value You can determine a company’s value (and thus the value of its stock) in many ways. The most basic way is to look at the company’s market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share. Calculating the market cap is easy. If a company has 1 million shares outstanding and its share price is $10, the market cap is $10 million. Small cap, mid cap, and large cap aren’t references to headgear; they’re references to how large a company is as measured by its market value. Here are the five basic stock categories of market capitalization: ✓ Micro cap (under $250 million): These stocks are the smallest and hence the riskiest available. ✓ Small cap ($250 million to $1 billion): These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is “potential.” ✓ Mid cap ($1 billion to $10 billion): For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps. ✓ Large cap ($10 billion to $50 billion): This category is usually best reserved for conservative stock investors who want steady appreciation with greater safety. Stocks in this category are frequently referred to as blue chips. ✓ Ultra cap (over $50 billion): These stocks are also called mega caps and obviously refer to companies that are the biggest of the big. Stocks such as General Electric and Exxon Mobil are examples. From a safety point of view, a company’s size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees: Which tree is sturdier, a giant California redwood or a small oak tree that’s just a year old? In a great storm, the redwood holds up well, while the smaller tree has a rough time. But you also have to ask yourself which tree has more opportunity for growth. The redwood may not have much growth left, but the small oak tree has plenty of growth to look forward to.
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Chapter 1: Welcome to the World of Stock Investing
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For beginning investors, comparing market cap to trees isn’t so far-fetched. You want your money to branch out without becoming a sap. Although market capitalization is important to consider, don’t invest (or not invest) based solely on it. It’s just one measure of value. As a serious investor, you need to look at numerous factors that can help you determine whether any given stock is a good investment. Keep reading — this book is full of information to help you decide.
Sharpening your investment skills Investors who analyze a company can better judge the value of its stock and profit from buying and selling it. Your greatest asset in stock investing is knowledge (and a little common sense). To succeed in the world of stock investing, keep in mind these key success factors: ✓ Understand why you want to invest in stocks. Are you seeking appreciation (capital gains) or income (dividends)? Look at Chapters 8 and 9 for information on these topics. ✓ Get a good grounding in economics. It could save your financial life! In Chapter 10, I include some basic (but interesting) points on economics because I think that stock investors (as a group) are woefully undereducated in economics and are therefore at risk (translation: bad stock decisions!). Check it out — you’ll be glad you did. ✓ Do some research. Look at the company whose stock you’re considering to see whether it’s a profitable business worthy of your investment dollars. Chapters 11 and 12 help you scrutinize companies. ✓ Choosing a winning stock also means that you choose a winning industry. You’ll frequently see stock prices of mediocre companies in hot industries rise higher and faster than solid companies in floundering industries. Therefore, choosing the industry is very important. Find out more about analyzing industries in Chapter 13. ✓ Understand and identify megatrends. Doing so makes it easier for you to make money. This edition spends more time and provides more resources to help you see the opportunities in emerging sectors and avoid the problem areas (see Chapter 14 for details). ✓ Understand how the world affects your stock. Stocks succeed or fail in large part because of the environment in which they operate. Economics (see Chapter 10) and politics (see Chapter 15) make up that world, so you should know something about them.
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Part I: The Essentials of Stock Investing
Stock market insanity Have you ever noticed a stock going up even though the company is reporting terrible results? How about seeing a stock nosedive despite the fact that the company is doing well? What gives? Well, judging the direction of a stock in a short-term period — over the next few days or weeks — is almost impossible. Yes, in the short term, stock investing is irrational. The price of a stock and the value of its company seem disconnected and crazy. The key phrase to remember is “short term.” A stock’s price and the company’s value become more logical over an extended period of time.
The longer a stock is in the public’s view, the more rational the performance of the stock’s price. In other words, a good company continues to draw attention to itself; hence, more people want its stock, and the share price rises to better match the company’s value. Conversely, a bad company doesn’t hold up to continued scrutiny over time. As more and more people see that the company isn’t doing well, the share price declines. Over the long run, a stock’s share price and the company’s value eventually become equal for the most part.
✓ Use investing strategies like the pros do. In other words, how you go about investing can be just as important as what you invest in. Chapters 17, 18, and 19 highlight techniques for investing to help you make more money from your stocks. ✓ Keep more of the money you earn. After all your great work in getting the right stocks and making the big bucks, you should know about keeping more of the fruits of your investing. I cover taxes in stock investing in Chapter 21. ✓ Sometimes, what people tell you to do with stocks is not as revealing as what people are actually doing. This is why I like to look at company insiders before I buy or sell a particular stock. To find out more about insider buying and selling, read Chapter 20. Actually, every chapter in this book offers you valuable guidance on some essential aspect of the fantastic world of stocks. The knowledge you pick up and apply from these pages has been tested over nearly a century of stock picking. The investment experience of the past — the good, the bad, and some of the ugly — is here for your benefit. Use this information to make a lot of money (and make me proud!). And don’t forget to check out the appendixes, where I provide a wide variety of investing resources and financial ratios!
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Chapter 1: Welcome to the World of Stock Investing
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Boning Up on Strategies and Tactics Successful investing isn’t just what you invest in; it’s also the way you invest. I’m very big on strategies such as trailing stops and limit orders. You can find out more in Chapter 18. Buying stocks doesn’t always mean that you must buy through a broker and that it must be 100 shares. You can buy stock for as little as $25 using programs such as dividend reinvestment plans. Chapter 19 tells you more. While you’re at it, you may as well find out what the corporate insiders are doing. Why? Because corporate insiders are among the first to find out what’s really going on inside a company, and that knowledge is reflected in their investing decisions, which you should pay attention to. You can find out more about insider trading and other management doings in Chapter 20.
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Part I: The Essentials of Stock Investing
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Chapter 2
Taking Stock of Your Current Financial Situation and Goals In This Chapter ▶ Preparing your personal balance sheet ▶ Looking at your cash flow statement ▶ Determining your financial goals
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es, you want to make the big bucks. Or maybe you just want to get back the big bucks you lost in stocks during the bear market (a long period of falling prices) of 2000–2002, or perhaps in the tumultuous volatility of 2007 and early 2008. (Investors who followed the guidelines from the 1st and 2nd editions of this book did much better than the crowd!) Either way, you want your money to grow so that you can have a better life. But before you make reservations for that Caribbean cruise you’re dreaming about, you have to map out your action plan for getting there. Stocks can be a great component of most wealth-building programs, but you must first do some homework on a topic that you should be very familiar with — yourself. That’s right. Understanding your current financial situation and clearly defining your financial goals are the first steps in successful investing. Let me give you an example. I met an investor at one of my seminars who had a million dollars worth of Procter & Gamble (PG) stock, and he was nearing retirement. He asked me whether he should sell his stock and be more growth-oriented and invest in a batch of small cap stocks (stocks of a company worth $250 million to $1 billion; see Chapter 1 for more information). Because he already had enough assets to retire on at that time, I said that he didn’t need to get more aggressive. In fact, I told him that he had too much tied to a single stock, even though it was a solid, large company. What would happen to his assets if problems arose at PG? It seemed obvious to tell him to shrink his stock portfolio and put that money elsewhere, such as paying off debt or adding investment-grade bonds for diversification.
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Part I: The Essentials of Stock Investing This chapter is undoubtedly one of the most important chapters in this book. At first, you may think it’s a chapter more suitable for some general book on personal finance. Wrong! Unsuccessful investors’ greatest weakness is not understanding their financial situation and how stocks fit in. Often, I counsel people to stay out of the stock market if they aren’t prepared for the responsibilities of stock investing — they haven’t been regularly reviewing the company’s financial statements or tracking the company’s progress. Investing in stocks requires balance. Investors sometimes tie up too much money in stocks, putting themselves at risk of losing a significant portion of their wealth if the market plunges. Then again, other investors place little or no money in stocks and therefore miss out on excellent opportunities to grow their wealth. Investors should make stocks a part of their portfolios, but the operative word is part. You should let stocks take up only a portion of your money. A disciplined investor also has money in bank accounts, investmentgrade bonds, precious metals, and other assets that offer growth or income opportunities. Diversification is the key to minimizing risk. (For more on risk, see Chapter 4.)
Establishing a Starting Point by Preparing a Balance Sheet Whether you’re already in stocks or you’re looking to get into stocks, you need to find out about how much money you can afford to invest. No matter what you hope to accomplish with your stock investing plan, the first step you should take is to figure out how much you own and how much you owe. To do this, prepare and review your personal balance sheet. A balance sheet is simply a list of your assets, your liabilities, and what each item is currently worth so you can arrive at your net worth. Your net worth is total assets minus total liabilities. I know that these terms sound like accounting mumbo jumbo, but knowing your net worth is important to your future financial success, so just do it. Composing your balance sheet is simple. Pull out a pencil and a piece of paper. For the computer savvy, a spreadsheet software program accomplishes the same task. Gather all your financial documents, such as bank and brokerage statements and other such paperwork — you need figures from these documents. Then follow the steps that I outline in the following sections. Update your balance sheet at least once a year to monitor your financial progress (is your net worth going up or down?).
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Chapter 2: Taking Stock of Your Current Financial Situation and Goals
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Your personal balance sheet is really no different from balance sheets that giant companies prepare. (The main difference is a few zeros, but you can use my advice in this book to work on changing that.) In fact, the more you find out about your own balance sheet, the easier it is to understand the balance sheet of companies in which you’re seeking to invest. See Chapter 11 for details on reviewing company balance sheets.
Step 1: Make sure you have an emergency fund First, list cash on your balance sheet. Your goal is to have, in reserve, at least three to six months’ worth of your gross living expenses in cash and cash equivalents. The cash is important because it gives you a cushion. Three to six months is usually enough to get you through the most common forms of financial disruption, such as losing your job. If your monthly expenses (or outgo) are $2,000, you should have at least $6,000, and probably closer to $12,000, in a secure, FDIC-insured, interestbearing bank account (or other, relatively safe interest-bearing vehicle such as a money market fund). Consider this account an emergency fund and not an investment. Don’t use this money to buy stocks. Too many Americans don’t have an emergency fund, meaning that they put themselves at risk. Walking across a busy street while wearing a blindfold is a great example of putting yourself at risk, and in recent years, investors have done the financial equivalent. Investors piled on tremendous debt, put too much into investments (such as stocks) that they didn’t understand, and had little or no savings. One of the biggest problems during this past decade was that savings were sinking to record lows while debt levels were reaching new heights. People then sold many stocks because they needed funds for — you guessed it — paying bills and debt. Resist the urge to start thinking of your investment in stocks as a savings account generating over 20 percent per year. This is dangerous thinking! If your investments tank, or if you lose your job, you will have financial difficulty and that will affect your stock portfolio (you may have to sell some stocks in your account just to get money to pay the bills). An emergency fund helps you through a temporary cash crunch.
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Step 2: List your assets in decreasing order of liquidity Liquid assets aren’t references to beer or cola (unless you’re AnheuserBusch). Instead, liquidity refers to how quickly you can convert a particular asset (something you own that has value) into cash. If you know the liquidity of your assets, including investments, you have some options when you need cash to buy some stock (or pay some bills). All too often, people are short on cash and have too much wealth tied up in illiquid investments such as real estate. Illiquid is just a fancy way of saying that you don’t have the immediate cash to meet a pressing need. (Hey, we’ve all had those moments!) Review your assets and take measures to ensure that enough of them are liquid (along with your illiquid assets). Listing your assets in order of liquidity on your balance sheet gives you an immediate picture of which assets you can quickly convert to cash and which ones you can’t. If you need money now, you can see that cash in hand, your checking account, and your savings account are at the top of the list. The items last in order of liquidity become obvious; they’re things like real estate and other assets that can take a long time to convert to cash. Selling real estate, even in a seller’s market, can take months. Investors who don’t have adequate liquid assets run the danger of selling assets quickly and possibly at a loss because they scramble to accumulate the cash for their short-term financial obligations. For stock investors, this scramble may include prematurely selling stocks that they originally intended to use as longterm investments. Table 2-1 shows a typical list of assets in order of liquidity. Use it as a guide for making your own asset list.
Table 2-1
John Q. Investor: Personal Assets as of December 31, 2008
Asset Item
Market Value
Annual Growth Rate %
$150
0
Current assets Cash on hand and in checking
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Bank savings accounts and certificates of deposit
$5,000
2%
Stocks
$2,000
11%
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Market Value
Annual Growth Rate %
Mutual funds
$2,400
9%
Total current assets
$9,790
23
Long-term assets Auto
$1,800
–10%
Residence
$150,000
5%
Real estate investment
$125,000
6%
Personal stuff (such as jewelry)
$4,000
Total long-term assets
$280,800
Total assets
$290,590
Here’s how to break down the information in Table 2-1: ✓ The first column describes the asset. You can quickly convert current assets to cash — they’re more liquid; long-term assets have value, but you can’t necessarily convert them to cash quickly — they aren’t very liquid. Please take note — I have stocks listed as short-term in the table. The reason is that this balance sheet is meant to list items in order of liquidity. Liquidity is best embodied in the question, “How quickly can I turn this asset into cash?” Because a stock can be sold and converted to cash very quickly, it’s a good example of a liquid asset. (However, that’s not the main purpose for buying stocks.) ✓ The second column gives the current market value for that item. Keep in mind that this value isn’t the purchase price or original value; it’s the amount you would realistically get if you sold the asset in the current market at that moment. ✓ The third column tells you how well that investment is doing, compared to one year ago. If the percentage rate is 5 percent, that item increased in value by 5 percent from a year ago. You need to know how well all your assets are doing. Why? To adjust your assets for maximum growth or to get rid of assets that are losing money. Assets that are doing well are kept (consider increasing your holdings in these assets), and assets that are down in value should be scrutinized to see whether they’re candidates for removal. Perhaps you can sell them and reinvest the money elsewhere. In addition, the realized loss has tax benefits (see Chapter 21).
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Part I: The Essentials of Stock Investing Figuring the annual growth rate (in the third column) as a percentage isn’t difficult. Say that you buy 100 shares of the stock Gro-A-Lot Corp. (GAL), and its market value on December 31, 2007, is $50 per share for a total market value of $5,000 (100 shares × $50 per share). When you check its value on December 31, 2008, you find out that the stock is at $60 per share for a total market value of $6,000 (100 shares × $60). The annual growth rate is 20 percent. You calculate this by taking the amount of the gain ($60 per share less $50 per share = $10 gain per share), which is $1,000 (100 shares times the $10 gain), and dividing it by the value at the beginning of the time period ($5,000). In this case, you get 20 percent ($1,000 ÷ $5,000). What if GAL also generates a dividend of $2 per share during that period — now what? In that case, GAL generates a total return of 24 percent. To calculate the total return, add the appreciation ($10 per share × 100 shares = $1,000) and the dividend income ($2 per share × 100 shares = $200) and divide that sum ($1,000 + $200, or $1,200) by the value at the beginning of the year ($50 per share × 100 shares, or $5,000). The total is $1,200 ÷ $5,000, or 24 percent. ✓ The last line lists the total for all the assets and their current market value.
Step 3: List your liabilities Liabilities are simply the bills that you’re obligated to pay. Whether it’s a credit card bill or a mortgage payment, a liability is an amount of money you have to pay back eventually (usually with interest). If you don’t keep track of your liabilities, you may end up thinking that you have more money than you really do. Table 2-2 lists some common liabilities. Use it as a model when you list your own. You should list the liabilities according to how soon you need to pay them. Credit card balances tend to be short-term obligations, while mortgages are long-term.
Table 2-2
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Listing Personal Liabilities
Liabilities
Amount
Paying Rate %
Credit cards
$4,000
15%
Personal loans
$13,000
10%
Mortgage
$100,000
8%
Total liabilities
$117,000
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Here’s a summary of the information in Table 2-2: ✓ The first column names the type of debt. Don’t forget to include student loans and auto loans if you have them. Never avoid listing a liability because you’re embarrassed to see how much you really owe. Be honest with yourself — doing so helps you improve your financial health. ✓ The second column shows the current value (or current balance) of your liabilities. List the most current balance to see where you stand with your creditors. ✓ The third column reflects how much interest you’re paying for carrying that debt. This information is an important reminder about how debt can be a wealth zapper. Credit card debt can have an interest rate of 18 percent or more, and to add insult to injury, it isn’t even tax-deductible. Using a credit card to make even a small purchase costs you if you don’t pay off the balance each month. Within a year, a $50 sweater at 18 percent costs $59 when you add in the potential interest you pay. If you compare your liabilities in Table 2-2 and your personal assets in Table 2-1, you may find opportunities to reduce the amount you pay for interest. Say, for example, that you pay 15 percent on a credit card balance of $4,000 but also have a personal asset of $5,000 in a bank savings account that’s earning 2 percent in interest. In that case, you may want to consider taking $4,000 out of the savings account to pay off the credit card balance. Doing so saves you $520; the $4,000 in the bank was earning only $80 (2 percent of $4,000), while you were paying $600 on the credit card balance (15 percent of $4,000). If you can’t pay off high-interest debt, at least look for ways to minimize the cost of carrying the debt. The most obvious ways include the following: ✓ Replace high-interest cards with low-interest cards. Many companies offer incentives to consumers, including signing up for cards with favorable rates (recently under 10 percent) that can be used to pay off highinterest cards (typically 12 to 18 percent or higher). ✓ Replace unsecured debt with secured debt. Credit cards and personal loans are unsecured (you haven’t put up any collateral or other asset to secure the debt); therefore, they have higher interest rates because this type of debt is considered riskier for the creditor. Sources of secured debt (such as home equity line accounts and brokerage accounts) provide you with a means to replace your high-interest debt with lowerinterest debt. You get lower interest rates with secured debt because it’s less risky for the creditor — the debt is backed up by collateral (your home or your stocks).
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Part I: The Essentials of Stock Investing ✓ Replace variable-interest debt with fixed-interest debt. Think about how homeowners got blindsided when their monthly payments on adjustable-rate mortgages went up drastically in the wake of the housing bubble that popped during 2005–2008. If you can’t lower your debt, at least make it fixed and predictable. The year 2007 was the 11th consecutive year that personal bankruptcies surpassed the million mark in the United States. Corporate bankruptcies were also at record levels. Due to the fallout of the housing bubble, it’s probably safe to say that by the time you read this, 2008 will also join the million-plus bankruptcies club, unfortunately. Make a diligent effort to control and reduce your debt; otherwise, the debt can become too burdensome. If you don’t control it, you may have to sell your stocks just to stay liquid. Remember, Murphy’s Law states that you will sell your stock at the worst possible moment! Don’t go there.
Step 4: Calculate your net worth Your net worth is an indication of your total wealth. You can calculate your net worth with this basic equation: total assets (Table 2-1) less total liabilities (Table 2-2) equal net worth (net assets or net equity). Table 2-3 shows this equation in action with a net worth of $173,590 — a very respectable number. For many investors, just being in a position where assets exceed liabilities (a positive net worth) is great news. Use Table 2-3 as a model to analyze your own financial situation. Your mission (if you choose to accept it — and you should) is to ensure that your net worth increases from year to year as you progress toward your financial goals (I discuss financial goals later in this chapter).
Table 2-3
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Figuring Your Personal Net Worth
Totals
Amounts ($)
Increase from Year Before
Total assets (from Table 2-1)
$290,590
+5%
Total liabilities (from Table 2-2)
($117,000)
–2%
Net worth (total assets less total liabilities)
$173,590
+3%
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27
I owe, I owe, so off to work I go One reason you continue to work is probably so that you can pay off your bills. But many people today are losing their jobs because their company owes, too! Debt is one of the biggest financial problems in America today. Companies and individuals holding excessive debt contributed to the stock market’s massive decline in 2000 and the U.S. recession in 2001. If individuals managed their personal liabilities more responsibly, the general economy would be much better off. One reason the U.S. appeared to be doing so well during the late 1990s was the fact that
individuals and organizations went on an unprecedented spending binge, financed mostly by excessive debt. The economy looked unstoppable. However, sooner or later you have to pay the piper. Stock prices may go up and down, but debt stays up until it’s either paid down or the debtor files for bankruptcy. As of the first quarter of 2008, U.S. debt has surpassed a mind-boggling $49 trillion, which means that consumers, businesses, and governments will continue dealing with challenging times through this decade and into the next. Yes, the stock market (and the stocks in your portfolio) will be affected!
Step 5: Analyze your balance sheet Create a balance sheet based on the prior steps in this chapter to illustrate your current finances. Take a close look at it and try to identify any changes you can make to increase your wealth. Sometimes, reaching your financial goals can be as simple as refocusing the items on your balance sheet (use Table 2-3 as a general guideline). Here are some brief points to consider: ✓ Is the money in your emergency (or rainy day) fund sitting in an ultrasafe account and earning the highest interest available? Bank money market accounts or money market funds are recommended. The safest type of account is a U.S. Treasury money market fund. Banks are backed by the Federal Deposit Insurance Corporation (FDIC), while U.S. treasury securities are backed by the “full faith and credit” of the federal government. Shop around for the best rates. ✓ Can you replace depreciating assets with appreciating assets? Say that you have two stereo systems. Why not sell one and invest the proceeds? You may say, “But I bought that unit two years ago for $500, and if I sell it now, I’ll get only $300.” That’s your choice. You need to decide what helps your financial situation more — a $500 item that keeps shrinking in value (a depreciating asset) or $300 that can grow in value when invested (an appreciating asset).
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Part I: The Essentials of Stock Investing ✓ Can you replace low-yield investments with high-yield investments? Maybe you have $5,000 in a bank certificate of deposit (CD) earning 3 percent. You can certainly shop around for a better rate at another bank, but you can also seek alternatives that can offer a higher yield, such as U.S. savings bonds or short-term bond funds. Just remember that if you already have a CD and you withdraw the funds before it matures, you may face a penalty (such as losing some interest). ✓ Can you pay off any high-interest debt with funds from low-interest assets? If, for example, you have $5,000 earning 2 percent in a taxable bank account, and you have $2,500 on a credit card charging 18 percent (nondeductible), you may as well pay off the credit card balance and save on the interest. ✓ If you’re carrying debt, are you using that money for an investment return that’s greater than the interest you’re paying? Carrying a loan with an interest rate of 8 percent is acceptable if that borrowed money is yielding more than 8 percent elsewhere. Suppose that you have $6,000 in cash in a brokerage account. If you qualify, you can actually make a stock purchase greater than $6,000 by using margin (essentially a loan from the broker). You can buy $12,000 of stock using your $6,000 in cash, with the remainder financed by the broker. Of course, you pay interest on that margin loan. But what if the interest rate is 6 percent and the stock you’re about to invest in has a dividend that yields 9 percent? In that case, the dividend can help you pay off the margin loan, and you keep the additional income. (For more on buying on margin, see Chapter 18.) ✓ Can you sell any personal stuff for cash? You can replace unproductive assets with cash from garage sales and auction Web sites. ✓ Can you use your home equity to pay off consumer debt? Borrowing against your home has more favorable interest rates, and this interest is still tax-deductible. (Be careful about your debt level. See Chapter 24 for warnings on debt and other concerns.) Paying off consumer debt by using funds borrowed against your home is a great way to wipe the slate clean. What a relief to get rid of your credit card balances! Just don’t turn around and run up the consumer debt again. You can get overburdened and experience financial ruin (not to mention homelessness). Not a pretty picture. The important point to remember is that you can take control of your finances with discipline (and with the advice I offer in this book).
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Funding Your Stock Program If you’re going to invest money in stocks, the first thing you need is . . . money! Where can you get that money? If you’re waiting for an inheritance to come through, you may have to wait a long time, considering all the advances being made in healthcare lately. What’s that? You were going to invest in healthcare stocks? How ironic. Yet, the challenge still comes down to how to fund your stock program. Many investors can reallocate their investments and assets to do the trick. Reallocating simply means selling some investments or other assets and reinvesting that money into something else (such as stocks). It boils down to deciding what investment or asset you can sell or liquidate. Generally, you want to consider those investments and assets that give you a low return on your money (or no return at all). If you have a complicated mix of investments and assets, you may want to consider reviewing your options with a financial planner. Reallocation is just part of the answer; your cash flow is the other part. Ever wonder why there’s so much month left at the end of the money? Consider your cash flow. Your cash flow refers to what money is coming in (income) and what money is being spent (outgo). The net result is either a positive cash flow or a negative cash flow, depending on your cash management skills. Maintaining a positive cash flow (more money coming in than going out) helps you increase your net worth. A negative cash flow ultimately depletes your wealth and wipes out your net worth if you don’t turn it around immediately. The following sections show you how to analyze your cash flow. The first step is to do a cash flow statement. With a cash flow statement, you ask yourself three questions: ✓ What money is coming in? In your cash flow statement, jot down all sources of income. Calculate income for the month and then for the year. Include everything: salary, wages, interest, dividends, and so on. Add them all up and get your grand total for income. ✓ What is your outgo? Write down all the things that you spend money on. List all your expenses. If possible, categorize them into essential and nonessential. You can get an idea of all the expenses that you can reduce without affecting your lifestyle. But before you do that, make as complete a list as possible of what you spend your money on. ✓ What’s left? If your income is greater than your outgo, you have money ready and available for stock investing. No matter how small the amount seems, it definitely helps. I’ve seen fortunes built when people started to diligently invest as little as $25 to $50 per week or per month. If your outgo is greater than your income, you better sharpen your pencil. Cut down on nonessential spending and/or increase your income. If your budget is a little tight, hold off on your stock investing until your cash flow improves.
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Part I: The Essentials of Stock Investing
Dot-com-and-go If you were publishing a book about negative cash flow, you could look for the employees of any one of 100 dot-com companies to write it. Their qualifications include working for a company that flew sky-high in 1999 and crashed in 2000 and 2001. Companies such as eToys.com, Pets.com, and DrKoop.com were given millions, yet they couldn’t turn a profit and eventually
closed for business. You may as well call them “dot-com-and-go.” You can learn from their mistakes. (Actually, they could have learned from you.) In the same way that profit is the most essential single element in a business, a positive cash flow is important for your finances in general and for funding your stock investment program in particular.
Don’t confuse a cash flow statement with an income statement (also called a profit and loss statement or an income and expense statement). A cash flow statement is simple to calculate because you can easily track what goes in and what goes out. Income statements are a little different (especially for businesses) because they take into account things that aren’t technically cash flow (such as depreciation or amortization). Find out more about income statements in Chapter 11.
Step 1: Tally up your income Using Table 2-4 as a worksheet, list and calculate the money you have coming in. The first column describes the source of the money, the second column indicates the monthly amount from each respective source, and the last column indicates the amount projected for a full year. Include all income, such as wages, business income, dividends, interest income, and so on. Then project these amounts for a year (multiply by 12) and enter those amounts in the third column.
Table 2-4 Item
Listing Your Income Monthly $ Amount
Yearly $ Amount
Salary and wages Interest income and dividends Business net (after taxes) income Other income Total income
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This is the amount of money you have to work with. To ensure your financial health, don’t spend more than this amount. Always be aware of and carefully manage your income.
Step 2: Add up your outgo Using Table 2-5 as a worksheet, list and calculate the money that’s going out. How much are you spending and on what? The first column describes the source of the expense, the second column indicates the monthly amount, and the third column shows the amount projected for a full year. Include all the money you spend: credit card and other debt payments; household expenses, such as food, utility bills, and medical expenses; and nonessential expenses such as video games and elephant-foot umbrella stands.
Table 2-5 Item
Listing Your Expenses (Outgo) Monthly $ Amount
Yearly $ Amount
Payroll taxes Rent or mortgage Utilities Food Clothing Insurance (medical, auto, homeowners, and so on) Telephone Real estate taxes Auto expenses Charity Recreation Credit card payments Loan payments Other Total Payroll taxes is just a category in which to lump all the various taxes that the government takes out of your paycheck. Feel free to put each individual tax on its own line if you prefer. The important thing is creating a comprehensive list that’s meaningful to you.
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Part I: The Essentials of Stock Investing You may notice that the outgo doesn’t include items such as payments to a 401(k) plan and other savings vehicles. Yes, these items do impact your cash flow, but they’re not expenses; the amounts that you invest (or your employer invests for you) are essentially assets that benefit your financial situation versus expenses that don’t help you build wealth. To account for the 401(k), simply deduct it from the gross pay before you calculate the preceding worksheet. If, for example, your gross pay is $2,000 and your 401(k) contribution is $300, then use $1,700 as your income figure.
Step 3: Create a cash flow statement Okay, you’re almost to the end. The last step is creating a cash flow statement so that you can see (all in one place) how your money moves — how much comes in and how much goes out and where it goes. Plug the amount of your total income (from Table 2-4) and the amount of your total expenses (from Table 2-5) into the Table 2-6 worksheet to see your cash flow. Do you have positive cash flow — more coming in than going out — so that you can start investing in stocks (or other investments), or are expenses overpowering your income? Doing a cash flow statement isn’t just about finding money in your financial situation to fund your stock program. First and foremost, it’s about your financial well-being. Are you managing your finances well or not?
Table 2-6 Item
Looking at Your Cash Flow Monthly $ Amount
Yearly $ Amount
Total income (from Table 2-4) Total outgo (from Table 2-5) Net inflow/outflow At the time of this writing, 2008 was shaping up to be yet another record year for personal and business bankruptcies. Personal debt and expenses far exceeded whatever income they generated. That announcement is another reminder to watch your cash flow; keep your income growing and your expenses and debt as low as possible.
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33
Step 4: Analyze your cash flow Use your cash flow statement in Table 2-6 to identify sources of funds for your investment program. The more you can increase your income and the more you can decrease your outgo, the better. Scrutinize your data. Where can you improve the results? Here are some questions to ask yourself: ✓ How can you increase your income? Do you have hobbies, interests, or skills that can generate extra cash for you? ✓ Can you get more paid overtime at work? How about a promotion or a job change? ✓ Where can you cut expenses? ✓ Have you categorized your expenses as either “necessary” or “nonessential”? ✓ Can you lower your debt payments by refinancing or consolidating loans and credit card balances? ✓ Have you shopped around for lower insurance or telephone rates? ✓ Have you analyzed your tax withholdings in your paycheck to make sure that you’re not overpaying your taxes (just to get your overpayment back next year as a refund)?
Another option: Finding investment money in tax savings According to the Tax Foundation, the average U.S. citizen pays more in taxes than in food, clothing, and shelter combined. Sit down with your tax advisor and try to find ways to reduce your taxes. A home-based business, for example, is a great way to gain new income and increase your tax deductions, resulting in a lower tax burden. Your tax advisor can make recommendations that work for you. One tax strategy to consider is doing your stock investing in a tax-sheltered account such as a traditional Individual Retirement Account (IRA) or a Roth Individual Retirement Account (Roth IRA). Again, check with your tax advisor for deductions and strategies available to you. For more on the tax implications of stock investing, see Chapter 21.
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Part I: The Essentials of Stock Investing
Setting Your Sights on Your Financial Goals Consider stocks as tools for living, just like any other investment — no more, no less. Stocks are the tools you use (one of many) to accomplish something — to achieve a goal. Yes, successfully investing in stocks is the goal that you’re probably shooting for if you’re reading this book. However, you must complete the following sentence: “I want to be successful in my stock investing program to accomplish _____.” You must consider stock investing as a means to an end. When people buy a computer, they don’t (or shouldn’t) think of buying a computer just to have a computer. People buy a computer because doing so helps them achieve a particular result, such as being more efficient in business, playing fun games, or having a nifty paperweight (tsk, tsk). Know the difference between long-term, intermediate-term, and short-term goals, and then set some of each (see Chapter 3 for more information). ✓ Long-term goals refer to projects or financial goals that need funding five or more years from now. ✓ Intermediate term refers to financial goals that need funding two to five years from now. ✓ Short-term goals need funding less than two years from now. Stocks, in general, are best suited for long-term goals such as these: ✓ Achieving financial independence (think retirement funding) ✓ Paying for future college costs ✓ Paying for any long-term expenditure or project Some categories of stock (such as conservative or large cap) may be suitable for intermediate-term financial goals. If, for example, you’ll retire four years from now, conservative stocks can be appropriate. If you’re optimistic (or bullish) about the stock market and confident that stock prices will rise, go ahead and invest. However, if you’re negative about the market (you’re bearish, or you believe that stock prices will decline), you may want to wait until the economy starts to forge a clear path. For more on investing in bull or bear markets, see Chapter 14. Stocks generally aren’t suitable for short-term investing goals because stock prices can behave irrationally in a short period of time. Stocks fluctuate from day to day, so you don’t know what the stock will be worth in the near future. You may end up with less money than you expected. For investors seeking to reliably accrue money for short-term needs, short-term bank certificates of deposit or money market funds are more appropriate.
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35
In recent years, investors have sought quick, short-term profits by trading and speculating in stocks. Lured by the fantastic returns generated by the stock market in the late 1990s, investors saw stocks as a get-rich-quick scheme. It’s very important for you to understand the difference between investing, saving, and speculating. Which one do you want to do? Knowing the answer to this question is crucial to your goals and aspirations. Investors who don’t know the difference tend to get burned. Here’s some information to help you distinguish among these three actions: ✓ Investing is the act of putting your current funds into securities or tangible assets for the purpose of gaining future appreciation, income, or both. You need time, knowledge, and discipline to invest. The investment can fluctuate in price, but it has been chosen for long-term potential. ✓ Saving is the safe accumulation of funds for a future use. Savings don’t fluctuate and are generally free of financial risk. The emphasis is on safety and liquidity. ✓ Speculating is the financial world’s equivalent of gambling. An investor who speculates is seeking quick profits gained from short-term price movements in a particular asset or investment. (In recent years, many folks are trading stocks, which is in the realm of short-term speculating. Find out more about trading in Chapter 16.) These distinctly different concepts are often confused, even among so-called financial experts. I know of one financial advisor who actually put a child’s college fund money into an Internet stock fund, only to lose over $17,000 in less than ten months! This advisor thought that she was investing, but in reality, she was speculating. I know of another advisor who told a client to avoid savings accounts altogether because the client had a 401(k) plan. This particular advisor didn’t catch the crucial difference between saving and investing. The client eventually found out the difference; his 401(k) fell by 40 percent when the bear market of 2000 arrived. Fortunately, we can learn from these situations and get back on track. That child who lost the $17,000? He’s my neighbor, and I helped the father reinvest the remaining funds. The portfolio doubled in value by the following year, and it’s still growing. The second fellow who lost 40 percent in his 401(k) account? He became my student, he has recouped his losses, and his 401(k) plan is up (this occurred within two years). As of 2008, both investors have portfolios that are out-performing the general stock market.
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Part I: The Essentials of Stock Investing
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Chapter 3
Defining Common Approaches to Stock Investing In This Chapter ▶ Pairing stock strategies with investing goals ▶ Deciding what time frame fits your investment strategy ▶ Looking at your purpose for investing: growth versus income ▶ Determining your investing style: conservative versus aggressive
“I
nvesting for the long term” isn’t just some perfunctory investment slogan. It’s a culmination of proven stock market experience that goes back many decades. Unfortunately, investor buying and selling habits have deteriorated in recent years due to impatience. Today’s investors think that short term is measured in days, intermediate term is measured in weeks, and long term is measured in months. Yeesh! It’s no wonder that so many folks are complaining about lousy investment returns. Investors have lost the profitable art of patience! What should you do? Become an investor with a time horizon greater than one year. Give your investments time to grow. Everybody dreams about emulating the success of someone like Warren Buffett, but few emulate his patience (a huge part of his investment success). Stocks are tools you can use to build your wealth. When used wisely, for the right purpose, and in the right environment, they do a great job. But when improperly applied, they can lead to disaster. In this chapter, I show you how to choose the right types of investments based on your short- and long-term financial goals. I also show you how to decide on your purpose for investing (growth or income investing) and your style of investing (conservative or aggressive).
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Matching Stocks and Strategies with Your Goals Various stocks are out there, as well as various investment approaches. The key to success in the stock market is matching the right kind of stock with the right kind of investment situation. You have to choose the stock and the approach that match your goals. (Refer to Chapter 2 for more on defining your financial goals.) Before investing in a stock, ask yourself, “When do I want to reach my financial goal?” Stocks are a means to an end. Your job is to figure out what that end is — or, more important, when it is. Do you want to retire in ten years or next year? Must you pay for your kid’s college education next year or 18 years from now? The length of time you have before you need the money you hope to earn from stock investing determines what stocks you should buy. Table 3-1 gives you some guidelines for choosing the kind of stock best suited for the type of investor you are and the goals you have.
Table 3-1
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Stock Types, Financial Goals, and Investor Types
Type of Investor
Time Frame for Financial Goals
Type of Stock Most Suitable
Conservative (worries about risk)
Long term (over 5 years)
Large cap stocks and mid cap stocks
Aggressive (high tolerance to risk)
Long term (over 5 years)
Small cap stocks and mid cap stocks
Conservative (worries about risk)
Intermediate term (2 to 5 years)
Large cap stocks, preferably with dividends
Aggressive (high tolerance to risk)
Intermediate term (2 to 5 years)
Small cap stocks and mid cap stocks
Short term
1 to 2 years
Stocks are not suitable for the short term. Instead, look at vehicles such as savings accounts and money market funds.
Very short term
Less than 1 year
Stocks? Don’t even think about it! Well . . . you can invest in stocks for less than a year, but seriously, you’re not really investing — you’re either trading (see Chapter 16) or speculating (see Chapter 2). Instead, use savings accounts and money market funds.
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Dividends are payments made to a stock owner (unlike interest, which is payment to a creditor). Dividends are a great form of income, and companies that issue dividends tend to have more stable stock prices as well. For more information on dividend-paying stocks, see the section “Steadily making money: Income investing,” later in this chapter, and also see Chapter 9. Table 3-1 gives you general guidelines, but not everyone fits into a particular profile. Every investor has a unique situation, set of goals, and level of risk tolerance. The terms large cap, mid cap, and small cap refer to the size (or market capitalization, also known as market cap) of the company. All factors being equal, large companies are safer (less risky) than small companies. For more on market caps, see the section “Investing for Your Personal Style,” later in this chapter.
Investing for the Future Are your goals long term or short term? Answering this question is important because individual stocks can be either great or horrible choices, depending on the time period you want to focus on. Generally, the length of time you plan to invest in stocks can be short term, intermediate term, or long term. The following sections outline what kinds of stocks are most appropriate for each term length. Investing in quality stocks becomes less risky as the time frame lengthens. Stock prices tend to fluctuate on a daily basis, but they have a tendency to trend up or down over an extended period of time. Even if you invest in a stock that goes down in the short term, you’re likely to see it rise and possibly exceed your investment if you have the patience to wait it out and let the stock price appreciate.
Focusing on the short term Short term generally means one year or less, although some people extend the period to two years or less. Short-term investing isn’t about making a quick buck on your stock choices — it refers to when you may need the money. Every person has short-term goals. Some are modest, such as setting aside money for a vacation next month or paying for medical bills. Other shortterm goals are more ambitious, such as accruing funds for a down payment to purchase a new home within six months. Whatever the expense or purchase, you need a predictable accumulation of cash soon. If this sounds like your situation, stay away from the stock market!
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Part I: The Essentials of Stock Investing Because stocks can be so unpredictable in the short term, they’re a bad choice for short-term considerations. I get a kick out of market analysts on TV saying things such as, “At $25 a share, XYZ is a solid investment, and we feel that its stock should hit our target price of $40 within six to nine months.” You know that an eager investor hears that and says, “Gee, why bother with 3 percent at the bank when this stock will rise by more than 50 percent? I better call my broker.” It may hit that target amount (or surpass it), or it may not. Most of the time, the stock doesn’t reach the target price, and the investor is disappointed. The stock could even go down! The reason that target prices are frequently missed is that it’s difficult to figure out what millions of investors will do in the short term. The short term can be irrational because so many investors have so many reasons for buying and selling that it can be difficult to analyze. If you invest for an important short-term need, you could lose very important cash quicker than you think. During the raging bull market (see more about bull markets in Chapter 14) of the late 1990s, investors watched as some high-profile stocks went up 20 to 50 percent in a matter of months. Hey, who needs a savings account earning a measly interest rate when stocks grow like that! Of course, when the bear market hit from 2000 to 2003 and those same stocks fell 50 to 85 percent, a savings account earning a measly interest rate suddenly didn’t seem so bad. Short-term stock investing is very unpredictable. Stocks — even the best ones — fluctuate in the short term. In a negative environment, they can be very volatile. No one can accurately predict the price movement (unless he or she has some inside information), so stocks are definitely inappropriate for any financial goal you need to reach within one year. You can better serve your short-term goals with stable, interest-bearing investments like certificates of deposit at your local bank. Check Table 3-1 for suggestions about your short-term strategies.
Considering intermediate-term goals Intermediate term refers to the financial goals you plan to reach within five years. For example, if you want to accumulate funds to put money down for investment in real estate four years from now, some growth-oriented investments may be suitable. (I discuss growth investing in more detail later in this chapter.) Although some stocks may be appropriate for a two- or three-year period, not all stocks are good intermediate-term investments. Some stocks are fairly stable and hold their value well, such as the stock of large or established dividend-paying companies. Other stocks have prices that jump all over the place, such as those of untested companies that haven’t been in existence long enough to develop a consistent track record.
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Short-term investing = speculating My case files are littered with examples of long-term stock investors who morphed into short-term speculators. I know of one fellow who had $80,000 and was set to get married within 12 months and then put a down payment on a new home for him and his bride. He wanted to surprise her by growing his nest egg quickly so they could have a glitzier wedding and a larger down payment. What happened? The money instead shrunk to $11,000 as his stock choices pulled back sharply. Ouch! How
does that go again? For better or for worse . . . uh . . . for richer or for poorer? I’m sure they had to adjust their plans accordingly. I recall some of the stocks he chose, and now, years later, those stocks have recovered and gone on to new highs. The bottom line is that investing in stocks for the short term is nothing more than speculating. Your only possible strategy is luck.
If you plan to invest in the stock market to meet intermediate-term goals, consider large, established companies or dividend-paying companies in industries that provide the necessities of life (like the food and beverage industry, or electric utilities). In today’s economic environment, I strongly believe that stocks attached to companies that serve basic human needs should have a major presence in most stock portfolios. They’re especially well-suited for intermediate investment goals. Just because a particular stock is labeled as being appropriate for the intermediate term doesn’t mean you should get rid of it by the stroke of midnight five years from now. After all, if the company is doing well and going strong, you can continue holding the stock indefinitely. The more time you give a wellpositioned, profitable company’s stock to grow, the better you’ll do.
Preparing for the long term Stock investing is best suited for making money over a long period of time. When you measure stocks against other investments in terms of five to (preferably) ten or more years, they excel. Even investors who bought stocks during the depths of the Great Depression saw profitable growth in their stock portfolios over a ten-year period. In fact, if you examine any ten-year period over the past fifty years, you see that stocks beat out other financial investments (such as bonds or bank investments) in almost every period when measured by total return (taking into account reinvesting and compounding of capital gains and dividends)! Of course, your work doesn’t stop at deciding on a long-term investment. You still have to do your homework and choose stocks wisely, because even in good times, you can lose money if you invest in companies that go out of
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Part I: The Essentials of Stock Investing business. Part III of this book shows you how to evaluate specific companies and industries and alerts you to factors in the general economy that can affect stock behavior. Appendix A provides plenty of resources you can turn to. Because so many different types and categories of stocks are available, virtually any investor with a long-term perspective should add stocks to his investment portfolio. Whether you want to save for a young child’s college fund or for future retirement goals, carefully selected stocks have proven to be a superior long-term investment.
Investing for a Purpose When someone asked the lady why she bungee jumped off the bridge that spanned a massive ravine, she answered, “Because it’s fun!” When someone asked the fellow why he dove into a pool chock-full of alligators and snakes, he responded, “Because someone pushed me.” You shouldn’t invest in stocks unless you have a purpose that you understand, like investing for growth or investing for income. Even if an advisor pushes you to invest, be sure that your advisor gives you an explanation of how each stock choice fits your purpose. I know of a very nice, elderly lady who had a portfolio brimming with aggressive-growth stocks because she had an overbearing broker. Her purpose should’ve been conservative, and she should’ve chosen investments that would preserve her wealth rather than grow it. Obviously, the broker’s agenda got in the way. Stocks are just a means to an end. Figure out your desired end and then match the means. To find out more about dealing with brokers, go to Chapter 7.
Making loads of money quickly: Growth investing When investors want their money to grow (versus just trying to preserve it), they look for investments that appreciate in value. Appreciate is just another way of saying grow. If you bought a stock for $8 per share and now its value is $30 per share, your investment has grown by $22 per share — that’s appreciation. I know I would appreciate it.
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Appreciation (also known as capital gain) is probably the number one reason people invest in stocks. Few investments have the potential to grow your wealth as conveniently as stocks. If you want the stock market to make you loads of money (and you can assume some risk), head to Chapter 8, which takes an in-depth look at investing for growth. Stocks are a great way to grow your wealth, but they’re not the only way. Many investors seek alternative ways to make money, but many of these alternative ways are more aggressive than stocks and carry significantly more risk. You may have heard about people who made quick fortunes in areas such as commodities (like wheat, pork bellies, or precious metals), options, and other more sophisticated investment vehicles. Keep in mind that you should limit these more risky investments to only a small portion of your portfolio, such as 10 percent of your investable funds. Experienced investors, however, can go as high as 20 percent.
Steadily making money: Income investing Not all investors want to take on the risk that comes with making a killing. (Hey . . . no guts, no glory!) Some people just want to invest in the stock market as a means of providing a steady income. They don’t need stock values to go through the ceiling. Instead, they need stocks that perform well consistently. If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record as of specific dates. How do you know if the dividend you’re being paid is higher (or lower) than other vehicles (such as bonds)? The next sections will help you figure it out.
Distinguishing between dividends and interest Don’t confuse dividends with interest. Most people are familiar with interest because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders — and if you own stock you’re a shareholder because shares of stock represent ownership in a publicly traded company). When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor, and as such, it must eventually pay your money back to you with interest.
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Part I: The Essentials of Stock Investing Recognizing the importance of an income stock’s yield When you invest for income, you have to consider your investment’s yield and compare it with the alternatives. The yield is an investment’s payout expressed as a percentage of the investment amount. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others. Table 3-2 shows some comparative yields.
Table 3-2
Comparing the Yields of Various Investments
Investment
Type
Amount
Pay Type
Payout
Yield
Smith Co.
Stock
$50/share
Dividend
$2.50
5.0%
Jones Co.
Stock
$100/share
Dividend
$4.00
4.0%
Acme Bank
Bank CD
$500
Interest
$25.00
5.0%
Acme Bank
Bank CD
$2,500
Interest
$131.25
5.25%
Acme Bank
Bank CD
$5,000
Interest
$287.50
5.75%
Brown Co.
Bond
$5,000
Interest
$300.00
6.0%
To calculate yield, use the following formula: Yield = Payout ÷ Investment amount For the sake of simplicity, the following exercise is based on an annual percentage yield basis (compounding would increase the yield). Jones Co. and Smith Co. are typical dividend-paying stocks. Looking at Table 3-2 and presuming that both companies are similar in most respects except for their differing dividends, how can you tell whether the $50 stock with a $2.50 annual dividend is better (or worse) than the $100 stock with a $4.00 dividend? The yield tells you. Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent). Therefore, if you had to choose between those two stocks as an income investor, you would choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate a lot, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent. Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but at the very least, they have a greater potential for capital gain than CDs or bonds. Dividend-paying stocks (investing for income) are covered in Chapter 9.
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Investing for Your Personal Style Your investing style isn’t a blue-jeans-versus-three-piece-suit debate. It refers to your approach to stock investing. Do you want to be conservative or aggressive? Would you rather be the tortoise or the hare? Your investment personality greatly depends on your purpose and the term over which you’re planning to invest (see the previous two sections in this chapter). The following sections outline the two most general investment styles.
Conservative investing Conservative investing means that you put your money in something proven, tried, and true. You invest your money in safe and secure places, such as banks and government-backed securities. But how does that apply to stocks? (Table 3-1 gives you suggestions.) If you’re a conservative stock investor, you want to place your money in companies that exhibit some of the following qualities: ✓ Proven performance: You want companies that have shown increasing sales and earnings year after year. You don’t demand anything spectacular — just a strong and steady performance. ✓ Large market size: You want to invest in large cap companies (short for large capitalization). In other words, they should have a market value exceeding $5–$25 billion. Conservative investors surmise that bigger is safer. ✓ Proven market leadership: Look for companies that are leaders in their industries. ✓ Perceived staying power: You want companies with the financial clout and market position to weather uncertain market and economic conditions. It shouldn’t matter what happens in the economy or who gets elected. As a conservative investor, you don’t mind if the companies’ share prices jump (who would?), but you’re more concerned with steady growth over the long term.
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Part I: The Essentials of Stock Investing
Aggressive investing Aggressive investors can plan long term or look over only the intermediate term, but in any case, they want stocks that resemble jack rabbits — those that show the potential to break out of the pack. If you’re an aggressive stock investor, you want to invest your money in companies that exhibit some of the following qualities: ✓ Great potential: Choose companies that have superior goods, services, ideas, or ways of doing business compared to the competition. ✓ Capital gains possibility: Don’t even consider dividends. If anything, you dislike dividends. You feel that the money dispensed in dividend form is better reinvested in the company. This, in turn, can spur greater growth. ✓ Innovation: Find companies that have innovative technologies, ideas, or methods that make them stand apart from other companies. Aggressive investors usually seek out small capitalization stocks, known as small caps, because they can have plenty of potential for growth. Take the tree example, for instance: A giant redwood may be strong, but it may not grow much more, whereas a brand-new sapling has plenty of growth to look forward to. Why invest in big, stodgy companies when you can invest in smaller enterprises that may become the leaders of tomorrow? Aggressive investors have no problem buying stock in obscure businesses because they hope that such companies will become another IBM or McDonald’s. Find out more about growth investing in Chapter 8.
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Chapter 4
Recognizing the Risks In This Chapter ▶ Considering different types of risk ▶ Taking steps to reduce your risk ▶ Balancing risk against return
I
nvestors face many risks, most of which I cover in this chapter. The simplest definition of risk for investors is “the possibility that your investment will lose some (or all) of its value.” Yet you don’t have to fear risk if you understand it and plan for it. You must understand the oldest equation in the world of investing — risk versus return. This equation states the following: If you want a greater return on your money, you need to tolerate more risk. If you don’t want to tolerate more risk, you must tolerate a lower rate of return. This point about risk is best illustrated from a moment in one of my investment seminars. One of the attendees told me that he had his money in the bank but was dissatisfied with the rate of return. He lamented, “The yield on my money is pitiful! I want to put my money somewhere where it can grow.” I asked him, “How about investing in common stocks? Or what about growth mutual funds? They have a solid, long-term growth track record.” He responded, “Stocks? I don’t want to put my money there. It’s too risky!” Okay, then. If you don’t want to tolerate more risk, then don’t complain about earning less on your money. Risk (in all its forms) has a bearing on all your money concerns and goals. That’s why it’s so important that you understand risk before you invest. This man — as well as the rest of us — needs to remember that risk is not a four-letter word. (Well, it is a four-letter word, but you know what I mean.) Risk is present no matter what you do with your money. Even if you simply stick your money in your mattress, risk is involved — several kinds of risk, in
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Part I: The Essentials of Stock Investing fact. You have the risk of fire. What if your house burns down? You have the risk of theft. What if burglars find your stash of cash? You also have relative risk. (In other words, what if your relatives find your money?) Be aware of the different kinds of risk that I describe in this chapter, and you can easily plan around them to keep your money growing.
Exploring Different Kinds of Risk Think about all the ways that an investment can lose money. You can list all sorts of possibilities. So many that you may think, “Holy cow! Why invest at all?” Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risk that I discuss in the following sections before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals.
Financial risk The financial risk of stock investing is that you can lose your money if the company whose stock you purchase loses money or goes belly up. This type of risk is the most obvious because companies do go bankrupt. You can greatly enhance the chances of your financial risk paying off by doing an adequate amount of research and choosing your stocks carefully (which this book helps you do — see Part III for details). Financial risk is a real concern even when the economy is doing well. Some diligent research, a little planning, and a dose of common sense help you reduce your financial risk. In the stock investing mania of the late 1990s, millions of investors (along with many well-known investment gurus) ignored some obvious financial risks of many then-popular stocks. Investors blindly plunked their money into stocks that were bad choices. Consider investors who put their money in DrKoop. com, a health information Web site, in 1999 and held on during 2000. This company had no profit and was over-indebted. DrKoop.com went into cardiac arrest as it collapsed from $45 per share to $2 per share by mid-2000. By the time the stock was DOA, investors lost millions. RIP (risky investment play!). Internet and tech stocks littered the graveyard of stock market catastrophes during 2000–2001 because investors didn’t see (or didn’t want to see?) the risks involved with companies that didn’t offer a solid record of results (profits, sales, and so on). When you invest in companies that don’t have a proven track record, you’re not investing, you’re speculating.
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Fast forward to 2007–2008. New risks abound as the headlines rail on about the credit crisis on Wall Street and the subprime fiasco in the wake of the housing bubble popping. Think about how this crisis impacted investors as the market went through its stomach-churning roller-coaster ride. A good example of a casualty you didn’t want to be a part of was Bear Stearns (BSC), which was caught in the subprime buzz saw. Bear Stearns was sky-high at $170 a share in early 2007, yet it crashed to $2 a share by March 2008. Yikes! Its problems arose from massive overexposure to bad debt, and investors could have done some research (the public data was revealing!) and avoided the stock entirely. Investors who did their homework regarding the financial conditions of companies such as the Internet stocks (and Bear Stearns, among others) would have discovered that these companies had the hallmarks of financial risk — high debt, low (or no) earnings, and plenty of competition. They steered clear, avoiding tremendous financial loss. Investors who didn’t do their homework were lured by the status of these companies and lost their shirts. Of course, the individual investors who lost money by investing in these trendy, high-profile companies don’t deserve all the responsibility for their tremendous financial losses; some high-profile analysts and media sources also should have known better. The late 1990s may someday be a case study of how euphoria and the herd mentality (rather than good, old-fashioned research and common sense) ruled the day (temporarily). The excitement of making potential fortunes gets the best of people sometimes, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” Achieving true wealth takes diligent work and careful analysis. In terms of financial risk, the bottom line is . . . well . . . the bottom line! A healthy bottom line means that a company is making money. And if a company is making money, then you can make money by investing in its stock. However, if a company isn’t making money, you won’t make money if you invest in it. Profit is the lifeblood of any company. See Chapter 11 for the scoop on determining whether a company’s bottom line is healthy.
Interest rate risk You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rates have changed.” Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers its interest rates, actions that, in turn, cause banks to raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.
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Part I: The Essentials of Stock Investing Here’s a generic introduction to the way fluctuating interest rate risk can affect investors in general: Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2 percent interest. The only way to get out of your 6 percent bond is to sell it at current market values and use the money to reinvest at the higher rate. The only problem with this scenario is that the 6 percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny (LM). According to the bond agreement, LM must pay 6 percent (called the face rate or nominal rate) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they’re issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however. Say that he decides to sell the bond long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6 percent bond if the market is offering bonds at 8 percent. What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bond. What has to change so that current investors get the equivalent yield of 8 percent? If you said, “The bond’s value has to go down,” . . . bingo! In this example, the bond’s market value needs to drop to $7,500 so that investors buying the bond get an equivalent yield of 8 percent. (For simplicity’s sake, I left out the time it takes for the bond to mature.) Here’s how that figures: New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500. In this example, little, if any, financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond, yet you still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss. (For more on the how and why of selling your stock, review Chapters 17 and 18.) Historically, rising interest rates have had an adverse effect on stock prices. I outline several reasons why in the following sections. Because our country is top-heavy in debt, rising interest rates are an obvious risk that threatens both stocks and fixed-income securities (such as bonds).
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Hurting a company’s financial condition Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt, because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.
Affecting a company’s customers A company’s success comes when it sells its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings. For a good example, consider Home Depot (HD) during 2005–2008. The company had soaring sales and earnings during 2005 and into early 2006 as the housing boom hit its high point (record sales, construction, and so on). As the housing bubble popped and the housing and construction industries went into an agonizing decline, the fortunes of Home Depot followed suit because its success is directly tied to home building, repair, and improvement. By late 2006, HD’s sales were slipping and earnings were dropping as the housing industry sunk deeper into its depression. This was bad news for stock investors. HD’s stock went from over $44 in 2005 to $21 by October 2008 (a drop of about 52 percent). Ouch! No “home improvement” there.
Impacting investors’ decision-making considerations When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes: ✓ Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others. ✓ Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher yield. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.
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Part I: The Essentials of Stock Investing Hurting stock prices indirectly High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices. As this book goes to press, the stock market and the U.S. economy face perhaps the greatest challenge since the Great Depression — debt. In terms of Gross Domestic Product (GDP), the size of the economy is about $14 trillion (give or take $100 billion), but the debt level is about $49 trillion (this includes personal, corporate, mortgage, and government debt). This already enormous amount doesn’t include $53 trillion of liabilities such as Social Security and Medicare. Additionally (Yikes! There’s more?), some of our financial institutions hold over $100 trillion worth of derivatives. These can be very complicated and sophisticated investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron and Bear Stearns), and investors should be aware of them. Just check out the company’s financial reports. (Find out more in Chapter 12.) Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles. A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (series I), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio. (I discuss diversification in more detail later in this chapter.)
Market risk People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is — a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand.
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Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth. A good example of market risk with a stock is Apple (AAPL). Had you bought AAPL in early 2007, you could have gotten it for about $75 a share in January 2007 and watched it rise joyfully upward to hit $205 a share by December 2007. At that point some giddy investor may be thinking, “It’s time to pop the champagne! I’ll be able to buy Rhode Island!” Hold on a second! Within three months of that top, AAPL had a dizzying plunge to under $120 by March 2008. It’s typical for stocks to take a relatively long time to climb, but they can fall in a relatively short time. In that example, a long-term patient investor would still be up, but some short-term folks that “jump in” and “jump out” would have been burned. I’m sure that some of them lived in Rhode Island (but probably renting). Markets are volatile by nature; they go up and down, and investments need time to grow. Market volatility is an increasingly common condition that we have to live with. Investors should be aware of the fact that stocks in general (especially in today’s marketplace) aren’t suitable for short-term (one year or less) goals (see Chapters 2 and 3 for more on short-term goals). Despite the fact that companies you’re invested in may be fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward. Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there! Consider the married couple nearing retirement who decided to play with their money to see about making their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.) What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money. Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks, or similar aggressive investment vehicles). Remember, you can lose everything.
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Part I: The Essentials of Stock Investing
Inflation risk Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a stock that doesn’t appreciate much, for example) may not keep up with inflation. Say that you have money in a bank savings account currently earning 4 percent. This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money. At the time of this writing, inflation is a very real and a very serious concern and it should not be ignored. I deal more with inflation in Chapter 10.
Tax risk Taxes (such as income tax or capital gains tax) don’t affect your stock investment directly. Taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that you’re trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions. Chapter 21 covers in greater detail the impact of taxes.
Political and governmental risks If companies were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies can kill companies. Of course, if you own stock in a company exposed to political and governmental risks, you need to be aware of these risks. For some companies, a single new regulation or law is enough to send them into bankruptcy. For other companies, a new law could help them increase sales and profits.
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What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop-loss orders on the stock (see Chapter 18). For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?” (See Chapter 15 for more on how politics can affect the stock market.) Taking the preceding point a step further, I’d like to remind you that politics and government have a direct and often negative impact on the economic environment. And one major pitfall for investors is that many misunderstand even basic economics. Considering all the examples I could find in recent years, I could write a book! Or . . . uh . . . simply add it to this book. Chapter 10 goes into greater detail to help you make (and keep) stock market profits just by understanding rudimentary (and quite interesting) economics. (Don’t worry; the dry stuff will be kept to a minimum!)
Personal risks Frequently, the risk involved with investing in the stock market may not be directly involved with the investment or factors directly related to the investment; sometimes the risk is with the investor’s circumstances. Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week and Ralph’s stocks drop to a market value of $14,000. Because stocks are good for the long term, this type of decrease is usually not an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price. (Chapter 18 covers orders you can place with your broker to help you do that.) Over the long term, Ralph would probably see the value of his investment grow substantially. But what if during a period when his stocks are declining, Ralph experiences financial difficulty and needs quick cash? He may have to sell his stock to get some money. This problem occurs frequently for investors who don’t have an emergency fund or a rainy day fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone.
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Part I: The Essentials of Stock Investing You probably won’t get much comfort from knowing that stock losses are tax deductible — a loss is a loss (see Chapter 21 for more on taxes). However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund. A good place for your emergency cash fund is in either a bank savings account or a money market fund. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills. (Chapter 2 provides more guidance on having liquid assets for emergencies.)
Emotional risk What does emotional risk have to do with stocks? Emotions are important risk considerations because the main decision makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to. If you get too attached to a sinking stock, then you don’t need a stock investing book — you need Dr. Phil!
Paying the price for greed In 1998–2000, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes (just like slot machines) when they saw that easy street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios and earnings when you can just buy stock, make a fortune, and get out with millions? (Of course, you care about making money with stocks, so you can flip to Chapter 11 and Appendix B to find out more about P/E ratios.) Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense (such as investing for quick short-term gains in dubious hot stocks rather than doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus, as I explain in Part III).
Recognizing the role of fear Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss.
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Investment lessons from September 11 September 11, 2001, was a horrific day that is burned in our minds and won’t be forgotten in our lifetime. The acts of terrorism that day took over 3,000 lives and caused untold pain and grief. A much less important aftereffect was the hard lessons that investors learned that day. Terrorism reminds us that risk is more real than ever and that we should never let our guard down. What lessons can investors learn from the worst acts of terrorism to ever happen on U.S. soil? Here are a few pointers: ✓ Diversify your portfolio. Of course, the events of September 11 were certainly surreal and unexpected. But before the events occurred, investors should have made it a habit to assess their situations and see whether they had any vulnerabilities. Stock investors with no money outside the stock market are always more at risk. Keeping your portfolio diversified is a time-tested strategy that is more relevant than ever before. (I discuss diversification later in this chapter.)
✓ Review and re-allocate. September 11 triggered declines in the overall market, but specific industries, such as airlines and hotels, were hit particularly hard. In addition, some industries, such as defense and food, saw stock prices rise. Monitor your portfolio and ask yourself whether it’s overly reliant on or exposed to events in specific sectors. If so, reallocate your investments to decrease your risk exposure. ✓ Check for signs of trouble. Techniques such as trailing stops (which I explain in Chapter 18) come in very handy when your stocks plummet because of unexpected events. Even if you don’t use these techniques, you can make it a regular habit to analyze your stocks and check for signs of trouble, such as debts or P/E ratios that are too high. If you see signs of trouble (check out Chapter 24), consider selling anyway.
Also, keep in mind that fear is frequently a symptom of lack of knowledge about what’s going on. If you see your stocks falling and don’t understand why, fear will take over and you may act irrationally. When stock investors are affected by fear, the tendency is to sell their stocks and head for the exits and the life boats. When an investor sees his stock go down 20 percent, what goes through his head? Experienced, knowledgeable investors see that no bull market goes straight up. Even the strongest bull goes up in a zigzag fashion. Conversely, even bear markets don’t go straight down, they zigzag down. Out of fear, inexperienced investors will sell good stocks if they see them go down temporarily (the “correction”) while experienced investors see that temporary down move as a good buying opportunity to add to their positions. (Flip to Chapter 14 for details on dealing with bull and bear markets.)
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Part I: The Essentials of Stock Investing Looking for love in all the wrong places Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell it, even when the stock is plummeting and shows all the symptoms of getting worse. Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends. Love and attachment are great in relationships with people but can be horrible with investments. To deal with this emotion, investors have to deploy techniques that take the emotion out. For example, you can use brokerage orders (such as trailing stops and limit orders), which can automatically trigger buy and sell transactions and leave some of the agonizing out. Hey, disciplined investing may just become your new passion!
Minimizing Your Risk Now, before you go crazy thinking that stock investing carries so much risk that you may as well not get out of bed, take a breath. Minimizing your risk in stock investing is easier than you think. Although wealth building through the stock market doesn’t take place without some amount of risk, you can practice the following tips to maximize your profits and still keep your money secure.
Gaining knowledge Some people spend more time analyzing a restaurant menu to choose a $10 entrée than analyzing where to put their next $5,000. Lack of knowledge constitutes the greatest risk for new investors, but diminishing that risk starts with gaining knowledge. The more familiar you are with the stock market — how it works, factors that affect stock value, and so on — the better you can navigate around its pitfalls and maximize your profits. The same knowledge that enables you to grow your wealth also enables you to minimize your risk. Before you put your money anywhere, you want to know as much as you can. This book is a great place to start — check out Chapter 6 for a rundown of the kinds of information you want to know before you buy stocks, as well as the resources that can give you the information you need to invest successfully.
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Staying out until you get a little practice If you don’t understand stocks, don’t invest! Yeah, I know this book is about stock investing, and I think that some measure of stock investing is a good idea for most people. But that doesn’t mean you should be 100 percent invested 100 percent of the time. If you don’t understand a particular stock (or don’t understand stocks, period), stay away until you do understand. Instead, give yourself an imaginary sum of money, such as $100,000, give yourself reasons to invest, and just make believe (“simulated stock investing or trading”). Pick a few stocks that you think will increase in value, track them for a while, and see how they perform. Begin to understand how the price of a stock goes up and down, and watch what happens to the stocks you choose when various events take place. As you find out more and more about stock investing, you get better and better at picking individual stocks, and you haven’t risked — or lost — any money during your learning period. A good place to do your imaginary investing is at Web sites such as Marketocracy (www.marketocracy.com) and Investopedia’s simulator (http://simulator.investopedia.com). You can design a stock portfolio and track its performance with thousands of other investors to see how well you do.
Putting your financial house in order Advice on what to do before you invest could be a whole book all by itself. The bottom line is that you want to make sure that you are, first and foremost, financially secure before you take the plunge into the stock market. If you’re not sure about your financial security, look over your situation with a financial planner. (You can find more on financial planners in Appendix A.) Before you buy your first stock, here are a few things you can do to get your finances in order: ✓ Have a cushion of money. Set aside three to six months’ worth of your gross living expenses somewhere safe, such as in a bank account or treasury money market fund, in case you suddenly need cash for an emergency (see Chapter 2 for details). ✓ Reduce your debt. Overindulging in debt was the worst personal economic problem for many Americans in the late 1990s, and this has continued in recent years. The year 2001 was a record year for bankruptcy,
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Part I: The Essentials of Stock Investing with nearly 1.5 million people filing for bankruptcy. When the housing bubble popped, millions of foreclosures were the result as homeowners piled on too much debt. ✓ Make sure that your job is as secure as you can make it. Are you keeping your skills up to date? Is the company you work for strong and growing? Is the industry that you work in strong and growing? ✓ Make sure that you have adequate insurance. You need enough insurance to cover you and your family’s needs in case of illness, death, disability, and so on.
Diversifying your investments Diversification is a strategy for reducing risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments? The easiest way to understand proper diversification may be to look at what you shouldn’t do: ✓ Don’t put all your money in one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks. As a general rule, the money you tie up in a single stock should be money you can do without. ✓ Don’t put all your money in one industry. I know people who own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it could work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt. ✓ Don’t put all your money in one type of investment. Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio. Some of these alternatives can be found in mutual funds or exchange-traded funds (ETFs). An exchange-traded fund is a fund with a fixed portfolio of stocks or other securities that tracks a particular index but is traded like a stock. By the way, I love ETFs and I think that every serious investor should consider them; see Chapter 14 for more information.
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Better luck next time! A little knowledge can be very risky. Consider the true story of one “lucky” fellow who played the California lottery in 1987. He discovered that he had a winning ticket, with the first prize of $412,000. He immediately ordered a Porsche, booked a lavish trip to Hawaii for his family, and treated his wife and friends to a champagne dinner at a posh Hollywood restaurant. When
he finally went to collect his prize, he found out that he had to share first prize with over 9,000 other lottery players who also had the same winning numbers. His share of the prize was actually only $45! Hopefully, he invested that tidy sum based on his increased knowledge about risk.
Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice: ✓ Keep only 10 percent (or less) of your investment money in a single stock. ✓ Invest in four or five (and no more than ten) different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand. To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities. See Chapter 13 for more information about analyzing industries.
Weighing Risk against Return How much risk is appropriate for you, and how do you handle it? Before you try to figure out what risks accompany your investment choices, analyze yourself. Here are some points to keep in mind when weighing risk versus return in your situation: ✓ Your financial goal: In five minutes with a financial calculator, you can easily see how much money you’re going to need to become financially independent (presuming financial independence is your goal). Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that’s a relatively low rate of return.
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Part I: The Essentials of Stock Investing The important point is that you don’t have to knock yourself out trying to double your money with risky, high-flying investments; some runof-the-mill bank investments will do just fine. All too often, investors take on more risk than is necessary. Figure out what your financial goal is so that you know what kind of return you realistically need. Flip to Chapters 2 and 3 for details on determining your financial goals. ✓ Your investor profile: Are you nearing retirement, or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return. • If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. Even if you lose big time, you still have a long time to recoup your money and get back on track. • However, if you’re within five years of retirement, risky or aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and the odds are that you’ll need the investment money (and its income-generating capacity) to cover your living expenses after you’re no longer employed. ✓ Asset allocation: I never tell retirees to put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, I don’t see a problem as long as they limit such investments to 5 percent of their total assets. As long as the bulk of their money is safe and sound in secure investments (such as U.S. treasury bonds), I know I can sleep well (knowing that they can sleep well!). Asset allocation beckons back to diversification, which I discuss earlier in this chapter. For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid cap and small cap stocks; see Chapter 1) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (mid caps and large caps are preferable). Check with your financial advisor to find the right mix for your particular situation.
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Chapter 5
Say Cheese: Getting a Snapshot of the Market with Indexes In This Chapter ▶ Defining index basics ▶ Looking at the Dow and other indexes ▶ Exploring indexes for practical use
“H
ow’s the market doing today?” is the most common question that interested parties ask about the stock market. “What did the Dow do?” “How about Nasdaq?” Invariably, people asking those questions expect an answer regarding how well the market performed that day. “Well, the Dow fell 157 points to 12,500, while Nasdaq was unchanged at 2,449.” The Dow and Nasdaq are indexes, which are statistical measures that represent the value of a batch of stocks. You can use indexes as general gauges of stock market activity. From them, you get a basic idea of how well (or how poorly) the overall market (or a portion of it) is doing. In this chapter, I focus my attention on the major stock market indexes and how to use them.
Knowing How Indexes Are Measured The oldest stock market index is the Dow Jones Industrial Average (DJIA or simply “The Dow”), which was created by Charles Dow (of Dow Jones fame) in 1896. The Dow covered only 12 stocks then, but the number increased to 30 stocks in 1928, and it remains the same to this day. Because Dow worked long before the age of computers, he kept the calculations of his stock market index simple and did them arithmetically by hand. Dow added up the stock prices of the 12 companies and then divided the sum by 12. Technically, this number is an average and not an index (hence the word “average” in the name). For simplicity’s sake, I refer to it as an index. Besides, the number gets tweaked nowadays to account for things such as stock splits. (For more on stock splits, see Chapter 20.)
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Part I: The Essentials of Stock Investing However, indexes and averages get calculated differently. The primary difference is the concept of weighting. Weighting refers to the relative importance of the items when they’re computed within the index. Several kinds of indexes exist, including: ✓ Price-weighted index: This index tracks changes based on the change in the individual stock’s price per share. For example, suppose you own two stocks: Stock A, worth $20 per share, and Stock B, worth $40 per share. A price-weighted index allocates a greater proportion of the index to the stock at $40 than to the one at $20. If the index contained only these two stocks, the index number would reflect the $40 stock as being 67 percent (two-thirds of the total), while the $20 stock would be 33 percent (one-third of the total). The Dow is a good example of a priceweighted index. ✓ Market-value weighted index: This index, also known as a capitalizationweighted index, tracks the proportion of a stock based on its market capitalization (or market value, also called market cap). Say that in your portfolio, you have 10 million shares of a $20 stock (Stock A) and 1 million shares of a $40 stock (Stock B). Stock A’s market cap is $200 million, while Stock B’s market cap is $40 million. Therefore, in a market-value weighted index, Stock A represents 83 percent of the index’s value because of its much larger market cap. An example of a market-value weighted index is the Nasdaq Composite Index. ✓ Broad-based index: The sample portfolios in the preceding bullets show only two stocks — obviously not a good representative index. Most investing professionals (especially money managers and mutual fund firms) use a broad-based index as a benchmark to compare their progress. A broad-based index provides a snapshot of the entire market. The S&P 500 and the Wilshire 5000 are good examples of broad-based indexes (they also happen to be market-value weighted indexes; see descriptions of both indexes later in this chapter.) ✓ Composite index: This index is a combination of several averages or indexes. An example is the New York Stock Exchange (NYSE) Composite, which tracks all the stocks on the NYSE. Another example is the Nasdaq Composite Index, which is a market-capitalization composite index of 3,000 companies on Nasdaq. (I discuss Nasdaq later in this chapter.) ✓ Performance-based index: This index includes not only the appreciation of the stocks represented in the index but also the dividends (and other cash payouts) issued to stockholders. The DAX (the most widely followed German index, composed of 30 major German companies) is a performance-based index.
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Checking Out the Indexes Although most people consider the Dow, Nasdaq, and Standard & Poor’s 500 to be the stars of the financial press, you may find other indexes equally important to follow because they cover other significant facets of the market, such as small cap and mid cap stocks, or specific sectors and industries. For example, if you invest in an Internet stock, you should check the Internet Stock Index to compare how your stock is doing when measured against the index. You can find indexes that cover industries such as transportation, brokerage firms, retailers, computer companies, and real estate firms. For a comprehensive list of indexes, go to www.djindexes.com (a Dow Jones & Co. Web site). The most reliable and most widely respected indexes are produced not only by Dow Jones but also Standard & Poor’s and the major exchanges/ markets themselves, such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and Nasdaq. Smaller exchanges also issue or provide indexes (such as the Philadelphia Exchange). Web sites for different exchanges can be found in Appendix A.
The Dow Jones Industrial Average The most famous stock market barometer is my first example in the previous section — the Dow Jones Industrial Average (DJIA). When someone asks how the market is doing, most investors quote the DJIA (simply referred to as “the Dow”). The Dow is price weighted and tracks a basket of 30 of the largest and most influential public companies in the stock market. I list the stocks tracked on the Dow and discuss the Dow’s drawbacks in the following sections.
The companies of the Dow The following list shows the current roster of 30 stocks tracked on the DJIA (in alphabetical order by company, with their stock symbols in parentheses).
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Alcoa (AA)
Caterpillar (CAT)
American Express Co. (AXP)
Chevron (CVX)
AT&T (T)
Citigroup (C)
Bank of America (BAC)
Coca-Cola Co. (KO)
Boeing (BA)
Disney & Co (DIS)
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Part I: The Essentials of Stock Investing DuPont (DD)
Kraft Food Inc. (KFT)
Exxon Mobil (XOM)
McDonald’s (MCD)
General Electric (GE)
Merck (MRK)
General Motors (GM)
Microsoft (MSFT)
Hewlett-Packard (HPQ) Home Depot (HD)
Minnesota Mining and Manufacturing (also known as 3M) (MMM)
Intel (INTC)
Pfizer (PFE)
International Business Machines (IBM)
Procter & Gamble (PG) United Technologies (UTX)
Johnson & Johnson (JNJ) Verizon (VZ) J.P. Morgan Chase (JPM) Wal-Mart Stores (WMT)
The drawbacks of the Dow The Dow has survived as a popular gauge of stock market activity for over a century because it was the first such statistical snapshot of the stock market, which helped it become quickly entrenched as a widely followed and quoted barometer. Although it’s an important indicator of the market’s progress, the Dow does have one major drawback: It tracks only 30 companies. Regardless of their status in the market, the companies in the Dow represent a limited sampling, so they don’t communicate the true pulse of the market. For example, when the Dow surpassed the record 10,000 and 11,000 milestones during 1999 and 2000, the majority of (nonindex) companies showed lackluster or declining stock price movement. (See the “Dow Jones milestones” sidebar, later in this chapter, for more information.) The roster of the Dow has changed many times during the 100-plus years of its existence. The only original company from 1896 is General Electric. Dow Jones made most of the changes because of company mergers and bankruptcy. However, Dow Jones also made some changes simply to reflect the changing times. In September 2008, as AIG Corp.’s stock was plummeting because of the credit crisis on Wall Street, it was quickly removed from the Dow and replaced with Kraft Foods. At that time, AIG fell from $25 per share to $3 per share within days. Had AIG stayed in the Dow, the Dow would have shown a larger drop, but it maintained a higher level because of the quick replacement. Investors unaware of such moves can be fooled regarding the market’s health — another drawback of the Dow.
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Dow Jones milestones This table shows when the Dow Jones Industrial Average reached each of 14 1,000-point milestones and how long it took to reach that point: Milestone
Date
How long it took
1,000
Nov. 14, 1972
76 years
2,000
Jan. 8, 1987
14 years
3,000
April 17, 1991
4 years
4,000
Feb. 23, 1995
4 years
5,000
Nov. 21, 1995
9 months
6,000
Oct. 14, 1996
11 months
7,000
Feb. 13, 1997
4 months
8,000
July 16, 1997
5 months
9,000
April 6, 1998
9 months
10,000
March 29, 1999
1 year
11,000
May 3, 1999
1 month
12,000
Oct. 19, 2006
7 years and 5 months
13,000
April 25, 2007
6 months
14,000
July 19, 2007
3 months
As you can see, the Dow took 76 years to hit its first milestone. But it took less and less time to hit each succeeding milestone because the higher the Dow is in a relative sense, the easier it is to jump 1,000 points. For example, it went from 6,000 to 7,000 in only four months. As the table indicates, most of the milestones happened during the 1982–1999 bull market. But the Dow didn’t reach a new milestone from 2000–2004. After the Dow hit a peak of 11,722 in January 2000, it entered a bear market that lasted three years. A new bull market started in 2003, and the Dow regained its traction and started an ascent to new highs. It finally hit the 12,000 mark in late 2006 (nearly 71/2 years after hitting the 11,000 level). Despite hitting the 14,000 plateau in July 2007, it spent the subsequent 12-month period trading sideways in the 11,000–13,000 range. The Dow hit an alltime closing high of 14,164.53 on October 9, 2007 (Hey! That’s my wedding anniversary!), although it is considerably lower a year later (under 9,300). Oh well . . . .
The Dow isn’t a pure gauge of industrial activity because it also includes a hodgepodge of nonindustrial companies such as J.P. Morgan Chase and Citigroup (banks), Home Depot (retailing), and Microsoft (software). During this decade, true industrial sectors like manufacturing had difficult times, yet the Dow rose to record levels. Given the Dow’s shortcomings, serious investors also look at the following indexes: ✓ Broad-based indexes: The S&P 500 and the Wilshire 5000 are more realistic gauges of the stock market’s performance than the Dow. (I discuss these indexes later in this chapter.)
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Part I: The Essentials of Stock Investing ✓ Industry or sector indexes: These indexes are better gauges of the growth (or lack of growth) of specific industries and sectors. If you buy a gold stock, for example, you should track the index for the precious metals industry. Dow Jones has several averages, including the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). Dow Jones manages both of these indexes more strictly than the Dow, so they tend to be a more accurate barometer of the market they represent. Find out more about the Dow Jones indexes at www.djindexes.com.
Standard & Poor’s 500 The Standard & Poor’s 500 (S&P 500) tracks 500 leading publicly traded companies considered to be widely held. The publishing firm Standard & Poor’s created this index (I bet you could’ve guessed that). Because it contains 500 companies, the S&P 500 more accurately represents overall market performance than the DJIA, with its 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the Dow. Most mutual funds especially like to measure their performance against the S&P 500 rather than any other index, although mutual funds that concentrate on small cap stocks usually prefer an index that has more small cap stocks in it, such as the Russell 2000 (which I discuss later in this chapter). The S&P 500 doesn’t attempt to cover the 500 biggest companies. Instead, it includes companies that are widely held and widely followed. The companies are also industry leaders in a variety of industries, including energy, technology, healthcare, and finance. Although it’s a reliable indicator of the market’s overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies make up 50 percent of the index’s market value. This situation can be a drawback, because those 50 companies have a greater influence on the index’s price movement than any other segment of companies. In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DIJA, it doesn’t give a perfectly accurate representation of the general market. Standard & Poor’s doesn’t set the 500 companies it tracks in stone — S&P can add or remove companies when market conditions change, removing a company if it isn’t doing well or goes bankrupt, for instance, and replacing it
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with a company that’s doing better. You can find out more at www.standard andpoors.com.
Wilshire Total Market Index The Wilshire 5000 Equity Index, often referred to as the Wilshire Total Market Index, is probably the largest stock index in the world. Wilshire Associates started out in 1980 tracking 5,000 stocks. Since then, the Wilshire 5000 has ballooned to cover more than 7,500 stocks. The advantage of the Wilshire 5000 is that it’s very comprehensive, covering nearly the entire market (at the very least, the Wilshire 5000 tracks the largest publicly traded stocks). It includes all the stocks on the major stock exchanges (NYSE, AMEX, and the largest issues on Nasdaq), which by default also includes all the stocks covered by the S&P 500. Investors and analysts who seek the greatest representation/performance of the general market look to the Wilshire 5000. The Wilshire 5000 is a market-value weighted index that also performs as a broad-based index. The Wilshire indexes are maintained by Wilshire Associates Incorporated, and you can find out more at www.wilshire.com.
Nasdaq indexes Nasdaq became a formalized market in 1971. The name used to stand for “National Association of Securities Dealers Automated Quote” system, but now it’s simply “Nasdaq” (as if it’s a name like Ralph or Eddie). Nasdaq indexes are similar to other indexes in style and structure. The only difference is that, well, they cover companies traded on the Nasdaq (www. nasdaq.com). The Nasdaq has two indexes, both of which are reported in the financial pages: ✓ Nasdaq Composite Index: Most frequently quoted on the news, the Nasdaq Composite Index covers about 3,000 companies that trade on Nasdaq. The companies encompass a variety of industries, but the index’s concentration is primarily technology, telecommunications, and related sectors. The Nasdaq Composite Index hit an all-time high of 5,048 in March 2000 before the worst bear market in its history occurred. The index dropped a whopping 77 percent by 2002 to bottom out at 1,114 in October 2002. As of early October 2008, the Nasdaq was at approximately 1,740 (still way below its all-time high, but higher than its bottom six years earlier).
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Part I: The Essentials of Stock Investing ✓ Nasdaq 100 Index: The Nasdaq 100 tracks the 100 largest companies in Nasdaq based on size in terms of market capitalization. This index is for investors who want to concentrate on the largest companies, which tend to be especially weighted in technology. It provides extra representation of technology-related companies such as Microsoft, Adobe, and Symantec. Although these indexes track growth-oriented companies, the stocks of these companies are also very volatile and carry commensurate risk. The indexes themselves bear this risk out; in the bear market of 2000 and 2001 (and even extending into 2002), they fell more than 60 percent. You can find out more about Nasdaq’s indexes at www.nasdaq.com.
Russell 3000 Index The Russell 3000 Index is a great example of an index that seeks more comprehensive inclusion of U.S. companies. It’s a performance-based index that includes the 3,000 largest publicly traded companies (nearly 98 percent of publicly traded stocks). The Russell 3000 is important because it includes many mid cap and small cap stocks. Most companies covered in the Russell 3000 have an average market value of a billion dollars or less. Russell Investments Group created and maintains the Russell 3000 Index, as well as the Russell 1000 and the Russell 2000. The Russell 2000 contains the smallest 2,000 companies from the Russell 3000, while the Russell 1000 contains the largest 1,000 companies. The Russell indexes don’t cover micro cap stocks (companies with a market capitalization under $250 million). You can find out more at www.russell.com.
International indexes Investors need to remember that the whole world is a vast marketplace that interacts with and exerts tremendous influence on individual national economies and markets. Whether you have one stock or one mutual fund, keep tabs on how world markets affect your portfolio. The best way to get a snapshot of international markets is, of course, with indexes. Here are some of the more widely followed international indexes: ✓ BSE SENSEX (India): The most widely followed index of Indian stocks is also referred to as the “BSE 30 Index” and is a value-weighted index maintained by the Bombay Stock Exchange (www.bseindia.com).
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✓ CAC-40 (France): This market-capitalization weighted index tracks 40 of the largest public stocks that trade on Paris’s stock exchange, the Euronext Paris. ✓ DAX (Germany): This index is similar to our DJIA in that it tracks 30 blue chip stocks (the largest and most active that trade on the Frankfurt Exchange). ✓ FTSE-100 (Great Britain): Usually referred to as the “footsie,” this market-value weighted index includes the top 100 public companies in the United Kingdom. ✓ Halter USX China Index (China): This index tracks a basket of 50 market-value weighted U.S. public companies that derive most of their revenues from China. ✓ Hang Seng Index (Hong Kong): This market-value weighted index tracks the top 45 companies on the Hong Kong Stock Exchange. ✓ Nikkei (Japan): This index is considered Japan’s version of the Dow. If you’re invested in Japanese stocks or in stocks that do business with Japan, you want to know what’s up with the Nikkei. ✓ SSE Composite Index (Shanghai): This is an index of all the stocks that trade on the Shanghai Stock Exchange. You can track these international indexes (among others) at major financial Web sites such as www.bloomberg.com and www.marketwatch.com. You may find international indexes useful in your analysis as you watch your stocks’ progress. What if you have stock in a company that has most of its customers in Japan? Then the Nikkei can help you get a general snapshot of how well the major companies are doing in Japan, which in turn can be a general barometer of Japan’s economic health. If your company’s business partners or customers are in the Nikkei and it’s plunging, you know it’s probably “sayonara” for the company’s stock price. As for me, I’m still waiting for the “Galaxy 1 Million Index” — no point in being overweight with Earth stocks, you know.
Using the Indexes Effectively You may be wondering which indexes you should be checking out and exactly what you should do with them. The sections that follow give you some idea of how to put all the pieces together.
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Part I: The Essentials of Stock Investing
Tracking the indexes The bottom line is that indexes give investors an instant snapshot of how well the market is doing. Indexes offer a quick way to compare the performance of one investor’s portfolio with the rest of the market. If the Dow goes up 10 percent in a year and your portfolio shows a cumulative gain of 12 percent, then you know you’re doing well. Appendix A lists resources to help you keep up with various indexes. The problem with indexes is that they can be misleading if you take them too literally as an accurate barometer of stock success. For example, the Dow has changed its roster of companies many times since 1896. Had it not, the Dow’s general upward trajectory in the past few decades would have been much different. Laggard stocks have been dropped and replaced with stocks that have shown more promise. Many of the original companies that were in the DJIA in 1896 went out of business or were bought by other companies that aren’t reflected in the index.
Investing in indexes If the market is doing well but your specific stock isn’t, can you find a way to invest in the index itself? Yes, and with investments based on indexes, you can invest in the general market or a particular industry. Say you want to invest in the DJIA. After all, why try to beat the market if just matching it is sufficient to grow your wealth? Why not have a portfolio that directly mirrors the DJIA? Well, it’s too impractical and expensive to invest in all 30 stocks in the DJIA. Fortunately, alternatives can accomplish the act of investing in indexes. Here are the best ways: ✓ Index mutual funds: An index mutual fund is much like a regular mutual fund except that it only invests in securities (in this case, stocks) that match as closely as possible the basket of stocks in that particular index. For example, you can find index mutual funds that track the DJIA and the S&P 500. Find out more about index mutual funds at places such as Morningstar (www.morningstar.com). ✓ Exchange-traded funds (ETFs): This is a particular favorite of mine. ETFs have similar characteristics to mutual funds except for a few key differences. An ETF can reflect a basket of stocks that mirror a particular index, but you can trade the ETF like a stock itself. You can transact ETFs like stocks in that you can buy, sell, or go short. You can put
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stop losses on them, and you can even purchase them on margin (see Chapter 18 for more on stop losses and buying on margin). ETFs can give you the diversification of mutual funds coupled with the versatility of stocks. Examples of ETFs that track indexes are the DJIA ETF (symbol DIA) and the ETF for Nasdaq (QQQ). You can find out more about ETFs at the American Stock Exchange (www.amex.com).
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Part I: The Essentials of Stock Investing
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Part II
Before You Start Buying
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In this part . . .
hen you’re about to begin investing in stocks, you should know that different types of stocks exist for different objectives. If you can at least get a stock that fits your situation, you’re that much ahead in the game. In this part, you can find out where to start gathering information and discover what stockbrokers can do for you. In addition, you’ll find a fun chapter on the basics of economics (really!) that will keep you ahead of the curve because stock choices are made more intelligently when you know the economic environment.
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Chapter 6
Gathering Information In This Chapter ▶ Using stock exchanges to get investment information ▶ Applying accounting and economic know-how to your investments ▶ Exploring financial issues ▶ Deciphering stock tables ▶ Interpreting dividend news ▶ Recognizing good (and bad) investing advice
K
nowledge and information are two critical success factors in stock investing. (Isn’t that true about most things in life?) People who plunge headlong into stocks without sufficient knowledge of the stock market in general, and current information in particular, quickly learn the lesson of the eager diver who didn’t find out ahead of time that the pool was only an inch deep (ouch!). In their haste to avoid missing so-called golden investment opportunities, investors too often end up losing money.
Opportunities to make money in the stock market will always be there, no matter how well or how poorly the economy and the market are performing in general. There’s no such thing as a single (and fleeting) magical moment, so don’t feel that if you let an opportunity pass you by, you’ll always regret that you missed your one big chance. For the best approach to stock investing, you want to build your knowledge and find quality information first. Then buy stocks and make your fortunes more assuredly. Basically, before you buy stock, you need to know that the company you’re investing in is ✓ Financially sound and growing ✓ Offering products and services that are in demand by consumers ✓ In a strong and growing industry (and general economy) Where do you start and what kind of information do you want to acquire? Keep reading.
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Part II: Before You Start Buying
Looking to Stock Exchanges for Answers Before you invest in stocks, you need to be completely familiar with the basics of stock investing. At its most fundamental, stock investing is about using your money to buy a piece of a company that will give you value in the form of appreciation or income. Fortunately, many resources are available to help you find out about stock investing. Some of my favorite places are the stock exchanges themselves. Stock exchanges are organized marketplaces for the buying and selling of stocks (and other securities). The New York Stock Exchange (NYSE), the premier stock exchange, provides a framework for stock buyers and sellers to make their transactions. The NYSE makes money not only from a piece of every transaction but also from fees (such as listing fees) charged to companies and brokers that are members of its exchanges. In 2007, the NYSE merged with Euronext, a major European exchange, but no material differences exist for stock investors. The main exchanges for most stock investors are the NYSE and the American Stock Exchange (AMEX). Nasdaq is technically not an exchange, but it is a formal market that effectively acts as an exchange. These three encourage and inform people about stock investing. Because these exchanges/markets benefit from increased popularity of stock investing and continued demand for stocks, they offer a wealth of free (or low-cost) resources and information for stock investors. Go to their Web sites and you find useful resources such as: ✓ Tutorials on how to invest in stocks, common investment strategies, and so on ✓ Glossaries and free information to help you understand the language, practice, and purpose of stock investing ✓ A wealth of news, press releases, financial data, and other information about companies listed on the exchange or market, usually accessed through an on-site search engine ✓ Industry analysis and news ✓ Stock quotes and other market information related to the daily market movements of stocks, including data such as volume, new highs, new lows, and so on ✓ Free tracking of your stock selections (you can input a sample portfolio, or the stocks you’re following, to see how well you’re doing)
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What each exchange/market offers keeps changing and is often updated, so go explore them at their Web sites: ✓ New York Stock Exchange: www.nyse.com ✓ American Stock Exchange: www.amex.com ✓ Nasdaq: www.nasdaq.com
Understanding Stocks and the Companies They Represent Stocks represent ownership in companies. Before you buy individual stocks, you want to understand the companies whose stock you’re considering and find out about their operations. It may sound like a daunting task, but you’ll digest the point more easily when you realize that companies work very similarly to how you work. They make decisions on a day-to-day basis just as you do. Think about how you grow and prosper as an individual or as a family, and you see the same issues with businesses and how they grow and prosper. Low earnings and high debt are examples of financial difficulties that can affect both people and companies. You’ll understand companies’ finances when you take the time to pick up some information in two basic disciplines: accounting and economics. These two disciplines play a significant role in understanding the performance of a firm’s stock.
Accounting for taste and a whole lot more Accounting. Ugh! But face it: Accounting is the language of business, and believe it or not, you’re already familiar with the most important accounting concepts! Just look at the following three essential principles: ✓ Assets minus liabilities equal net worth. In other words, take what you own (your assets), subtract what you owe (your liabilities), and the rest is yours (net worth)! Your own personal finances work the same way as Microsoft’s (except yours have fewer zeros at the end). See Chapter 2 to figure out how to calculate your own net worth.
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Part II: Before You Start Buying A company’s balance sheet shows you its net worth at a specific point in time (such as December 31). The net worth of a company is the bottom line of its asset and liability picture, and it tells you whether the company is solvent (has the ability to pay its debts without going out of business). The net worth of a successful company is regularly growing. To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier. A firm that has a $4 million net worth on December 31, 2007, and a $5 million net worth on December 31, 2008, is doing well; its net worth has gone up 25 percent ($1 million) in one year. ✓ Income less expenses equal net income. In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain). A company’s profitability is the whole point of investing in its stock. As it profits, the business becomes more valuable, and in turn, its stock price becomes more valuable. To discover a firm’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either reinvesting them for continued growth or paying down debt. ✓ Do a comparative financial analysis. That’s a mouthful, but it’s just a fancy way of saying how a company is doing now compared with something else (like a prior period or a similar company). If you know that the company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else. If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid that company or see what went wrong (if anything) with it. Accounting can be this simple. If you understand these three basic points, you’re ahead of the curve (in stock investing as well as in your personal finances). For more information on how to use a company’s financial statements to pick good stocks, see Chapters 11 and 12.
Understanding how economics affects stocks Economics. Double ugh! No, you aren’t required to understand “the inelasticity of demand aggregates” (thank heavens!) or “marginal utility” (say what?). But a working knowledge of basic economics is crucial (and I mean crucial)
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to your success and proficiency as a stock investor. The stock market and the economy are joined at the hip. The good (or bad) things that happen to one have a direct effect on the other.
Getting the hang of the basic concepts Alas, many investors get lost on basic economic concepts (as do some socalled experts that you see on TV). I owe my personal investing success to my status as a student of economics. Understanding basic economics helps me (and will help you) filter the financial news to separate relevant information from the irrelevant in order to make better investment decisions. Be aware of these important economic concepts: ✓ Supply and demand: How can anyone possibly think about economics without thinking of the ageless concept of supply and demand? Supply and demand can be simply stated as the relationship between what’s available (the supply) and what people want and are willing to pay for (the demand). This equation is the main engine of economic activity and is extremely important for your stock investing analysis and decisionmaking process. I mean, do you really want to buy stock in a company that makes elephant-foot umbrella stands if you find out that the company has an oversupply and nobody wants to buy them anyway? (I discuss supply and demand in more detail in Chapter 10.) ✓ Cause and effect: If you pick up a prominent news report and read, “Companies in the table industry are expecting plummeting sales,” do you rush out and invest in companies that sell chairs or manufacture tablecloths? Considering cause and effect is an exercise in logical thinking, and believe you me, logic is a major component of sound economic thought. When you read business news, play it out in your mind. What good (or bad) can logically be expected given a certain event or situation? If you’re looking for an effect (“I want a stock price that keeps increasing”), you also want to understand the cause. Here are some typical events that can cause a stock’s price to rise (see Chapter 10 for additional info on cause and effect): • Positive news reports about a company: The news may report that the company is enjoying success with increased sales or a new product. • Positive news reports about a company’s industry: The media may be highlighting that the industry is poised to do well. • Positive news reports about a company’s customers: Maybe your company is in industry A, but its customers are in industry B. If you see good news about industry B, that may be good news for your stock.
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Part II: Before You Start Buying • Negative news reports about a company’s competitors: If the competitors are in trouble, their customers may seek alternatives to buy from, including your company. ✓ Economic effects from government actions: Political and governmental actions have economic consequences. As a matter of fact, nothing (and I mean nothing!) has a greater effect on investing and economics than government. Government actions usually manifest themselves as taxes, laws, or regulations. They also can take on a more ominous appearance, such as war or the threat of war. Government can willfully (or even accidentally) cause a company to go bankrupt, disrupt an entire industry, or even cause a depression. It controls the money supply, credit, and all public securities markets. For more information on political effects, see Chapter 15.
Gaining insight from past mistakes Because most investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios. During 2000–2008, the U.S. experienced the greatest expansion of total debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing. This activity hyperstimulated the stock market and caused stocks to rise 25 percent per year for five straight years during the late 1990s. When the stock market bubble popped during 2000–2002, it was soon replaced with the housing bubble, which popped during 2005–2006 and is still hurting the economy in 2008. Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. This artificial stimulation by the Fed resulted in the following: ✓ More and more people depleted their savings. After all, why settle for 3 percent in the bank when you can get 25 percent in the stock market? ✓ More and more people bought on credit. If the economy is booming, why not buy now and pay later? Consumer credit hit record highs. ✓ More and more people borrowed against their homes. Why not borrow and get rich now? I can pay off my debt later. ✓ More and more companies sold more goods as consumers took more vacations and bought SUVs, electronics, and so on. Companies then borrowed to finance expansion, open new stores, and so on. ✓ More and more companies went public and offered stock to take advantage of more money that was flowing to the markets from banks and other financial institutions.
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Know thyself before you invest in stocks If you’re reading this book, you’re probably doing so because you want to become a successful investor. Granted, to be a successful investor, you have to select great stocks, but having a realistic understanding of your own financial situation and goals is equally important. I recall one investor who lost $10,000 in a speculative stock. The loss wasn’t that bad because he had most of his money safely tucked away elsewhere. He also understood
that his overall financial situation was secure and that the money he lost was “play” money — the loss wouldn’t have a drastic effect on his life. But many investors often lose even more money, and the loss does have a major, negative effect on their lives. You may not be like the investor who can afford to lose $10,000. Take time to understand yourself, your own financial picture, and your personal investment goals before you decide to buy stocks.
In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. However, companies had too much overhead, capacity, and debt because they expanded too eagerly. At this point, businesses were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. Companies, to stay in business, had to do the logical thing — cut expenses. What’s usually the biggest expense for companies? People! To stay in business, many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security. As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell. The lessons from the 1990s are important ones for investors today: ✓ Stocks are not a replacement for savings accounts. Always have some money in the bank. ✓ Stocks should never occupy 100 percent of your investment funds. ✓ When anyone (including an expert) tells you that the economy will keep growing indefinitely, be skeptical and read diverse sources of information. ✓ If stocks do well in your portfolio, consider protecting your stocks (both your original investment and any gains) with stop-loss orders. (See Chapter 18 for more on these strategies.)
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Part II: Before You Start Buying ✓ Keep debt and expenses to a minimum. ✓ If the economy is booming, a decline is sure to follow as the ebb and flow of the economy’s business cycle continues.
Staying on Top of Financial News Reading the financial news can help you decide where or where not to invest. Many newspapers, magazines, and Web sites offer great coverage of the financial world. Obviously, the more informed you are, the better, but you don’t have to read everything that’s written. The information explosion in recent years has gone beyond overload, and you can easily spend so much time reading that you have little time left for investing. In the following sections, I describe the types of information you need to get from the financial news. Appendix A of this book provides more information on the following resources, along with a treasure trove of some of the best publications, resources, and Web sites to assist you: ✓ The most obvious publications of interest to stock investors are The Wall Street Journal and Investor’s Business Daily. These excellent publications report the news and stock data as of the prior trading day. ✓ Some of the more obvious Web sites are MarketWatch (www.market watch.com) and Bloomberg (www.bloomberg.com). These Web sites can actually give you news and stock data within 15 to 20 minutes after an event occurs. ✓ Don’t forget the exchanges’ Web sites that I list in the earlier section, “Looking to Stock Exchanges for Answers”!
Figuring out what a company’s up to Before you invest, you need to know what’s going on with the company. When you read about the company, either from the firm’s literature (its annual report, for example) or from media sources, be sure to get answers to some pertinent questions: ✓ Is the company making more net income than it did last year? You want to invest in a company that’s growing. ✓ Are the company’s sales greater than they were the year before? Remember, you won’t make money if the company isn’t making money.
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✓ Is the company issuing press releases on new products, services, inventions, or business deals? All these achievements indicate a strong, vital company. Knowing how the company is doing, no matter what’s happening with the general economy, is obviously important. To better understand how companies tick, see Chapters 11 and 12.
Discovering what’s new with an industry As you consider investing in a stock, make it a point to know what’s going on in that company’s industry. If the industry is doing well, your stock is likely to do well, too. But then again, the reverse is also true. Yes, I’ve seen investors pick successful stocks in a failing industry, but those cases are exceptional. By and large, it’s easier to succeed with a stock when the entire industry is doing well. As you’re watching the news, reading the financial pages, or viewing financial Web sites, check out the industry to see that it’s strong and dynamic. See Chapter 13 for information on analyzing industries.
Knowing what’s happening with the economy No matter how well or how poorly the overall economy is performing, you want to stay informed about its general progress. It’s easier for the value of stock to keep going up when the economy is stable or growing. The reverse is also true; if the economy is contracting or declining, the stock has a tougher time keeping its value. Some basic items to keep tabs on include the following: ✓ Gross domestic product (GDP): This is roughly the total value of output for a particular nation, measured in the dollar amount of goods and services. The GDP is reported quarterly, and a rising GDP bodes well for your stock. When the GDP is rising 3 percent or more on an annual basis, that’s solid growth. If it rises at more than zero but less than 3 percent, that’s generally considered less than stellar (or mediocre). A GDP under zero (or negative) means that the economy is shrinking (heading into recession).
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Part II: Before You Start Buying ✓ The index of leading economic indicators (LEI): The LEI is a snapshot of a set of economic statistics covering activity that precedes what’s happening in the economy. Each statistic helps you understand the economy in much the same way that barometers (and windows!) help you understand what’s happening with the weather. Economists don’t just look at an individual statistic; they look at a set of statistics to get a more complete picture of what’s happening with the economy. Chapter 10 goes into greater detail on economics and its effect on stock prices.
Seeing what politicians and government bureaucrats are doing Being informed about what public officials are doing is vital to your success as a stock investor. Because federal, state, and local governments pass literally thousands of laws every year, monitoring the political landscape is critical to your success. The news media report what the president and Congress are doing, so always ask yourself, “How does a new law, tax, or regulation affect my stock investment?” Because government actions have a significant effect on your investments, it’s a good idea to see what’s going on. Laws being proposed or enacted by the federal government can be found through the Thomas legislative search engine, which is run by the Library of Congress (www.loc.gov). Also, some great organizations inform the public about tax laws and their impact, such as the National Taxpayers Union (www.ntu.org). Chapter 15 gives you more insights into politics and its effect on the stock market.
Checking for trends in society, culture, and entertainment As odd as it sounds, trends in society, popular culture, and entertainment affect your investments, directly or indirectly. For example, a headline such as, “The Graying of America — More People Than Ever Before Will Be Senior Citizens” gives you some important information that can make or break your stock portfolio. With that particular headline, you know that as more and more people age, companies that are well positioned to cater to that growing market’s wants and needs will do well — meaning a successful stock for you.
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Keep your eyes open to emerging trends in society at large. What trends are evident now? Can you anticipate the wants and needs of tomorrow’s society? Being alert, staying a step ahead of the public, and choosing stocks appropriately gives you a profitable edge over other investors. If you own stock in a solid company with growing sales and earnings, other investors eventually notice. As more investors buy up your company’s stocks, you’re rewarded as the stock price increases.
Reading (And Understanding) Stock Tables The stock tables in major business publications such as The Wall Street Journal and Investor’s Business Daily are loaded with information that can help you become a savvy investor — if you know how to interpret them. You need the information in the stock tables for more than selecting promising investment opportunities. You also need to consult the tables after you invest to monitor how your stocks are doing. Looking at the stock tables without knowing what you’re looking for or why you’re looking is the equivalent of reading War and Peace backwards through a kaleidoscope — nothing makes sense. But I can help you make sense of it all (well, at least the stock tables!). Table 6-1 shows a sample stock table for you to refer to as you read the sections that follow.
Table 6-1
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A Sample Stock Table
52Wk High 21.50
52Wk Low 8.00
Name (Symbol)
Div
Vol
SkyHighCorp (SHC)
47.00
31.75
LowDownInc (LDI)
2.35
2,735
25.00
21.00
ValueNowInc (VNI)
1.00
1,894
83.00
33.00
DoinBadly Corp (DBC)
Yld
P/E
Day Last
Net Chg
76
21.25
+.25
5.9
18
41.00
–.50
4.5
12
22.00
+.10
33.50
–.75
3,143
7,601
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Part II: Before You Start Buying Every newspaper’s financial tables are a little different, but they give you basically the same information. Updated daily, this section is not the place to start your search for a good stock; it’s usually where your search ends. The stock tables are the place to look when you own a stock or know what you want to buy and you’re just checking to see the most recent price. Each item gives you some clues about the current state of affairs for that particular company. The sections that follow describe each column to help you understand what you’re looking at.
52-week high The column in Table 6-1 labeled “52-Wk High” gives you the highest price that particular stock has reached in the most recent 52-week period. Knowing this price lets you gauge where the stock is now versus where it has been recently. SkyHighCorp’s (SHC) stock has been as high as $21.50, while its last (most recent) price is $21.25, the number listed in the “Day Last” column. (Flip to the “Day last” section for more on understanding this information.) SkyHighCorp’s stock is trading very high right now because it’s hovering right near its overall 52-week high figure. Now, take a look at DoinBadlyCorp’s (DBC) stock price. It seems to have tumbled big time. Its stock price has had a high in the past 52 weeks of $83, but it’s currently trading at $33.50. Something just doesn’t seem right here. During the past 52 weeks, DBC’s stock price fell dramatically. If you’re thinking about investing in DBC, find out why the stock price fell. If the company is strong, it may be a good opportunity to buy stock at a lower price. If the company is having tough times, avoid it. In any case, research the firm and find out why its stock has declined.
52-week low The column labeled “52-Wk Low” gives you the lowest price that particular stock reached in the most recent 52-week period. Again, this information is crucial to your ability to analyze stock over a period of time. Look at DBC in Table 6-1, and you can see that its current trading price of $33.50 is close to its 52-week low of $33. Keep in mind that the high and low prices just give you a range of how far that particular stock’s price has moved within the past 52 weeks. They could alert you that a stock has problems, or they could tell you that a stock’s price has fallen enough to make it a bargain. Simply reading the 52-Wk High and 52-Wk Low columns isn’t enough to determine which of those two scenarios is happening. They basically tell you to get more information before you commit your money.
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Name and symbol The “Name (Symbol)” column is the simplest in Table 6-1. It tells you the company name (usually abbreviated) and the stock symbol assigned to the company. When you have your eye on a stock for potential purchase, get familiar with its symbol. Knowing the symbol makes it easier for you to find your stock in the financial tables, which list stocks in alphabetical order by the company’s name. Stock symbols are the language of stock investing, and you need to use them in all stock communications, from getting a stock quote at your broker’s office to buying stock over the Internet.
Dividend Dividends (shown under the “Div” column in Table 6-1) are basically payments to owners (stockholders). If a company pays a dividend, it’s shown in the dividend column. The amount you see is the annual dividend quoted for one share of that stock. If you look at LowDownInc (LDI) in Table 6-1, you can see that you get $2.35 as an annual dividend for each share of stock that you own. Companies usually pay the dividend in quarterly amounts. If I own 100 shares of LDI, the company pays me a quarterly dividend of $58.75 ($235 total per year). A healthy company strives to maintain or upgrade the dividend for stockholders from year to year. (I discuss additional dividend details later in this chapter.) The dividend is very important to investors seeking income from their stock investment. For more about investing for income, see Chapter 9. Investors buy stock in companies that don’t pay dividends primarily for growth. For more information on growth stocks, see Chapter 8.
Volume Normally, when you hear the word “volume” on the news, it refers to how much stock is bought and sold for the entire market: “Well, stocks were very active today. Trading volume at the New York Stock Exchange hit 2 billion shares.” Volume is certainly important to watch because the stocks that you’re investing in are somewhere in that activity. For the “Vol” column in Table 6-1, though, the volume refers to the individual stock.
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Part II: Before You Start Buying Volume tells you how many shares of that particular stock were traded that day. If only 100 shares are traded in a day, then the trading volume is 100. SHC had 3,143 shares change hands on the trading day represented in Table 6-1. Is that good or bad? Neither, really. Usually the business news media only mention volume for a particular stock when it’s unusually large. If a stock normally has volume in the 5,000 to 10,000 range and all of a sudden has a trading volume of 87,000, then it’s time to sit up and take notice. Keep in mind that a low trading volume for one stock may be a high trading volume for another stock. You can’t necessarily compare one stock’s volume against that of any other company. The large cap stocks like IBM or Microsoft typically have trading volumes in the millions of shares almost every day, while less active, smaller stocks may have average trading volumes in far, far smaller numbers. The main point to remember is that trading volume that is far in excess of that stock’s normal range is a sign that something is going on with that stock. It may be negative or positive, but something newsworthy is happening with that company. If the news is positive, the increased volume is a result of more people buying the stock. If the news is negative, the increased volume is probably a result of more people selling the stock. What are typical events that cause increased trading volume? Some positive reasons include the following: ✓ Good earnings reports: The company announces good (or better-thanexpected) earnings. ✓ A new business deal: The firm announces a favorable business deal, such as a joint venture, or lands a big client. ✓ A new product or service: The company’s research and development department creates a potentially profitable new product. ✓ Indirect benefits: The business may benefit from a new development in the economy or from a new law passed by Congress. Some negative reasons for an unusually large fluctuation in trading volume for a particular stock include the following: ✓ Bad earnings reports: Profit is the lifeblood of a company. When its profits fall or disappear, you see more volume. ✓ Governmental problems: The stock is being targeted by government action, such as a lawsuit or a Securities and Exchange Commission (SEC) probe.
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✓ Liability issues: The media report that the company has a defective product or similar problem. ✓ Financial problems: Independent analysts report that the company’s financial health is deteriorating. Check out what’s happening when you hear about heavier than usual volume (especially if you already own the stock).
Yield In general, yield is a return on the money you invest. However, in the stock tables, yield (“Yld” in Table 6-1) is a reference to what percentage that particular dividend is to the stock price. Yield is most important to income investors. It’s calculated by dividing the annual dividend by the current stock price. In Table 6-1, you can see that the yield du jour of ValueNowInc (VNI) is 4.5 percent (a dividend of $1 divided by the company’s stock price of $22). Notice that many companies report no yield; because they have no dividends, their yield is zero. Keep in mind that the yield reported in the financial pages changes daily as the stock price changes. Yield is always reported as if you’re buying the stock that day. If you buy VNI on the day represented in Table 6-1, your yield is 4.5 percent. But what if VNI’s stock price rises to $30 the following day? Investors who buy stock at $30 per share obtain a yield of just 3.3 percent. (The dividend of $1 divided by the new stock price, $30.) Of course, because you bought the stock at $22, you essentially locked in the prior yield of 4.5 percent. Lucky you. Pat yourself on the back.
P/E The P/E ratio is the ratio between the price of the stock and the company’s earnings. P/E ratios are widely followed and are important barometers of value in the world of stock investing. The P/E ratio (also called the “earnings multiple” or just “multiple”) is frequently used to determine whether a stock is expensive (a good value). Value investors (such as yours truly) find P/E ratios to be essential to analyzing a stock as a potential investment. As a general rule, the P/E should be 10 to 20 for large cap or income stocks. For growth stocks, a P/E no greater than 30 to 40 is preferable. (See Chapter 11 for full details on P/E ratios.)
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Part II: Before You Start Buying In the P/E ratios reported in stock tables, price refers to the cost of a single share of stock. Earnings refers to the company’s reported earnings per share as of the most recent four quarters. The P/E ratio is the price divided by the earnings. In Table 6-1, VNI has a reported P/E of 12, which is considered a low P/E. Notice how SHC has a relatively high P/E (76). This stock is considered too pricey because you’re paying a price equivalent to 76 times earnings. Also notice that DBC has no available P/E ratio. Usually this lack of a P/E ratio indicates that the company reported a loss in the most recent four quarters.
Day last The “Day Last” column tells you how trading ended for a particular stock on the day represented by the table. In Table 6-1, LDI ended the most recent day of trading at $41. Some newspapers report the high and low for that day in addition to the stock’s ending price for the day.
Net change The information in the “Net Chg” column answers the question, “How did the stock price end today compared with its price at the end of the prior trading day?” Table 6-1 shows that SHC stock ended the trading day up 25 cents (at $21.25). This column tells you that SHC ended the prior day at $21. VNI ended the day at $22 (up 10 cents), so you can tell that the prior trading day it ended at $21.90.
Using News about Dividends Reading and understanding the news about dividends is essential if you’re an income investor (someone who invests in stocks as a means of generating regular income; see Chapter 9 for details). The following sections explain some basics about dividends you should know. You can find news and information on dividends in newspapers such as The Wall Street Journal, Investor’s Business Daily, and Barron’s (you can find their Web sites online with your favorite search engine, or just check out Appendix A).
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Looking at important dates In order to understand how buying stocks that pay dividends can benefit you as an investor, you need to know how companies report and pay dividends. Some important dates in the life of a dividend are as follows: ✓ Date of declaration: This is the date when a company reports a quarterly dividend and the subsequent payment dates. On January 15, for example, a company may report that it “is pleased to announce a quarterly dividend of 50 cents per share to shareholders of record as of February 10.” That was easy. The date of declaration is really just the announcement date. If you buy the stock before, on, or after the date of declaration, it won’t matter in regard to receiving the stock’s quarterly dividend. The date that matters is the date of record (see that bullet later in this list). ✓ Date of execution: This is the day you actually initiate the stock transaction (buying or selling). If you call up a broker (or contact her online) today to buy a particular stock, then today is the date of execution, or the date on which you execute the trade. You don’t own the stock on the date of execution; it’s just the day you put in the order. For an example, skip to the following section. ✓ Closing date (settlement date): This is the date on which the trade is finalized, which usually happens three business days after the date of execution. The closing date for stock is similar in concept to a real estate closing. On the closing date, you’re officially the proud new owner (or happy seller) of the stock. ✓ Date of record: This is used to identify which stockholders qualify to receive the declared dividend. Because stock is bought and sold every day, how does the company know which investors to pay? The company establishes a cut-off date by declaring a date of record. All investors who are official stockholders as of the declared date of record receive the dividend on the payment date, even if they plan to sell the stock any time between the date of declaration and the date of record. ✓ Ex-dividend date: Ex-dividend means without dividend. Because it takes three days to process a stock purchase before you become an official owner of the stock, you have to qualify (that is, you have to own or buy the stock) before the three-day period. That three-day period is referred to as the “ex-dividend period.” When you buy stock during this short time frame, you aren’t on the books of record, because the closing (or settlement) date falls after the date of record. See the next section to see the effect that the ex-dividend date can have on an investor. ✓ Payment date: The date on which a company issues and mails its dividend checks to shareholders. Finally!
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Part II: Before You Start Buying For typical dividends, the events in Table 6-2 happen four times per year.
Table 6-2
The Life of the Quarterly Dividend
Event
Sample Date
Comments
Date of declaration
January 15
The date that the company declares the quarterly dividend
Ex-dividend date
February 7
Starts the three-day period during which, if you buy the stock, you don’t qualify for the dividend
Record date
February 10
The date by which you must be on the books of record to qualify for the dividend
Payment date
February 27
The date that payment is made (a dividend check is issued and mailed to stockholders who were on the books of record as of February 10)
Understanding why these dates matter Three business days pass between the date of execution and the closing date. Three business days also pass between the ex-dividend date and the date of record. This information is important to know if you want to qualify to receive an upcoming dividend. Timing is important, and if you understand these dates, you know when to purchase stock and whether you qualify for a dividend. As an example, say that you want to buy ValueNowInc (VNI) in time to qualify for the quarterly dividend of 25 cents per share. Assume that the date of record (the date by which you have to be an official owner of the stock) is February 10. You have to execute the trade (buy the stock) no later than February 7 to be assured of the dividend. If you execute the trade right on February 7, the closing date occurs three days later, on February 10 — just in time for the date of record. But w
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