Intro to Investing

Investing is NOT gambling.

Every investment available can be categorized by 2 general properties, either lender or owner investments; basically you are either buying an investment or loaning money. Some examples would include stocks (ownership), bonds (lender), real estate (ownership), or checking/savings accounts with a local bank (lender). Of course, some investment concoctions and products get much more complicated than that, but for the purposes of these articles we’ll just need to understand this simplified concept.

A stock investment is simply buying a piece of a company. If you buy 30 shares of Nike, you’re essentially a part owner of Nike (albeit a very small part owner). Long-term investments in stocks have done really well historically. After all, the Dow Jones Industrial Average (DOW), a large US stock market, was once worth only 100 points and today it sits around 10,400 points. Diversifying your stock holdings means you’ll take the amount of money you want to invest in the stock market, then buy many different kinds of stocks from different companies, industries, and sectors; these terms are used to categorize companies. For example, Google Inc. belongs to the technology sector, while Nike belongs to the consumer goods sector. Holding those two companies at the same time would give you some diversification. The importance is that no one stock holding you own can swing you disproportionately; if one holding goes down and you’re diversified, you’ll minimize your risk. More on diversification.

What goes up must always come down

As you know from physics, every action has a reaction. That is a basic principle that you can also apply to the investment game. If someone is making money in stocks, it’s because someone else is losing, and vice versa. There are always at least two players in every game. Here’s how that principle applies to share price fluctuations.

So let’s say you buy some shares of Google Inc., and now you’re a shareholder. You have a vested interest in the success of Google. If the company is run well, the stock price will of course increase, however, if Google begins to lose money, the stock price will decrease. Stock prices move on the same principles of supply and demand that you’re familiar with. No one wants a companies stock that is losing money, and everyone wants stock in a company that is making money. But companies can only issue so much stock and in Google’s case, there’s about 317 million shares outstanding (“shares outstanding” means issued and owned). Share prices can rise or fall based on the amound of shares outstanding. So let’s use Google as an example, and let’s say they need money. They can sell more shares to raise capital, but the effect is on the existing shareholders. Their shares are “diluted”, because their piece of the overall pie is now smaller. Diluting shares almost immediately causes stock prices to fall. But the opposite can happen also. Let’s say Google has a bunch of loose cash, and they want their investors to be happy. They may buy back some outstanding shares at a premium – causing the stock price to immediately jump because now existing shareholders are holding a bigger piece of the pie!

Basically, you want your company to buy back stocks from you, not issue more.

More on share pricing

If a company’s share price is rising, it means that investors are buying the stock, and the vise versa holds too. If a share price is plummeting, investors are selling that stock. As you gain more knowledge and experience valuing companies to determine whether or not their stock is worth buying, these principles will become engrained in you. Never forget that there is always someone out there who wants to make money off you; if you don’t know what you’re doing, you’ll likely end up on the wrong side of the transactions. Remember – there are hundreds of thousands of professional traders out there who are smart, sophisticated, and have much more access to product, cash, and technology that you or I. I’m not talking about your grandpa who logs on to a $15,000 Scottrade account through a dial-up conncetion in his kitchen to trade penny stocks. I’m talking about hedge fund managers, investment bank floor traders, and independent boutique brokerage houses. These guys are trading millions of dollars at a time, all day, everyday – and they’re making fortunes off of you and I. One of our favorite quotes: “if you look around and you can’t find a fool, it’s you”. We have some strategies we use to beat these guys that we’ll introduce later. For now, just understand that whoever you’re buying and selling to stocks to, they are your competition. You need to be aggressive in this game. Click here to learn about your compeition. More on high-frequency trading.

Money is made everywhere

Because stocks are relatively easy to buy, hold, and make money from, everyone wants a piece of the little profit you’ve created. First and foremost, in order to buy or sell stocks, you must have an account with a securities broker/dealer. Some familiar names include Merrill Lynch, Goldman Sachs, Charles Schwab, and E*trade. The first three are “sell-side” investment banks and you wouldn’t likely be using them anyway. Merrill and Goldman typically associate with the rich, the high net-worth clientele. Schwab is considered a “discount broker”, but even their services are totally unnecessary to the first-time investor. Today, it’s all about the individual online brokerage accounts. You can link your existing bank account to the brokerage firm and easily transfer money in and out using ACH (the same systems Paypal uses). These brokerage firms have their own “FDIC” – it’s called FINRA-SIPC and it protects every penny of your principle you put in in the event the brokerage goes out of business. An example of an online brokerage house is E*Trade. E*Trade and other online brokerage firms gave rise to the “day-trader”, people who trade stocks from their home using an internet account. Forty years ago, if you wanted to buy stock in Geico Insurance, you would have to call a stockbroker, pay fat fees, and would not trade – just buy and hold. Not the case anymore today thanks to technology, knowledge, and the independent nature of investors. Volumes of cash and liquidity have poured into markets, pushing the DOW from 10,000 points in 1999 to almost 15,000 points by 2007. More on the history of broker/dealers.

You have to use a brokerage service to buy and sell stocks and they make their money by charging fees. E*Trade, for example, charges a flat-rate of $12.99 per trade (a trade is only one order-$12.99 is charged twice to buy and sell the same stock.) There’s only one online brokerage service we use and can recommend. We use OptionsHouse.com because of their flat-rate fees ($2.95 per trade) and their easy-to-use platform. They charge no other fees. Open a virtual account (fake money) with to practice some fake trades, compare OH commission fees to competitors, or watch trader education video series at OptionsHouse.com.

Price fluctuations are inevitable so practice taking the emotions out of investing

Every day, the actual dollar value of your investment account (known as a “portfolio”) will move indescretionally. You may be up $15 or $25 or $100 one day and be down the next. When you take the emotions out of investing, you’re accepting the fluctuating nature of stock markets. If you see your account down 2-3%, don’t worry – the only time losses or gains become permanent are when you sell. Set price targets for yourself – you’ll sell your stocks if they reach a certain price and lock in the gains, or you’ll sell your stocks if they dip to a certain price and prevent extra losses. These are called “stop losses”, and actually they are used by traders when the order to buy those stocks are placed (OptionsHouse has a whole education series on using stop-losses). If that’s too confusing, just remember this: determine your risk level and how much you’re willing to lose, and then stick to it. For example, let’s say you bought $1000 worth of Harry Winston Diamond and it’s the only stock in your portfolio. You’re willing to lose 10% in the hopes of gaining 25%. Let’s say the stock price dips 10% after you bought it, and your portfolio is only worth $900. Can you stick to your plan? Can you sell the shares and eat the loss to be safe? Or would you hold the shares in hopes it rises, even a little bit, and minimize your loss? The trade-off, or course is that you run the risk of the stock price falling more, and adding more loss (if a stock has dropped 10%, it’s not unlikely for it to fall some more).

Let’s look at the other side. Let’s say the stock price gained 25%, and your portfolio is now worth $1250. The same principles apply – you can sell the stock and lock in the profits, or you can hold on to it and hope it rises just a little bit more. The risk, of course is that the price falls and you end up with less than a 25% gain (if a stock has gained 25%, it likely will NOT gain anymore).

After you sell the stock, you’ve got some options. If it is a great company, you may want to wait for the stock to drop some, and get back in – with the expectation it continues to run higher. Perhaps that stock isn’t a great company, and you bought and sold on spec (speculation). You may be pushing your luck to get back in – only you can decide what’s best for your money, yourself, and your objectives.

Risk to reward

Rick to reward is simple and we’ve already briefly touched on it: how much are you willing to risk in relation to how much you want to gain? Let’s use our 10% loss vs. 25% gain example.

Risk to reward means you’re willing to lose a certain amount of times to gain a certain amount. Let’s say you bought 3 stocks – Company A, Company B, and Company C. The first two stocks lost 10% each, but the third stock gained 25%. When the gains outweigh the losses, you’re still up 5% (25% – 10% + 10% = 5% gain).

In the beginning, keep your goals simple. A gain of 10% is great; gaining 15% is even better, and any gains above and beyond that are very exceptional and you’re a gifted investor if you can continuously produce that kind of performance over any sustainable period of time. Once you find your target gains, you need to asses the amount of risk you can stomach (note that not many people can stomach too much). Finding your comfort level with risk is very important, even if you’re not planning on ever picking your own stocks. Remember, any financial product whether it be an IRA or a mutual fund can lose value.

If you’re risk averse, consider some safer investments like funds, bonds, and “blue chip” stocks – large companies with years and years of profitability who are in no real danger of losing stock value. More on blue chip stocks.

If you think you can handle some risk, you’re going to want to consider low-cap, high growth stocks. What you’re basically looking for are small companies with lots of cash, no debt, high investments in research and development products, operate in a competitive market, and have some market share cornered. These stocks are very risky (typically, they haven’t yet turned a profit and you can’t be sure they are a great company or worthless) and they are no guarantees. But if you’re right, you could be sitting on the next Google Inc. (Google went public in 1998 for $80/share; today, Google is worth almost $550/share). More on high growth stocks.

Investing is a lifelong journey

It’s also likely to have a few bumps along the road. But that’s ok – especially if you start now. Building up a fortune is important; equally important is protecting it as you get older. Approach investing with the notion that you’ll get rich quick, that you’ll become an overnight millionaire, or that you’ll produce enough income to retire at 26 and you’ll lose. Investing is not about getting rich – it’s about making your money work for you and turning a dollar into two. And if you get rich in the process – great! That being said, there is a life cycle you’ll likely follow:

• The accumulation period is where it all starts. You’ll want to gain as much knowledge as possible about investing principles to make up your lack of experience. Read, study, and absorb all the information you can. You’ll make your first few investments, you’ll grow your portfolio, and you’ll acquire new investment products. Imagine this period as the first twenty years.
• The growth period is the next twenty years. You’re investment portfolio, by now should have begun to post some healthy gains. You’ll learn to maximize your gains, begin to enjoy your investments. Take some money out and spend it on something nice.
• The preservation period is the last and most important stage of your investment cycle. After forty years, you’re probably nearing retirement. This is where it all pays off! If you’re done it right, you should have enough money to spend the rest of your life comfortably. Get out of stocks and into investment products created and tailored to preserve cash. Inflation-protected investments, bonds, and government securities are the best moves for protecting your nest egg.

There are many ways to invest your money and we’re going to name and explain a few.

Typical fist-time investments:

• Stocks are purchased as shares of ownership in companies.
• Mutual Funds are pools of money that are invested in securities of all sorts. You could find a fund for just about anything. Their shares trade just like stocks – shares of ownership in the fund. Typical funds will include index funds, emerging market funds, or bond funds.
• Bonds can be issued by the companies, the government, or at the state level in the form of municipal bonds. Essentially, you pay the issue price, and for a certain amount of years your paid interest and your principle back. It’s a lender investment, and they are less risky than stocks – but they also lack the opportunity to create huge returns. In all cases they guarantee modest interest rates you’ll be paid. Bonds should be apart of everyone’s portfolio as they are in most cases a safe and secure investment.
• Certificates of Deposit (CD) is another lender investment. This time, you buy a CD with a bank and they pay you pack principle plus interest in one lump sum at the maturity date.
• IRA is a tax-deferred retirement account. Most of the time, the funds in your IRA are invested by whoever you bought the IRA from. They’ll invest in stocks, bonds, and other products.
• Treasuries are lender investments issued by the Federal Treasury Department. You’re investing in US American dollars, and at the time of this writing, their rates are very low. They can be bought by anyone at anytime by visiting http://www.treasurydirect.org. They serve as a sort of short-term parking for loose cash, and in many cases can hedge or protect you from inflation.

A little more complicated…

• ETF’s, or exchange-traded funds are pools of stocks that are traded at the net asset value of those stocks. Net asset value is assets minus liabilities divided by the number of available shares.
• Options are contracts that you can buy or sell that gives you the right, but not the obligation, to buy or sell stocks at a certain price. Options aren’t just used for stocks; you can find an option on just about anything.
• Futures are like options, but the contract calls for obligations. You must buy or sell that underlying security at whatever price the contract is set for. There are futures available for trade with oil, corn, soybeans, and even pork bellies.

There are hundred of other ways to invest money, and you’ll discover them as time goes on and you have more money to invest. Some investments are not offered or recommended for first-time investors, but will be there when you’re ready. And as for the future, you can always count on genius investment bankers to come up with new investment products and trades. The smartest bet you could ever make would be to bet that Wall Street will forever be coming up with new ways to turn one buck into two.

For now, that’s one hell of a Bullworthy Introduction to Investing, so feel free to contact me if you have any questions, comments, or concerns at tom@bullworthy.com.