When investment mistakes happen, money is lost. Mistakes can occur for a variety of reasons, but they can generally be attributed to the clouding of the investor’s judgment by the influence of emotions, the misunderstanding of basic investment principles, or misconceptions about how securities react to varying economic, political, and fear-driven circumstances. The investor should always keep a calm, cool and rational head, and avoid these common investment mistakes:
Not having a clearly-defined investment plan. A well-conceived investment plan does not need frequent adjustments, and a well-managed plan is not susceptible to the introduction of trendy speculations and “hot picks”. Investment decisions should be made with that investment plan in mind. Investing is a goal-orientated activity that should include considerations of time, risk-tolerance, and future income. The prudent investor should ponder carefully the direction of his or her decision before actually moving in that direction.
Investors become bored with their plan or the rate of gradual growth too quickly, change direction frequently, and make drastic rather than measured adjustments. Investing should always be regarded as a long-term proposition, and the mindset of the savvy investor should reflect that.
Investors tend to fall in love with securities that rise in price and forget to take their profits, particularly if the company was once their employer. One must not become so blinded to the beauty of unrealized gain that he or she forgets the “whys” and “hows” of prudent investing. Aside from the love issue, this often becomes an “unwilling-to-pay-the-taxes” problem that could very well manifest itself on the tax return as a realized loss. The rules of diversification must always be adhered to.
Investors often overdose themselves on information, causing a constant state of "the paralysis of analysis". Such investors are likely to be confused and tend to become indecisive. Neither of these characteristics spells health for an investment portfolio. Compounding this issue is the inability to distinguish between research and sales materials, which can quite often be the same document. A somewhat narrow focus on information which supports a logical and well-documented investment strategy is a much more productive means of fact-finding.
Investors are constantly in search of a shortcut or gimmick that will provide instant success with a minimum of effort; i.e. the “get-rich-quick pick”. Consequently, they initiate a feeding frenzy for every new product or service that comes along. Their portfolios become a hodgepodge of Mutual Funds, Index Funds, partnerships, penny stocks, hedge funds, commodities, options, etc. This obsession with Product simply shows how Wall Street has made it impossible for financial professionals to survive without them. But the prudent investor always remembers: consumers buy Products; investors by Securities.
Investing has become a very competitive event for investors, although it certainly should not be. Investing is a personal venture where individual and familial goals and objectives should dictate one’s portfolio structure, management strategy, and performance evaluation techniques. It is difficult enough to manage a portfolio in an environment that encourages instant gratification, supports unfounded and unwarranted speculation, and applauds shortsighted goals and achievements.
Friday, December 28, 2007
A Comparison of Investments
There are many different ways to invest your money. So how do you choose what's right for you? First, you must examine your own financial circumstances, your goals, and your individual personality. For instance, how much risk will you be able to tolerate before you're driven to walk the floors all night long worrying about your money? Along those same lines, the primary criterion for evaluating any investment is to weigh the potential profit against the risk that it will expose you to. Finding the proper match is crucial, not only to your financial success but to your psyche, as well. Use the list below as an at-a-glance comparison tool to help you sort through the general types of investment vehicles that are available.
Cash - Even today, with electronic methods of sending and receiving money globally, physical spendable cash still remains our basic medium of exchange. It has the advantage of complete liquidity – in other words, it can easily be converted into something else, such as goods or services. Cash, both paper and coins, is the criterion by which all other assets are measured. However, the value of paper money is solely a function of the general public's confidence in it, and their willingness to accept it as payment for goods and services rendered.
Advantages of Cash as an investment:
Cash is readily accepted for goods and services.
It's the standard of value used in our society.
It's easily portable, so it can be efficiently used to purchase goods and services in lieu of bartering.
Disadvantages of Cash as an investment:
Cash in itself earns no interest, and in periods of high inflation it can rapidly lose its value and capability to be exchanged for goods and services.
It is subject to fire, theft, and other hazards.
Large quantities of cash are cumbersome to handle and transport, and risky to carry. Most major transactions today are therefore completed by check or electronic funds transfer.
Savings Accounts - Insured savings accounts are the most liquid of all traditional investments, which means that they can be most easily converted to cash, which in turn can be used to buy goods and services. As opposed to cash on hand, savings accounts earn interest and are insured by the Federal Deposit Insurance Corporation (assuming, of course, that the bank is a member). For the purposes of this article, the term "savings account" also includes bank money market accounts and certificates of deposit.
Advantages of Savings Accounts as an investment:
Savings accounts are the safest interest-bearing investment available. Your principal is usually protected by the FDIC as well as federal and state banking regulations.
Due to the advent of electronic banking, money in savings accounts is readily accessible at any time of the day or night.
Disadvantages of Savings Accounts as an investment:
Because of the generally low rates of interest that savings accounts earn, there's the potential for loss of your money's purchasing power due to inflation.
The maximum FDIC insurance is $100,000 per depositor account. If the bank fails, it could take a while to receive your money while the FDIC audits and verifies balances.
A significant financial penalty is imposed for cashing in a certificate of deposit before its maturity date.
Debt Instruments - Debt instruments, which are bonds and notes, are obligations of a government, a business, or other entity. Notes have an original life (or maturity) of less than ten years, while bonds have a maturity time of greater than ten years. Their safety (or lack of it) is a function of the financial strength of the issuer. In the United States, for example, the safest debt instruments are U. S. government bonds and notes, followed by state and municipal, corporate, and individual bonds and notes. The riskier the bond, the higher the interest rate it must pay.
Advantages of Debt Instruments as an investment:
Bonds and notes pay higher rates of interest than savings accounts.
Because of the fact that there's a trillion-dollar market for government and corporate bonds, they can generally be considered to be liquid investments.
If you prefer not to liquidate them, they can be used as collateral for loans.
Disadvantages of Debt Instruments as an investment:
Bonds and notes are less liquid than savings accounts.
Their safety depends solely on the strength of the issuer.
If interest rates increase, lower-paying bonds may temporarily drop in value until their maturity, when the bond or note becomes payable.
During periods of inflation, the face value of bonds will be worth less than when they were first purchased.
Stocks - Because of their liquidity, stocks are subject to daily and short-term price fluctuations. Such ebbs and flows may be due to international, national, industrial, economic, or corporate events and circumstances – for example, new product introductions, corporate restructurings, interest rates, wars, hurricanes, etc. These price swings may actually be outside the long-term potential price range for the stock. Stocks have historically returned about 9 percent compounded annually for the last hundred years.
Advantages of Stocks as an investment:
As a shareholder in a corporation, an investor actually owns a piece of the business, enabling him or her to benefit from the distribution of profits (or dividends) without incurring any personal liability for losses.
During inflationary periods, the prices of the products or services that the corporation sells rise and the operation's profits increase, followed by a corresponding rise in share values.
Stocks can easily be sold and converted into cash, thus providing a high degree of liquidity.
Disadvantages of Stocks as an investment:
An important factor in stock prices is the ability of corporate management to run the company. If managers are effective the company will ideally grow, causing earnings to increase and thereby stock prices, as well. On the other hand, poor managers may hinder the organization's growth potential by making poor decisions.
Stock prices are subject to general stock market conditions. If there's a temporary downturn in the market at a time in which you must sell for any reason, you could realize a substantial loss.
Other people (the company's board of directors) are making decisions and handling your money for you.
Collectibles - These are objects that are difficult or impossible to duplicate and that have cultural, historical, or social value. Collectibles include, but are by no means limited to, artwork (including paintings and sculptures), antiques and relics, coins, stamps, rare books, dolls, automobiles, sports trading cards, and the like.
Advantages of Collectibles as an investment:
By definition, rare collectibles (especially artwork) cannot be replaced, and are therefore more highly valued.
They provide intangible benefits such as the enjoyment of accumulating a collection and the pride and pleasure of ownership.
Recognized, appraisable collections can be used as collateral for loans. Although generally considered to be somewhat illiquid, they can in this manner still provide some measure of liquidity.
Disadvantages of Collectibles as an investment:
Collectibles are not particularly liquid because there is not a ready, liquid market for them. In order to sell, you must find a dealer, an auction house, or a private buyer.
They generate no interest income.
The costs of preservation to prevent further aging and deterioration can often be prohibitive. Furthermore, the costs to insure collectibles against fire, theft, and other risks can also be quite high.
Precious Metals - Precious metals include gold, silver, and platinum, among others. Since ancient times, gold and other precious metals have been accepted as mediums of exchange worldwide. Today, many investors use precious metals, or their stocks, as a hedge against massive inflation. As the prices of the metals themselves rise, so do their stocks. Generally speaking, precious metal stocks have the same advantages and disadvantages as other stocks.
Advantages of Precious Metals as an investment:
Precious metals are an excellent hedge against inflation. Historically, gold, silver, and platinum have been accepted as standards of value. During periods of hyperinflation, their prices rise accordingly to keep pace.
Precious metal stocks, like other stocks, can be easily bought and sold on major stock exchanges, giving them a high measure of liquidity.
Owning shares in a precious metal company is an easy way to invest in precious metals without having to physically buy and hold the actual commodities.
Disadvantages of Precious Metals as an investment:
Like collectibles, precious metals do not earn interest.
Precious metal prices are greatly influenced by the actions of governments. For example, if Russia (the world's major producer of platinum) were to decide to sell off its stockpiles of the metal in order to raise capital, the price of platinum worldwide would drop.
Real Estate - Real estate includes land and the improvements thereon. As an investment vehicle, it's important to note that real estate is virtually always purchased with the use of "other people's money," or OPM. This form of leverage allows real estate to earn significantly higher rates of return than most other investment instruments.
Advantages of Real Estate as an investment:
There can be immediate income from the net cash flow of a well-chosen property after operating costs and debt service.
The loan balance is amortized and reduced with each mortgage payment, thus increasing equity.
Property depreciation can be deducted against property income for tax purposes.
As long as replacement costs or inflation (or a combination of the two) exceed the rate of depreciation, the property will continue to appreciate in spite of depreciation.
Disadvantages of Real Estate as an investment:
Real estate values, like stocks, are subject to the ups and downs of the economy as well as temporary value fluctuations. However, in both cases, if you hold the property long enough, overall growth in value will likely occur.
Real estate is not a liquid investment, which is the reason that it should be done only with surplus funds and should be designated as a long-term investment program.
Land does not become obsolete the way that buildings and equipment do. As such, only the depreciation of buildings and equipment may be deducted on your tax return. Therefore, in every real estate investment, you must allocate the purchase price between land and buildings in order to know how much is depreciable for income tax purposes.
Real estate generally requires more hands-on management than stocks or other types of investments, but this disadvantage can actually reap additional tax benefits.
Cash - Even today, with electronic methods of sending and receiving money globally, physical spendable cash still remains our basic medium of exchange. It has the advantage of complete liquidity – in other words, it can easily be converted into something else, such as goods or services. Cash, both paper and coins, is the criterion by which all other assets are measured. However, the value of paper money is solely a function of the general public's confidence in it, and their willingness to accept it as payment for goods and services rendered.
Advantages of Cash as an investment:
Cash is readily accepted for goods and services.
It's the standard of value used in our society.
It's easily portable, so it can be efficiently used to purchase goods and services in lieu of bartering.
Disadvantages of Cash as an investment:
Cash in itself earns no interest, and in periods of high inflation it can rapidly lose its value and capability to be exchanged for goods and services.
It is subject to fire, theft, and other hazards.
Large quantities of cash are cumbersome to handle and transport, and risky to carry. Most major transactions today are therefore completed by check or electronic funds transfer.
Savings Accounts - Insured savings accounts are the most liquid of all traditional investments, which means that they can be most easily converted to cash, which in turn can be used to buy goods and services. As opposed to cash on hand, savings accounts earn interest and are insured by the Federal Deposit Insurance Corporation (assuming, of course, that the bank is a member). For the purposes of this article, the term "savings account" also includes bank money market accounts and certificates of deposit.
Advantages of Savings Accounts as an investment:
Savings accounts are the safest interest-bearing investment available. Your principal is usually protected by the FDIC as well as federal and state banking regulations.
Due to the advent of electronic banking, money in savings accounts is readily accessible at any time of the day or night.
Disadvantages of Savings Accounts as an investment:
Because of the generally low rates of interest that savings accounts earn, there's the potential for loss of your money's purchasing power due to inflation.
The maximum FDIC insurance is $100,000 per depositor account. If the bank fails, it could take a while to receive your money while the FDIC audits and verifies balances.
A significant financial penalty is imposed for cashing in a certificate of deposit before its maturity date.
Debt Instruments - Debt instruments, which are bonds and notes, are obligations of a government, a business, or other entity. Notes have an original life (or maturity) of less than ten years, while bonds have a maturity time of greater than ten years. Their safety (or lack of it) is a function of the financial strength of the issuer. In the United States, for example, the safest debt instruments are U. S. government bonds and notes, followed by state and municipal, corporate, and individual bonds and notes. The riskier the bond, the higher the interest rate it must pay.
Advantages of Debt Instruments as an investment:
Bonds and notes pay higher rates of interest than savings accounts.
Because of the fact that there's a trillion-dollar market for government and corporate bonds, they can generally be considered to be liquid investments.
If you prefer not to liquidate them, they can be used as collateral for loans.
Disadvantages of Debt Instruments as an investment:
Bonds and notes are less liquid than savings accounts.
Their safety depends solely on the strength of the issuer.
If interest rates increase, lower-paying bonds may temporarily drop in value until their maturity, when the bond or note becomes payable.
During periods of inflation, the face value of bonds will be worth less than when they were first purchased.
Stocks - Because of their liquidity, stocks are subject to daily and short-term price fluctuations. Such ebbs and flows may be due to international, national, industrial, economic, or corporate events and circumstances – for example, new product introductions, corporate restructurings, interest rates, wars, hurricanes, etc. These price swings may actually be outside the long-term potential price range for the stock. Stocks have historically returned about 9 percent compounded annually for the last hundred years.
Advantages of Stocks as an investment:
As a shareholder in a corporation, an investor actually owns a piece of the business, enabling him or her to benefit from the distribution of profits (or dividends) without incurring any personal liability for losses.
During inflationary periods, the prices of the products or services that the corporation sells rise and the operation's profits increase, followed by a corresponding rise in share values.
Stocks can easily be sold and converted into cash, thus providing a high degree of liquidity.
Disadvantages of Stocks as an investment:
An important factor in stock prices is the ability of corporate management to run the company. If managers are effective the company will ideally grow, causing earnings to increase and thereby stock prices, as well. On the other hand, poor managers may hinder the organization's growth potential by making poor decisions.
Stock prices are subject to general stock market conditions. If there's a temporary downturn in the market at a time in which you must sell for any reason, you could realize a substantial loss.
Other people (the company's board of directors) are making decisions and handling your money for you.
Collectibles - These are objects that are difficult or impossible to duplicate and that have cultural, historical, or social value. Collectibles include, but are by no means limited to, artwork (including paintings and sculptures), antiques and relics, coins, stamps, rare books, dolls, automobiles, sports trading cards, and the like.
Advantages of Collectibles as an investment:
By definition, rare collectibles (especially artwork) cannot be replaced, and are therefore more highly valued.
They provide intangible benefits such as the enjoyment of accumulating a collection and the pride and pleasure of ownership.
Recognized, appraisable collections can be used as collateral for loans. Although generally considered to be somewhat illiquid, they can in this manner still provide some measure of liquidity.
Disadvantages of Collectibles as an investment:
Collectibles are not particularly liquid because there is not a ready, liquid market for them. In order to sell, you must find a dealer, an auction house, or a private buyer.
They generate no interest income.
The costs of preservation to prevent further aging and deterioration can often be prohibitive. Furthermore, the costs to insure collectibles against fire, theft, and other risks can also be quite high.
Precious Metals - Precious metals include gold, silver, and platinum, among others. Since ancient times, gold and other precious metals have been accepted as mediums of exchange worldwide. Today, many investors use precious metals, or their stocks, as a hedge against massive inflation. As the prices of the metals themselves rise, so do their stocks. Generally speaking, precious metal stocks have the same advantages and disadvantages as other stocks.
Advantages of Precious Metals as an investment:
Precious metals are an excellent hedge against inflation. Historically, gold, silver, and platinum have been accepted as standards of value. During periods of hyperinflation, their prices rise accordingly to keep pace.
Precious metal stocks, like other stocks, can be easily bought and sold on major stock exchanges, giving them a high measure of liquidity.
Owning shares in a precious metal company is an easy way to invest in precious metals without having to physically buy and hold the actual commodities.
Disadvantages of Precious Metals as an investment:
Like collectibles, precious metals do not earn interest.
Precious metal prices are greatly influenced by the actions of governments. For example, if Russia (the world's major producer of platinum) were to decide to sell off its stockpiles of the metal in order to raise capital, the price of platinum worldwide would drop.
Real Estate - Real estate includes land and the improvements thereon. As an investment vehicle, it's important to note that real estate is virtually always purchased with the use of "other people's money," or OPM. This form of leverage allows real estate to earn significantly higher rates of return than most other investment instruments.
Advantages of Real Estate as an investment:
There can be immediate income from the net cash flow of a well-chosen property after operating costs and debt service.
The loan balance is amortized and reduced with each mortgage payment, thus increasing equity.
Property depreciation can be deducted against property income for tax purposes.
As long as replacement costs or inflation (or a combination of the two) exceed the rate of depreciation, the property will continue to appreciate in spite of depreciation.
Disadvantages of Real Estate as an investment:
Real estate values, like stocks, are subject to the ups and downs of the economy as well as temporary value fluctuations. However, in both cases, if you hold the property long enough, overall growth in value will likely occur.
Real estate is not a liquid investment, which is the reason that it should be done only with surplus funds and should be designated as a long-term investment program.
Land does not become obsolete the way that buildings and equipment do. As such, only the depreciation of buildings and equipment may be deducted on your tax return. Therefore, in every real estate investment, you must allocate the purchase price between land and buildings in order to know how much is depreciable for income tax purposes.
Real estate generally requires more hands-on management than stocks or other types of investments, but this disadvantage can actually reap additional tax benefits.
Basic Investment Strategies
Your investment strategy deals with the overall, long-term guidelines that you set up and implement in an attempt to ensure success in meeting your financial goals. Most strategies used to invest in the stock market fall into three general categories: fundamental analysis, technical analysis, or buy and hold the market. Let's examine each technique.
The fundamental analysis approach is primarily concerned with value; it examines factors that determine a company's expected future earnings and dividends as well as the continued dependability of those earnings and dividends. It then attempts to put a value on the stock accordingly. Therefore, an investor who uses this approach seeks out stocks that are a good value; in other words, stocks that are priced low relative to their perceived value. The assumption is that the stock market will later recognize the value of the stock and its price will consequently increase.
The investor who uses technical analysis attempts to predict the future price of a stock or the future direction of the market based on past price and trading volume changes. This approach assumes that stock prices and the stock market follow discernible patterns, and if the beginning of a pattern can be identified then the balance of the pattern can also be predicted well enough to yield returns in excess of the general market. Most academic studies of this approach have generally concluded that investing based on purely technical analysis does not work well.
The buy-and-hold-the-market approach is the benchmark against which any other approach to market investing should be measured. This strategy provides the returns that would be obtained by buying and holding the stock market, often defined as the Standard & Poor's 500. Of course, no individual investor would likely buy all 500 stocks that make up the index (although this can be achieved by buying shares in an S&P 500 index mutual fund). By investing in a large number of well-diversified stocks, however, an investor can build a portfolio which closely resembles the S&P 500.
The buy-and-hold-the-market investment approach is used as a benchmark because no other investment approach based on analysis is valid unless it can outperform the market over the long run. When an investment produces a return that's above the market return with the same risk, the difference between the two returns is referred to as an excess return. The excess return represents the added value of the approach that's used.
The type of strategy that you ultimately employ will depend in large measure on your conceptual views of two basic stock market theories. According to the efficient market theory, stock prices reflect all publicly available information concerning that stock and so are extremely close to the true value of the stock. This is not to say that prices reflect the stock's true value at all times, but that prices on average reflect the stock's true value. Variations about this average price can exist. Conversely, the random walk theory (named for the seemingly random steps of a drunken person) expounds that these variations are unpredictable; sometimes they are positive and sometimes negative. As such, they are unpredictable; they cannot be used to obtain excess returns.
Therefore, the investor who believes that the market is efficient would see no point in pursuing the fundamental approach which seeks to find stocks that are selling significantly above or below their value, because the price very closely reflects the stock's true value. Alternatively, this investor would concentrate on developing a more efficient portfolio rather than concentrating on specific stock selection, a portfolio that provides returns closest to the market's return at a specified level of market risk. The investor simply determines the amount of risk that he or she is willing to bear and then builds the portfolio accordingly.
Investors who believe that the market is inefficient proceed on the assumption that variations in the way people receive and evaluate information cause the prices of some stocks to deviate significantly from their true value. Therefore, they see occasions for finding under- and overpriced stocks through diligent analysis, and believe that they're able to outperform a buy-and-hold-the-market strategy.
Based on substantial research evidence, many analysts believe that the market often is inefficient, and that there are indeed opportunities for outperforming the market. The excess return potential generally appears to be in the range of 2 to 6 percent annually. Over a lifetime of investing, even relatively small additional returns such as this can lead to substantially greater wealth.
The fundamental analysis approach is primarily concerned with value; it examines factors that determine a company's expected future earnings and dividends as well as the continued dependability of those earnings and dividends. It then attempts to put a value on the stock accordingly. Therefore, an investor who uses this approach seeks out stocks that are a good value; in other words, stocks that are priced low relative to their perceived value. The assumption is that the stock market will later recognize the value of the stock and its price will consequently increase.
The investor who uses technical analysis attempts to predict the future price of a stock or the future direction of the market based on past price and trading volume changes. This approach assumes that stock prices and the stock market follow discernible patterns, and if the beginning of a pattern can be identified then the balance of the pattern can also be predicted well enough to yield returns in excess of the general market. Most academic studies of this approach have generally concluded that investing based on purely technical analysis does not work well.
The buy-and-hold-the-market approach is the benchmark against which any other approach to market investing should be measured. This strategy provides the returns that would be obtained by buying and holding the stock market, often defined as the Standard & Poor's 500. Of course, no individual investor would likely buy all 500 stocks that make up the index (although this can be achieved by buying shares in an S&P 500 index mutual fund). By investing in a large number of well-diversified stocks, however, an investor can build a portfolio which closely resembles the S&P 500.
The buy-and-hold-the-market investment approach is used as a benchmark because no other investment approach based on analysis is valid unless it can outperform the market over the long run. When an investment produces a return that's above the market return with the same risk, the difference between the two returns is referred to as an excess return. The excess return represents the added value of the approach that's used.
The type of strategy that you ultimately employ will depend in large measure on your conceptual views of two basic stock market theories. According to the efficient market theory, stock prices reflect all publicly available information concerning that stock and so are extremely close to the true value of the stock. This is not to say that prices reflect the stock's true value at all times, but that prices on average reflect the stock's true value. Variations about this average price can exist. Conversely, the random walk theory (named for the seemingly random steps of a drunken person) expounds that these variations are unpredictable; sometimes they are positive and sometimes negative. As such, they are unpredictable; they cannot be used to obtain excess returns.
Therefore, the investor who believes that the market is efficient would see no point in pursuing the fundamental approach which seeks to find stocks that are selling significantly above or below their value, because the price very closely reflects the stock's true value. Alternatively, this investor would concentrate on developing a more efficient portfolio rather than concentrating on specific stock selection, a portfolio that provides returns closest to the market's return at a specified level of market risk. The investor simply determines the amount of risk that he or she is willing to bear and then builds the portfolio accordingly.
Investors who believe that the market is inefficient proceed on the assumption that variations in the way people receive and evaluate information cause the prices of some stocks to deviate significantly from their true value. Therefore, they see occasions for finding under- and overpriced stocks through diligent analysis, and believe that they're able to outperform a buy-and-hold-the-market strategy.
Based on substantial research evidence, many analysts believe that the market often is inefficient, and that there are indeed opportunities for outperforming the market. The excess return potential generally appears to be in the range of 2 to 6 percent annually. Over a lifetime of investing, even relatively small additional returns such as this can lead to substantially greater wealth.
Choosing a Broker
Selecting a stockbroker or brokerage firm can be handled in one of two ways: you can choose an individual broker, or you can choose a brokerage firm and then find a broker within that company. When shopping for a broker, it's likely that you'll begin to come across a few names over and over again. It stands to reason that a broker's reputation will go a long way in helping you to decide with whom to do business.
Both a firm's size and membership on the stock exchange can affect its reputation. Large national firms are known throughout the world; however, a small local firm may be renowned within its local community. If a stock brokerage firm is a member of the New York Stock Exchange, its brokers have most likely passed the exams given by both the Exchange and the National Association of Securities Dealers (NASD). In addition, the rules of conduct for member firms of those organizations tend to be more stringent.
Another consideration when choosing a broker is his or her area and level of expertise. If a broker's main proficiency is in bonds or commodities and you're interested in stocks, it might be wise to continue your search until you find a professional with specialized knowledge in your particular field of interest. Additionally, make it a point to ask about the fee structure for custodial services, account management, and transaction costs; and inquire about how the broker is specifically compensated.
Above all, you should feel comfortable with your broker's investment philosophy, and you should also be comfortable talking to him or her personally. Before making your final decision, be sure to review the brokers' employment history, licensing, and whether they've ever been disciplined or had any customer complaints or violations of NASD regulations. This information can be obtained on the NASD website.
Here are a few additional tips to keep in mind when searching for a broker:
Be aware that many stockbrokers make their living solely on commissions from trading securities. In such a case, the broker may be biased toward encouraging you to make frequent changes to your portfolio. Brokers who encourage excessive trading, known as churning, in order to earn more commissions may be exposed to lawsuits and should be avoided. On the other hand, if the broker is paid a salary, he or she may have sales quotas to meet in order to cover some of the fixed costs of the firm.
Be aware that most brokers are not financial analysts; don't assume, therefore, that they're experts in all aspects of investing. If you need information about stocks that your broker doesn't actively follow, he or she should be able to obtain the relevant information from the in-house research department or from other sources available to the brokerage firm.
Finally, be aware that brokers are professionally prohibited from offering unsuitable investments to their clients. For example, if a broker suggests a risky, speculative security when your investment objectives are income production and safety of principal, the broker could be held accountable for your losses. To protect yourself, always state your objectives in writing and give a copy to your broker. Don't rush into suggested investments if you're not sure about them. Ask for additional information and weigh the advice or recommendations carefully before making your decision.
Both a firm's size and membership on the stock exchange can affect its reputation. Large national firms are known throughout the world; however, a small local firm may be renowned within its local community. If a stock brokerage firm is a member of the New York Stock Exchange, its brokers have most likely passed the exams given by both the Exchange and the National Association of Securities Dealers (NASD). In addition, the rules of conduct for member firms of those organizations tend to be more stringent.
Another consideration when choosing a broker is his or her area and level of expertise. If a broker's main proficiency is in bonds or commodities and you're interested in stocks, it might be wise to continue your search until you find a professional with specialized knowledge in your particular field of interest. Additionally, make it a point to ask about the fee structure for custodial services, account management, and transaction costs; and inquire about how the broker is specifically compensated.
Above all, you should feel comfortable with your broker's investment philosophy, and you should also be comfortable talking to him or her personally. Before making your final decision, be sure to review the brokers' employment history, licensing, and whether they've ever been disciplined or had any customer complaints or violations of NASD regulations. This information can be obtained on the NASD website.
Here are a few additional tips to keep in mind when searching for a broker:
Be aware that many stockbrokers make their living solely on commissions from trading securities. In such a case, the broker may be biased toward encouraging you to make frequent changes to your portfolio. Brokers who encourage excessive trading, known as churning, in order to earn more commissions may be exposed to lawsuits and should be avoided. On the other hand, if the broker is paid a salary, he or she may have sales quotas to meet in order to cover some of the fixed costs of the firm.
Be aware that most brokers are not financial analysts; don't assume, therefore, that they're experts in all aspects of investing. If you need information about stocks that your broker doesn't actively follow, he or she should be able to obtain the relevant information from the in-house research department or from other sources available to the brokerage firm.
Finally, be aware that brokers are professionally prohibited from offering unsuitable investments to their clients. For example, if a broker suggests a risky, speculative security when your investment objectives are income production and safety of principal, the broker could be held accountable for your losses. To protect yourself, always state your objectives in writing and give a copy to your broker. Don't rush into suggested investments if you're not sure about them. Ask for additional information and weigh the advice or recommendations carefully before making your decision.
Constant Dollar Investment Strategy
Constant dollar investment is a strategy that attempts to keep a fixed dollar amount allocated to each of the various types of securities contained in a portfolio. The constant dollar technique works well when the total available investment dollars are allocated to two different investment types: one amount going to the more speculative instruments of the portfolio and the rest being used for more conservative offerings. This fixed dollar ratio between the two parts is typically regulated by either the buying or selling off of stocks.
The strategy works in this manner: let's assume, for example, that an investor has a portfolio with a total value of $100,000; of that total he wants to keep $50,000 invested in stocks and the rest allocated to bonds. When the value of the stock half of the portfolio increases to an upper limit (which is set by the investor), stocks are sold off so that the total market value of the stocks remaining in the portfolio is reduced to $50,000. So, if the upper limit set by the investor was, say, $60,000, when the value of the stock side of the portfolio reached that amount, $10,000 in stocks would be sold to reduce stock values back to $50,000. The $10,000 proceeds would be invested in additional bonds. If the stock in the portfolio declined to a lower (predetermined) limit, then additional stocks would be purchased to increase their total value back to $50,000. This type of plan forces the investor to take profits when the upper target amount is reached and to buy additional shares when the value falls to the lower target number.
This investment strategy works well for those investors who are somewhat risk adverse. By maintaining a fixed dollar amount in stocks and transferring the profits in excess of that fixed amount into the less risky investment instruments, conservative investors can still pursue a reasonable measure of growth for their portfolios. However, if stock prices continue to rise, the constant dollar plan will not offer as great a return as a buy-and-hold strategy. Furthermore, if the stocks chosen for a constant dollar plan don't fluctuate much in price, they won't work to enhance the overall value of the portfolio because the upper and lower target amounts will never be reached. Therefore, this type of plan performs best with stocks that fluctuate in price along with those that have good potential for long-term appreciation.
An investor who implements the constant dollar strategy must not only take great care in selecting the proper securities for the plan portfolio, he or she must also make decide what the constant dollar amount should be, as well as the upper and lower limits to set. A conservative investor might allocate too small an amount to stocks, which could result in a lack of overall growth for the total investment portfolio. On the other hand, too large a constant dollar amount allocated to stocks might cause that same investor to take on more risk than he's comfortable with. A more aggressive, growth-oriented investor would typically be expected to allocate a greater dollar amount to the stock side of the portfolio.
The strategy works in this manner: let's assume, for example, that an investor has a portfolio with a total value of $100,000; of that total he wants to keep $50,000 invested in stocks and the rest allocated to bonds. When the value of the stock half of the portfolio increases to an upper limit (which is set by the investor), stocks are sold off so that the total market value of the stocks remaining in the portfolio is reduced to $50,000. So, if the upper limit set by the investor was, say, $60,000, when the value of the stock side of the portfolio reached that amount, $10,000 in stocks would be sold to reduce stock values back to $50,000. The $10,000 proceeds would be invested in additional bonds. If the stock in the portfolio declined to a lower (predetermined) limit, then additional stocks would be purchased to increase their total value back to $50,000. This type of plan forces the investor to take profits when the upper target amount is reached and to buy additional shares when the value falls to the lower target number.
This investment strategy works well for those investors who are somewhat risk adverse. By maintaining a fixed dollar amount in stocks and transferring the profits in excess of that fixed amount into the less risky investment instruments, conservative investors can still pursue a reasonable measure of growth for their portfolios. However, if stock prices continue to rise, the constant dollar plan will not offer as great a return as a buy-and-hold strategy. Furthermore, if the stocks chosen for a constant dollar plan don't fluctuate much in price, they won't work to enhance the overall value of the portfolio because the upper and lower target amounts will never be reached. Therefore, this type of plan performs best with stocks that fluctuate in price along with those that have good potential for long-term appreciation.
An investor who implements the constant dollar strategy must not only take great care in selecting the proper securities for the plan portfolio, he or she must also make decide what the constant dollar amount should be, as well as the upper and lower limits to set. A conservative investor might allocate too small an amount to stocks, which could result in a lack of overall growth for the total investment portfolio. On the other hand, too large a constant dollar amount allocated to stocks might cause that same investor to take on more risk than he's comfortable with. A more aggressive, growth-oriented investor would typically be expected to allocate a greater dollar amount to the stock side of the portfolio.
Constant Ratio Plan
The constant ratio plan is an asset allocation strategy that establishes fixed percentages for the different types of securities contained in a portfolio. For example, a typical constant ratio plan could be made up of an allocation of 45 percent of portfolio investments in stocks, 45 percent in bonds, and 10 percent invested in money market (cash) securities. The percentages allocated to the different types of investments are determined by the investor's objectives and risk tolerance. Changes in asset allocation percentages can be made to coincide with changes in these objectives as well as changes in the conditions of the markets. A conservative, risk-averse investor who's approaching retirement and needs additional income might use a portfolio allocation of 25 percent stocks, 70 percent bonds, and 5 percent in money market securities. On the other hand, a young investor seeking growth in his or her portfolio may choose an allocation with a greater possible rate of return (along with more exposure to risk), such as 80 percent invested in stocks, 15 percent in bonds, and 5 percent in money market securities.
Once the allocation percentages have been decided, the investor must next determine the trigger points, or percentages, for rebalancing the portfolio. For instance, let's look at the example of a $100,000 portfolio, with 50 percent of its value allocated to stocks and 50 percent in bonds. Over time the values of the different securities will change and the investor will need to rebalance the portfolio (in other words, bring its allocation percentages back to their original levels). If the stocks in the portfolio increase to $60,000 and bonds decrease to $45,000, the ratio is no longer 50 percent for each. Rebalancing can be done after the passage of a certain amount of time – such as quarterly, biannually or annually – or based on percentage limits (10 percent, 20 percent, etc.). Using a 20 percent limit for the stocks in our example portfolio, rebalancing would be due because the stock values increased to $60,000, which is 20 percent above the $50,000 constant amount. Rebalancing would also be performed if the stocks dropped to a value of $40,000 (20 percent below $50,000).
Now, let's assume that the total value of the portfolio has increased to $105,000 with the stock portion accounting for $60,000 of that amount (which is 57 percent). To maintain the 50/50 ratio and proper risk exposure, the stock portion must be decreased. In this instance the investor would need to sell $7500 worth of stocks to reduce their total value to $52,500, which is 50 percent of the total portfolio value of $105,000. The $7500 proceeds would then be added to the bond holdings to bring their total level back up to 50 percent.
As with the constant dollar plan, the long-term expectation is that the stocks of the portfolio will appreciate in value (as stocks historically have). When this occurs, a portion of stocks will be sold to rebalance the portfolio and increase the amounts invested in the more conservative portfolio instruments. However, if stocks in the portfolio decline while bonds increase in value, then bonds will be sold off to provide funds to purchase additional stock.
Once the allocation percentages have been decided, the investor must next determine the trigger points, or percentages, for rebalancing the portfolio. For instance, let's look at the example of a $100,000 portfolio, with 50 percent of its value allocated to stocks and 50 percent in bonds. Over time the values of the different securities will change and the investor will need to rebalance the portfolio (in other words, bring its allocation percentages back to their original levels). If the stocks in the portfolio increase to $60,000 and bonds decrease to $45,000, the ratio is no longer 50 percent for each. Rebalancing can be done after the passage of a certain amount of time – such as quarterly, biannually or annually – or based on percentage limits (10 percent, 20 percent, etc.). Using a 20 percent limit for the stocks in our example portfolio, rebalancing would be due because the stock values increased to $60,000, which is 20 percent above the $50,000 constant amount. Rebalancing would also be performed if the stocks dropped to a value of $40,000 (20 percent below $50,000).
Now, let's assume that the total value of the portfolio has increased to $105,000 with the stock portion accounting for $60,000 of that amount (which is 57 percent). To maintain the 50/50 ratio and proper risk exposure, the stock portion must be decreased. In this instance the investor would need to sell $7500 worth of stocks to reduce their total value to $52,500, which is 50 percent of the total portfolio value of $105,000. The $7500 proceeds would then be added to the bond holdings to bring their total level back up to 50 percent.
As with the constant dollar plan, the long-term expectation is that the stocks of the portfolio will appreciate in value (as stocks historically have). When this occurs, a portion of stocks will be sold to rebalance the portfolio and increase the amounts invested in the more conservative portfolio instruments. However, if stocks in the portfolio decline while bonds increase in value, then bonds will be sold off to provide funds to purchase additional stock.
Community Investing
Community investing allows socially-conscious investors to put their money to work locally in the service of their values. It provides a means of creating solutions for many current social, economic, or natural problems by putting much-needed funding into the hands of those who are at the grass-roots level and thus able to make the most direct impact. From dilemmas such as inner-city poverty to third-world destitution, from saving a national park to saving the rain forests, community investing paves the way for conscientious individuals and companies to invest in dedicated and hardworking people who are actually bringing about the necessary and desired societal changes.
Community development financial institutions (or, CDFIs) are at the heart of this type of socially responsible investing. These institutions are the conduit by which investor funds are placed into the hands of the people operating on the ground to effect change. They provide a platform that fosters and encourages an attitude of self-help among community members to tackle and overcome their own common problems. Investing in CDFIs can bring about revitalization of local communities, help alleviate poverty, and empower individuals and families who've historically been on the fringes of economic improvement and growth.
CDFI entities include not only local community banks and credit unions, but also community loan funds and international microcredit programs. Through community banks and credit unions, virtually any investor can put his or her money to work to make a difference in the lives of local individuals. Most community banks target specific areas of need or service within their region of influence. Some specialize in women- or minority-owned businesses, while others may focus on low-income housing or nonprofit projects and organizations (such as providing initial loan funds for homeless shelters or health care facilities). Often, these borrowers would not be approved for more mainstream financing, making the funding from community institutions an even more critical pathway through which such programs and businesses can develop a foothold on the larger economic playing field.
Going a step further, community loan funds help to provide money directly to local disadvantaged or underserved individuals who may not qualify for or be able to afford loans from any commercial bank, including community institutions. These funds obtain their financial resources from investors who have an interest in their specific areas of focus.
The development and use in recent years of microcredit has had a dramatic impact on the economic development of individuals and small communities around the world. Microcredit investors provide small, low-interest loans to poor entrepreneurs who have little or no collateral, thereby boosting the prospect of growth and enrichment for local economies and communities throughout developing nations.
Although investing in loan funds or microcredit institutions usually entails a degree of sacrifice (many only accept investments at below-market interest rates), those with a special concern for the social problems that these entities seek to address will doubtless find the tradeoff not only acceptable, but even satisfying and fulfilling. Investors will have the gratification of knowing that they're helping to serve programs and individuals at the margins of the economy and of society, allowing them a sense of empowerment by unlocking and throwing open the doorway to full participation.
Community development financial institutions (or, CDFIs) are at the heart of this type of socially responsible investing. These institutions are the conduit by which investor funds are placed into the hands of the people operating on the ground to effect change. They provide a platform that fosters and encourages an attitude of self-help among community members to tackle and overcome their own common problems. Investing in CDFIs can bring about revitalization of local communities, help alleviate poverty, and empower individuals and families who've historically been on the fringes of economic improvement and growth.
CDFI entities include not only local community banks and credit unions, but also community loan funds and international microcredit programs. Through community banks and credit unions, virtually any investor can put his or her money to work to make a difference in the lives of local individuals. Most community banks target specific areas of need or service within their region of influence. Some specialize in women- or minority-owned businesses, while others may focus on low-income housing or nonprofit projects and organizations (such as providing initial loan funds for homeless shelters or health care facilities). Often, these borrowers would not be approved for more mainstream financing, making the funding from community institutions an even more critical pathway through which such programs and businesses can develop a foothold on the larger economic playing field.
Going a step further, community loan funds help to provide money directly to local disadvantaged or underserved individuals who may not qualify for or be able to afford loans from any commercial bank, including community institutions. These funds obtain their financial resources from investors who have an interest in their specific areas of focus.
The development and use in recent years of microcredit has had a dramatic impact on the economic development of individuals and small communities around the world. Microcredit investors provide small, low-interest loans to poor entrepreneurs who have little or no collateral, thereby boosting the prospect of growth and enrichment for local economies and communities throughout developing nations.
Although investing in loan funds or microcredit institutions usually entails a degree of sacrifice (many only accept investments at below-market interest rates), those with a special concern for the social problems that these entities seek to address will doubtless find the tradeoff not only acceptable, but even satisfying and fulfilling. Investors will have the gratification of knowing that they're helping to serve programs and individuals at the margins of the economy and of society, allowing them a sense of empowerment by unlocking and throwing open the doorway to full participation.
Dollar Cost Averaging
Dollar Cost Averaging is an extremely effective way to produce above-average long-term gains. It’s easy, it can be started with a small investment, and it works. Simply put, dollar cost averaging is the practice of buying securities at regular intervals in fixed dollar amounts, regardless of market conditions. Small investors have built fortunes by making systematic purchases of shares over long periods of time. For instance, by investing as little as $50 monthly in mutual funds, you can take advantage of dollar cost averaging, which is one of the simplest and most efficient ways of building an investment portfolio. The principle can also be used to purchase individual stocks and bonds; however, larger investment amounts are generally needed to purchase these.
When using this technique, you purchase more shares at relatively low prices than at high prices. As a result, the average cost of all shares bought is lower than the average of all the prices at which the purchases were made. The combination of buying shares at a variety of prices and acquiring more shares at lower rather than higher prices has proven to be a resourceful as well as cost-effective way of accumulating securities.
Dollar cost averaging works because an equal number of dollars buys more shares at low prices than it does at high prices. As long as share prices change at all during the investment period, the average cost of the shares purchased will be lower than the average of the prices paid. Long-term growth of the investment is not the main concern. The fluctuations of the share prices are more important to the success of this technique. Markets of greater volatility will in fact produce the best results. A conservative fund, such as an income fund where price movements are small, will not work as well.
It must be remembered, however, that dollar cost averaging does not guarantee that there will always be profits and never be losses in your portfolio. No investment can guarantee that. Even though you paid a lower average cost than the average price of the shares, if you choose the wrong time to exit the market, you could still lose money. If the market price is low when you get out, you won’t make a profit.
This program should be used only for long-term investment purposes. Over the years of continual systematic investing, shares are bound to be purchased at various price levels from high to low and in-between. This can substantially reduce the risks inherent in securities investing. The plan’s main advantage is that over time it will work to your benefit almost regardless of what the market does.
Building wealth by investing in stocks, bonds, or mutual funds is less a matter of investment skill or luck than of patience and persistence. The major decision that must be made is whether or not you are willing to forego immediate gratification to achieve your long-term financial goals. If you are, then dollar cost averaging can be a very effective way to help you get there.
When using this technique, you purchase more shares at relatively low prices than at high prices. As a result, the average cost of all shares bought is lower than the average of all the prices at which the purchases were made. The combination of buying shares at a variety of prices and acquiring more shares at lower rather than higher prices has proven to be a resourceful as well as cost-effective way of accumulating securities.
Dollar cost averaging works because an equal number of dollars buys more shares at low prices than it does at high prices. As long as share prices change at all during the investment period, the average cost of the shares purchased will be lower than the average of the prices paid. Long-term growth of the investment is not the main concern. The fluctuations of the share prices are more important to the success of this technique. Markets of greater volatility will in fact produce the best results. A conservative fund, such as an income fund where price movements are small, will not work as well.
It must be remembered, however, that dollar cost averaging does not guarantee that there will always be profits and never be losses in your portfolio. No investment can guarantee that. Even though you paid a lower average cost than the average price of the shares, if you choose the wrong time to exit the market, you could still lose money. If the market price is low when you get out, you won’t make a profit.
This program should be used only for long-term investment purposes. Over the years of continual systematic investing, shares are bound to be purchased at various price levels from high to low and in-between. This can substantially reduce the risks inherent in securities investing. The plan’s main advantage is that over time it will work to your benefit almost regardless of what the market does.
Building wealth by investing in stocks, bonds, or mutual funds is less a matter of investment skill or luck than of patience and persistence. The major decision that must be made is whether or not you are willing to forego immediate gratification to achieve your long-term financial goals. If you are, then dollar cost averaging can be a very effective way to help you get there.
Discerning the Two Types of Risk
Risk can be thought of as the possibility that your investment will be worth less at the end of your holding period than it was at the time that you originally bought it. The volatility of the financial markets creates risk. But risk is also the reason that you have the potential to earn more than what is available from T-bills, if you know how to recognize and manage it wisely. Your investment choices should be considered in terms of both reward and risk, and the trade-off that you're willing to make.
In the stock and bond markets, there are actually only two types of factors that can cause a stock's return to vary. One relates to changes in the corporation or the way that investors perceive the corporation. The other has to do with changes and movements in the overall securities markets. Consequently, this means there are two basic components to the risk that every investor faces: market risk, which is inherent in the market itself; and company risk, which encompasses the unique characteristics of any one stock or bond and the industry in which it operates.
About 70 percent of the risk that you face as an investor is company risk. Fortunately, you can minimize and control this risk by diversifying among different securities. For example, you can invest in ten different stocks or bonds rather than just one (which is certainly advisable). On the other hand, market risk – the remaining 30 percent of the total risk that you're exposed to – cannot be avoided by diversification; all stocks and bonds are affected to some degree by the overall market.
The fact that you can eliminate company risk simply by diversifying your portfolio is critical to the long-term success of your investment strategy. An investor who owns just one stock is taking on 100 percent of the risk associated with investing in common stocks, while an investor who owns a diversified portfolio has only 30 percent of that risk. In other words, a single-stock investor has more than three times the risk of a diversified investor.
Investors who think of themselves as conservative but who invest in one low-risk stock actually incur more risk than investors who have a portfolio of ten aggressive growth stocks. On top of that, the conservative investors are earning a lower expected return because they're invested in lower-risk, lower-return securities.
This is a crucial investment concept; many investors, however, commonly overlook it. The stock and bond markets provide higher returns for higher risks, but they provide those higher returns only for unavoidable risk – the risk inherent in the market. Company risk can to a large degree be circumvented through diversification. Regardless of the investment objective that you may have, what your intended holding period is, or what kind of securities analysis is performed, if you don't have a diversified portfolio you're either throwing away part of your return or assuming risk that could and should be avoided (or at least dramatically reduced), or both.
In the stock and bond markets, there are actually only two types of factors that can cause a stock's return to vary. One relates to changes in the corporation or the way that investors perceive the corporation. The other has to do with changes and movements in the overall securities markets. Consequently, this means there are two basic components to the risk that every investor faces: market risk, which is inherent in the market itself; and company risk, which encompasses the unique characteristics of any one stock or bond and the industry in which it operates.
About 70 percent of the risk that you face as an investor is company risk. Fortunately, you can minimize and control this risk by diversifying among different securities. For example, you can invest in ten different stocks or bonds rather than just one (which is certainly advisable). On the other hand, market risk – the remaining 30 percent of the total risk that you're exposed to – cannot be avoided by diversification; all stocks and bonds are affected to some degree by the overall market.
The fact that you can eliminate company risk simply by diversifying your portfolio is critical to the long-term success of your investment strategy. An investor who owns just one stock is taking on 100 percent of the risk associated with investing in common stocks, while an investor who owns a diversified portfolio has only 30 percent of that risk. In other words, a single-stock investor has more than three times the risk of a diversified investor.
Investors who think of themselves as conservative but who invest in one low-risk stock actually incur more risk than investors who have a portfolio of ten aggressive growth stocks. On top of that, the conservative investors are earning a lower expected return because they're invested in lower-risk, lower-return securities.
This is a crucial investment concept; many investors, however, commonly overlook it. The stock and bond markets provide higher returns for higher risks, but they provide those higher returns only for unavoidable risk – the risk inherent in the market. Company risk can to a large degree be circumvented through diversification. Regardless of the investment objective that you may have, what your intended holding period is, or what kind of securities analysis is performed, if you don't have a diversified portfolio you're either throwing away part of your return or assuming risk that could and should be avoided (or at least dramatically reduced), or both.
Explaining the P/E Ratio
One of the most common measures that investors use to evaluate a stock is its price-to-earnings (or P/E) ratio. The P/E ratio is calculated by dividing a stock's price by its per-share earnings for any given year. And while it's not a foolproof way of gauging a stock's value, it is a good place to start. Let's take a look at a simple example:
Suppose ABC Corporation is expected to earn $2.00 per share in the coming year and its stock is currently trading at $50 per share. The P/E ratio of ABC's stock shares, therefore, is calculated to be 25 ($50/$2.00 = 25). It must be noted that the P/E here was calculated based on the company's expected earnings; in other words, their earnings estimate. This is known as a forward P/E. Some investors choose to use a company's previous 12-month earnings instead, since that number is a certainty. And although this isn't necessarily wrong, it's probably better to use the forward P/E because it provides an idea of how much of a premium other investors are willing to pay for a company's future earnings. A higher P/E ratio indicates higher expectations for continued earnings growth. In other words, investors will pay more money based on the company's current earnings in the hope that it's future earnings will make the current price that they paid seem low.
P/E ratios are most helpful when compared against other P/E ratios. For instance, you may want to examine a stock's historical P/E range – how high and low its P/E has been in the past. You might also compare it with the P/Es of other similar companies. Or, you could compare the P/E ratio of a particular stock to the P/E ratio of a market index, such as the Standard & Poor's 500. These comparisons will give you an idea of where a particular stock stands with regard to its own history, its peers, and the stock market as a whole.
P/E ratios can be industry-specific, based on the characteristics of a particular group of stocks. For example, homebuilders and financial companies typically trade at below-market P/Es because their businesses tend to be fairly mature. It must also be remembered, however, that just because a stock has a relatively low P/E, it isn't automatically a great buy. Other investors may be aware of some company problem and therefore shying away from the company's shares in response. The actual fact of the matter is that a low P/E can be either a good or bad indicator. As stated earlier, it's a place to start your evaluation of a stock.
The P/E can also be used to look at how quickly a company's earnings have been growing over the past few years. In order to do this, you simply take the company's yearly earnings results and subtract them from the next year's earnings results. Then, divide that number by the earnings number that you just subtracted. The result – once the decimal point is moved two places to the right (remember you high school math?) – will be the percentage of earnings growth that year.
Revisiting ABC Corp., let's say that they earned $1.00 per share in 2001 and $1.30 in 2002; the calculations would be thus: $1.30 - $1.00 = $0.30. Then: 0.30/1.00 = .3 (and move the decimal point, yielding 30%). So, in 2002, ABC's earnings grew by 30 percent. By repeating these calculations for several years in a row, you can determine an average annual growth rate, which will give you a better idea of a company's long-term performance.
Keep in mind that a company can experience no growth, or even negative growth, for one or more years. It should also be noted that calculating this type of information for a company with an especially erratic earnings history likely wouldn't be very useful to you. You'll need to dig much deeper in order to get a clear picture of a stock's true worth.
Suppose ABC Corporation is expected to earn $2.00 per share in the coming year and its stock is currently trading at $50 per share. The P/E ratio of ABC's stock shares, therefore, is calculated to be 25 ($50/$2.00 = 25). It must be noted that the P/E here was calculated based on the company's expected earnings; in other words, their earnings estimate. This is known as a forward P/E. Some investors choose to use a company's previous 12-month earnings instead, since that number is a certainty. And although this isn't necessarily wrong, it's probably better to use the forward P/E because it provides an idea of how much of a premium other investors are willing to pay for a company's future earnings. A higher P/E ratio indicates higher expectations for continued earnings growth. In other words, investors will pay more money based on the company's current earnings in the hope that it's future earnings will make the current price that they paid seem low.
P/E ratios are most helpful when compared against other P/E ratios. For instance, you may want to examine a stock's historical P/E range – how high and low its P/E has been in the past. You might also compare it with the P/Es of other similar companies. Or, you could compare the P/E ratio of a particular stock to the P/E ratio of a market index, such as the Standard & Poor's 500. These comparisons will give you an idea of where a particular stock stands with regard to its own history, its peers, and the stock market as a whole.
P/E ratios can be industry-specific, based on the characteristics of a particular group of stocks. For example, homebuilders and financial companies typically trade at below-market P/Es because their businesses tend to be fairly mature. It must also be remembered, however, that just because a stock has a relatively low P/E, it isn't automatically a great buy. Other investors may be aware of some company problem and therefore shying away from the company's shares in response. The actual fact of the matter is that a low P/E can be either a good or bad indicator. As stated earlier, it's a place to start your evaluation of a stock.
The P/E can also be used to look at how quickly a company's earnings have been growing over the past few years. In order to do this, you simply take the company's yearly earnings results and subtract them from the next year's earnings results. Then, divide that number by the earnings number that you just subtracted. The result – once the decimal point is moved two places to the right (remember you high school math?) – will be the percentage of earnings growth that year.
Revisiting ABC Corp., let's say that they earned $1.00 per share in 2001 and $1.30 in 2002; the calculations would be thus: $1.30 - $1.00 = $0.30. Then: 0.30/1.00 = .3 (and move the decimal point, yielding 30%). So, in 2002, ABC's earnings grew by 30 percent. By repeating these calculations for several years in a row, you can determine an average annual growth rate, which will give you a better idea of a company's long-term performance.
Keep in mind that a company can experience no growth, or even negative growth, for one or more years. It should also be noted that calculating this type of information for a company with an especially erratic earnings history likely wouldn't be very useful to you. You'll need to dig much deeper in order to get a clear picture of a stock's true worth.
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