1. FIRE ALL FINANCIALADVISORS:
PATHS to INDEPENDENT INVESTING
Stock Investments in the Internet Age
By Kishore Jethanandani
Takeaways
The average success rate of pros is 49% which is about average you would
get by tossing a coin.
The key to successful stock-picking is checking facts against the majority
opinion
The reason why people don't make money from stocks lies in psychology:
group think.
In recent months, investors have realized to their dismay that professional
investors have been amiss in anticipating the downturn in financial markets. It is
time to ask whether an individual investor could do just as well and not have to
pay the exorbitant fees that financial "experts" demand. The Internet is a huge
resource for information, discussion and advice. While mastering the knowledge
available on the Internet may initially seem overwhelming, the more seasoned
investors will tell you that it gets enjoyable, if not addictive, once you begin to
master it. Here is a short guide to resources individual investors could use for
stocks.
2. Basics with stock-picking
Stock-picking, to be successful, requires five important decisions to be made for
the overall wealth of the individual to increase and these are
Return: A positive rate of return at least equal to the average rate of return
earned by the combination of stocks that represent the market index.
Minimal Risk: A positive return from a stock in one period could be followed by a
negative return in subsequent periods of time. This type of risk can be minimized
if another stock is added which is likely to earn positive returns when others earn
negative returns. Investors need to choose a combination of stocks or a portfolio
to maximize their wealth.
Stock-selection methods: What are the characteristics of stocks that perform best
and how do you choose them? Is a strategy for holding stocks for a short period of
time better than keeping them for long periods of time?
Tax minimization: The final rate of return depends on the taxes paid on capital
gains. How can the tax liability be minimized?
Investment Advisors: Are investors likely to earn higher rates of return if they use
the services of advisors enough to justify the fees paid to them? Is it more cost
effective to come to decisions about investment on your own?
More information on issues in investing can be found at
http://www.pathtoinvesting.org/
Why is this critical for you? The choices that a person makes in stock selection
have a very significant impact on a person's life in terms of time commitment,
peace of mind, comforts in life and risk of fraud. Here are some of the ways in
which it could influence your life
3. Conservative and aggressive investing: Conservatively invested stocks earn an
average rate of return of 8-10% per annum over a lifetime while the average for
aggressive investing is 21%. Returns from conservative investing are much more
certain, take very little learning and time commitment while the opposite is true
for aggressive investing.
Peace of mind: Conservative investing brings much greater peace of mind;
investors have to make very few decisions because they choose to hold stocks
over the long run and change them only when a company is likely to decline for
good. Aggressive investing is for those who enjoy making bets and are motivated
by the prospect of high levels of wealth; these investors enjoy reading about
businesses and economic trends.
Fraud: At its worst, bad judgment and excessive greed in stock selection can mean
ruin as you become victim to aggressive salespeople who pump up worthless
penny stocks. The movie Boiler Room, based on a true story, shows the
shenanigans that go in such schemes. To keep track of the latest frauds in stocks,
see http://www.stockpatrol.com/
Choosing stocks that fit your risk tolerance levels is important otherwise you
could be losing sleep and making bad judgments. Those who choose an aggressive
investment style should ask themselves whether they can weather steep drops in
stock prices like the meltdown in October 1987. On the other had, conservative
investors should ask themselves whether they will be satisfied with a relatively
lower level of consumption. You could estimate your level of risk tolerance at
http://www.rce.rutgers.edu/money/riskquiz/
What are your options?
4. Types of stocks: In terms of risk and return, stocks can be divided into three
broad categories of securities and these are
Growth stocks: these are securities of fast growing companies often in the
technology industry. Such stocks potentially earn the highest returns when their
profit growth accelerates. The stocks of such companies are also more likely to
disappoint if their growth falters. You can find growth stocks at
http://www.stocktables.com/
Value stocks: these are stocks of well established companies and earn moderate
return with a much lower risk. To select good value stocks, see
www.magicformulainvesting.com/.
High Dividend stocks: these are stocks of slow growing but profitable companies
which reinvest very little of their cash surplus and distribute a higher share of
their profits to investors. These stocks have the lowest risk. You can select
dividend stocks at www.dogsofthedow.com
Portfolio Diversification:
Investors looking to diversify their portfolios and lower their risk have to look for
a combination of stocks whose returns move in opposite directions. In current
conditions, they have two major options:
Invest in combination of small stocks and large stocks: While small stocks are
generally profitable in the early stages of the business cycle such as in the period
2002-2005, larger companies do well in the later stages of the business cycle as is
the case now.
Invest in domestic and international stocks: the prospects of foreign economies
and American economy often move in opposite directions. You can lower your
risk by buying a combination of domestic and overseas stocks.
5. Method of picking stocks:
There are two major methods of investing; the lazy way and the more active one.
Conservative investors believe that stock prices move randomly so that the highs
and lows in price movements cancel out. The only realistic choice is to earn an
average return. Such investors hold proven companies for very long periods of
time and buy and sell only when there is a compelling reason to do so. Aggressive
investors look for opportunities when they can buy cheap and sell at a high price
to maximize their return. They can do this over infrequently or often. These
investors typically buy in the early stages of the business cycle and sell towards
the end of it.
Taxes and Returns
The rate of taxation is higher, equal to the rate of tax on income, for short-term
gains while it is lower on long-term gains. In addition, short-term investors have
pay more in trading fees when they buy and sell frequently. Taxes on long-term
gains have dropped to 15% (for lower-income tax payers it is lower at 5%). For
dividend income, the tax is lower at 15% instead of the regular income tax.
Taxes can also be saved when stock investments are part of retirement plans
rather than brokerage accounts. According to estimates by Burton Malkiel, the
value of a retirement fund will be $1.7 million if the marginal tax rate is 28% and
average rate of return 8% with yearly investments of $4000 for 45 years. On the
other hand, the equivalent amount will be $600,000 if the money is invested in a
brokerage account. After paying taxes on withdrawals, you are left with $1.2
million.
6. Gurus and Advisors
Investors often presume that they need to consult an expert to understand the
complexities of investment before they make their decisions. The reality is that
the performance record of an average advisor is poor; one estimate shows that
they got their forecasts right only 49% of the time. For more detailed information
about advisors, see www.cxoadvisory.com/gurus/
What should you do?
Investors can choose to depend on reliable advisors to make their decisions about
investments or they can do it themselves. Those who want to leave stock-picking
to advisors, the ratings at Invertu will help to find a reliable investment advisor.
Alternatively, they can decide to take responsibility for their own investments. For
them, the Internet offers a huge variety of resources for finding information and
opportunities for brainstorming that are powerful aids for decision-making.
Value stocks and dividend stocks: Growth stocks are expected to earn the highest
rates of return since their profits increase at the fastest rate. A good example of a
growth stock is Google which is growing rapidly because it introduced new
concepts in online advertising. However, such stocks are also exposed to much
greater risk. Google, for example, is facing competition from Yahoo! Microsoft
and Wikipedia and it could lose its dominance to them. Whenever the market
perceives Google's profits are going to slowdown, its prices drop sharply. On the
other hand, its price will rise rapidly if growth exceeds expectations.
Value investing looks for well established companies in mature industries selling
at relatively low prices. Indicators such as high book value-to-market value, high
earnings growth relative to price and high cash inflows point to value that has not
7. been priced in. In other words, this kind of investing looks for bargains. A good
example of this would be Gillette.
Finally, the least risky stock investment strategy is to pick high dividend yield
earning stocks. These are companies that are in low growth sectors like coal
which accumulate high levels of cash because they reinvest only a small
proportion of their profits. The downside is that these companies could go out of
business as they are replaced by other industries.
Portfolio Diversification:
Small stocks and large company stocks: One important consideration of
diversification between stocks is the choice between small and large company
stocks. In general, small company stocks earn higher returns at a higher risk level
while large company returns are more moderate and their risk is low. In addition,
stock returns of small companies tend to be higher in the early stages of the
business cycle when interest rates are low and credit supply more abundant. On
the other hand, large companies perform better in the mature stages of the
business cycle when markets are more volatile and they have more cash reserves
to cope with slower growth in credit supply. Data on the performance of large
companies can be found at
http://www.forbes.com/2004/12/22/05platinumland.htmllarg and small
companies at http://www.forbes.com/lists/2006/23/biz_06200best_The-200-
Best-Small-Companies_land.html
Another important consideration is the choice between domestic and
international stocks. Very often, the returns from overseas stocks are higher
when they are low in the USA. American investors have invested large amounts of
money in international markets in early 2000s while the domestic market was
8. sluggish. Conversely, international markets were performing poorly in the late
1990s while the American stocks were booming. Some international stocks trade
on American stock exchanges as American Depository Receipts. Other ways to
buy Exchange Traded Funds that are a combination of stocks that form an index in
a foreign country.
Method of picking stocks:
Just how do you make money in stock-markets? What are the characteristics of
stocks that perform well? At what price do you buy and sell a stock? What is a
reasonable profit from a stock? How does an investor ensure that he or she does
not lose money in stocks?
There are really two serious methods in stock-picking and these can be described
as the "the lazy way to making average profits" and the other says "it takes hard
work and experience to make higher than average profits". We have excluded the
numerous "get-rich-quick" theories which we don't consider to be serious.
The best exponent of the first theory is Burton G Malkiel who has written the
much acclaimed book "A Random Walk down Wall Street: the time-tested
strategy for successful investing". The premise of the book is based on the idea
that markets are efficient and they take into account the profit prospects, the
risks, the sentiment and the news to determine the price of a stock. Actual prices
of stocks hover around the average value of the stock and fluctuate randomly;
there is no point in making predictions to try to earn more than the market rate of
return. By the logic of this method, you choose your level of risk tolerance and
target rate of return and pick stocks that you hold on over a long period of time.
The best stocks to pick are those that form the index; they will earn as much as
the market rate of return which is the most reasonable level of expectation.
9. There is another method of stock-picking which times the market. This method
seeks to buy stocks at the lowest price and sell it at the highest price possible.
This type of method is practiced in a variety of ways but the most successful
implementation has been done by people like Warren Buffet, Peter Lynch and Ken
Fisher. This style of management recognizes that market timing is hard to get
right and takes a great deal of experience. On an average, an investor has to be
right at least 70% of the time; the successful investors of this kind also earn twice
as much the average market rate of return. Typically, such investors do not try to
time every turn in the market; they look at the ups and downs in the business
cycle. They will buy in the early stages of the business cycle and sell when it is
expected to go down. Such investors buy for the long-run and pick stocks when
there is strong evidence to show that they are under-priced and have a high
chance of performing well in the long-run. A serious step-by-step guide helps you
to find your way.
There are two other methods of predicting and timing the market and these are
called technical and fundamental analysis. Technical analysis looks at short-term
trends as uncovered by charts. This type of analysis tries to find patterns which
point to the highs and lows in the market; there are far too many of these
methods to explain all of them here. A commonly used method is the
identification of the support and resistance level in price movements. While a
support level is a relatively firm bottom in the prices of stocks, the resistance level
is a relatively firm high in their prices. Prices will fluctuate around the resistance
or support level before they break away from them. When prices fall below the
support level, they are likely to go down and vice versa. More information on
10. technical analysis can be found at
http://www.equis.com/customer/resources/TAAZ/Default.aspx?
Another method of identification of suitable stock is fundamental analysis. This
method looks at the intrinsic value of a stock based on its future growth rates.
The higher the future growth rates, the higher the value of the stock. Since the
earnings in the future are of a lower value than the money invested today, the
expected cash inflows in the future are discounted at a rate that is equal to the
risk-free rate of return plus the compensation required for taking the risk. If the
actual price of the stock is less than its intrinsic value, it is worth buying. The
internet provides tools to screen stocks for their fundamental and technical worth
with the MSN Stock Scouter with convenient snapshots.
Taxes and Returns
In general, taxes on short-term are higher than those on long-term gains.
Currently, the rate for short-term gains is the same as that on ordinary income
and on long-term gains it has dropped to 15% (for lower-income tax payers it is
lower at 5%). For dividend income, the tax is lower at 15% instead of the regular
income tax.
When investors put all their money in retirement plans, they save all of these
taxes. They pay taxes on withdrawals for IRA accounts but not for Roth IRA
(however, they don't get tax benefits when they invest their money for Roth IRA).
The cumulative benefit of investing in retirement funds is considerable. According
to estimates by Burton Malkiel, the value of a retirement fund will be $1.7 million
if the marginal tax rate is 28% and average rate of return 8% with yearly
investments of $4000 for 45 years. On the other hand, the equivalent amount will
be $600,000. After paying taxes on withdrawals, you are left with $1.2 million.
11. Gurus and Advisors
Many investors would rather they did not have to understand the apparently
arcane world of investment and leave the job to investment advisors. The reality
is that the performance record of well-trained finance professionals is at best
good but variable, mostly mediocre and at its worst it is downright dishonest. Dr.
Malkiel in his book "Random Walk" has hundreds of pages of information,
commentary and satire tearing down the pretensions of analysts. Those who still
want to use analyst ratings, more information can be found at
http://www.newratings.com/
There is compelling data to show that well known gurus don't do any better than
a throw of a dice. The average success rate of pros is 49% which is about average
you would get by tossing a coin. The conclusions were based on 3000 forecasts
made by gurus over two years and these were compared with the outcomes. The
detailed data for the entire sample and individual gurus can be found at
http://www.cxoadvisory.com/gurus/
WHAT SHOULD YOU DO?
Stock-picking is clearly not an exact science; it is really analogous to finding a
partner in life. In both cases, you are stepping into the unknown. When you have
no idea and are inexperienced, the chances of getting suckered are high.
Extending the analogy of partners, young women looking for partners on
MySpace get duped by charming men who sometimes turn out to be conmen.
Similarly, inexperienced investors can get carried away by stories of people who
get rich by buying stocks and are caught off-guard when the market crashes. Over
time, you get the sense that there is a method that succeeds but you can't be
entirely sure it will work. Just like we learn to look for signs of a desirable partner
12. and decide to date quickly when we see them, we learn to recognize the
characteristics of good stocks and pick them quickly before we lose the
opportunity.
Many of us want to use advisors to avoid the burden of understanding the many
factors that influence the movement of stocks. One strategy to cope with this is to
buy brand name companies, selling at relatively low prices such as Corning, Pfizer,
and hold on to them for the long-run. Advisors are like counselors who can help
you to think but they can't provide the final answers.
The best of gurus like Buffet, Peter Lynch and Ken Fisher are in the habit of
repeating their belief that their methods can be emulated by anybody who has
steady nerves and common sense. Peter Lynch used to give spending money to
his daughters when he visiting retail stores. He would observe what they were
most inclined to buy. Their favorite purchases provided him with ideas about
investments.
The best way to begin is to first honestly assess what level of risk you can bear.
This is important because it is important to keep ones cool and look at facts when
the markets are in turmoil. In early 2007, the markets crashed as a result of
erratic movements in the Chinese stock-markets. People tended to believe Alan
Greenspan who made his characteristic ambiguous statement "recession is
probable and has a one in three chance of happening". Cooler heads looked at the
spreads between corporate bonds and treasuries and saw no change there. The
premiums earned on risky bonds are a very good indicator of how market actually
perceives risk. If you don't think you can take the suspense, its best to choose
proven companies and remain happy with moderate returns.
13. Those who decide they are ready for risks have plenty of resources to help them
make a decision. Many stocks with good value lie under-priced for long periods of
time and information about them is available in the public domain.
The business press is full of lists of fastest growing companies, the most admired
companies, the best places to work in based on large sized samples. Forbes, for
example, issues an annual list of fastest growing technology companies. The stock
performance of the fastest growing companies is better than the Nasdaq index.
For a review of the stock performance of the fastest growing companies, see
http://www.forbes.com/strategies/2006/01/26/lifecell-celgene-winnerslosers-
cz_pm_0127sf.html.
However, fast growth does not necessarily ensure that the company is going to be
able to sustain its performance. Biotech companies, for example, grow fast but
they often run into situations where their drugs or devices do damage to patients
and have to be recalled. The companies that are more likely to perform
consistently are those that have strong managements, well rewarded and trained
employees and ethical methods.
The Fortune Magazine has been producing annually a list of companies that are
most admired in the USA. These companies are selected based on the judgments
of 10,000 executives, business leaders and security analysts. One study compared
the stock performance of the portfolio of the most admired companies with the
S&P index. It was found that the Fortune list returned an average of 17.7%
compared to 13% for the S&P 500 index. All the companies in the Fortune
magazine list are stable companies so the difference in the rates is not explained
by any risk premium. For the details of the analysis, see
http://www.economics.pomona.edu/GarySmith/FortuneAdmired.pdf
14. The key to successful stock-picking is checking facts against the majority opinion
and you will find information that others have missed. Of the list of "gurus" we
had discussed earlier, Ken Fisher is the most successful because he trusts his own
analysis. He discusses how he checks out commonly held views and comes up
with an idea that is uniquely his. For more, see http://www.financial-
planning.com/pubs/fp/20061101025.html
Stock-picking involves two simple decisions which are the same for buying any
product or service. One, does the stock have value or does the company have the
ability to perform better than its competitors in the same industry? A related
question is whether the company is part of an industry which does better than
other sectors in the economy. Two, is the price of the stock equal to its intrinsic
value or the discounted value of its expected future earnings? It's a no-brainer
that anybody should buy stocks with high value and low prices and we will find
out this is the least implemented practice.
One source for screening for sectors and well performing companies is
http://www.equitytrader.com/structure/default.php. Click Yields to get a
selection of companies that yield high income. You can also look for sector with a
substantial difference between the potential and actual performance for finding
high growth companies. We had cited sources earlier which will help you to
identify companies that are underpriced and growing fast. While fundamental
analysis is a poor guide to future growth, it is not hard to find data to confirm
whether the target company has higher than average growth rate. To judge
whether the performance is going to be sustained, look at the news about what
the company is doing to launch new products and find new markets.
