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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Enhance your investment portfolio and take your investments to the next level! Do you have an investment portfolio set up, but want to take your knowledge of investing a step further? High-Level Investing For Dummies is the resource you need to achieve a more advanced understanding of investment strategies--and to maximize your portfolio's profits. Build upon your current knowledge of investment, particularly with regard to the stock market, in order to reach a higher level of understanding and ability when manipulating your assets on the market. This approachable resource pinpoints key pitfalls to avoid and explains how to time your investments in a way that maximizes your profits. Investing can be intimidating--but it can also be fun! By building upon your basic understanding of investment strategies you can take your portfolio to the next level, both in terms of the diversity of your investments and the profits that they bring in. Who doesn't want that? * Up your investment game with proven strategies that help increase profits and minimize risks * Avoid common pitfalls of stock speculating to make your investment strategy more impactful * Understand how to time the market to maximize returns and improve your portfolio's performance * Uncover hidden opportunities in niche markets that can bring welcome diversity to your portfolio High-Level Investing For Dummies is the perfect follow-up to Stock Investing For Dummies, and is a wonderful resource that guides you through the process of beefing up your portfolio and bringing home a higher level of profits!
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High-Level Investing For Dummies®
Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com
Copyright © 2016 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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Library of Congress Control Number: 2015954288
ISBN 978-1-119-14081-8 (pbk); ISBN 978-1-119-14083-2 (ebk); ISBN 978-1-119-14082-5 (ebk)
High-Level Investing For Dummies®
Visit www.dummies.com/cheatsheet/highlevelinvesting to view this book's cheat sheet.
Table of Contents
Cover
Introduction
About This Book
Foolish Assumptions
Icons Used in This Book
Beyond the Book
Where to Go from Here
Part I: Getting Started with High-Level Investing
Chapter 1: Taking Stock before You Invest at a Higher Level
The Basics: Defining and Categorizing Stocks
Investigating the Dual Nature of Stock Investing
Choosing Stocks Wisely
Measuring Stock Performance with Indexes
Going beyond Stocks: Exchange-Traded Funds and Options
Taking Tips and Techniques from Great Investors
Chapter 2: Assessing Risk and Volatility
Delving into Different Kinds of Risk
Minimizing Your Risk
Getting in the Swing of Things: Volatility
Chapter 3: Surveying Diversification and Allocation Strategies
Understanding Diversification and Allocation
Digging into Stock Sectors
Fitting In Your Personal Factors
Chapter 4: Finding Value and Income
Recognizing the Principles of Fundamental Analysis
Reviewing a Few Important Documents
Checking the Numbers
Understanding Ratios
Finding Undervalued Stocks
Considering Dividend Investing
Chapter 5: Breaking Down Brokerage Tools and Tactics
Before You Begin: Finding and Picking a Broker
Distinguishing between Brokerage Accounts
Looking at Brokerage Orders
Making Sense of Margin
Chapter 6: Intermarket Analysis
Looking at the Major Markets
Taking a Peek at Intermarket Analysis Charts
Shining a Spotlight on Major Marketplaces
Part II: Choosing High-Potential Stocks and Exchange-Traded Funds
Chapter 7: Small-Cap Stocks
Understanding Who Can Benefit from Small-Cap Stocks and Why
Considering Different Types of Small-Cap Stocks
Noting the Hallmarks of Potential Small-Cap Winners
Watching Out for the Pitfalls of Small-Cap Stocks
Trying Out Tactics and Principles for Small-Cap Success
Finding Small-Cap Gems
Chapter 8: Shorting Stocks
Understanding Some Important Points about Shorting
Getting a Handle on the Mechanics of Shorting
Your Shorting Strategy: Deciding What and When to Buy Safely
Chapter 9: Exchange-Traded Funds for Big Up Moves
Introducing ETFs: A Powerful Vehicle
Picking Out the Pros and Cons of ETFs
Checking Out the Main Categories of ETFs
Using ETFs for Income
Chapter 10: Exchange-Traded Funds for Big Down Moves
Defining Inverse ETFs
Exploring How Inverse ETFs Work
Comparing Inverse ETFs to Other Bearish Strategies
Knowing When to Use Inverse ETFs
Looking at the Next Level of Inverse ETFs
Part III: All about Options
Chapter 11: Introducing Options
Defining Options: Calls and Puts
Checking Out Reasons to Consider Options
Digging Deeper into the Features of an Option Contract
Walking through a Call Option Example
Placing Option Orders
Reading an Options Table
The Nuts ’n’ Bolts of Option Combinations
Trying Out Option Tutorials and Resources
Chapter 12: Call Options
The Uses of Call Options
The Golden Rules for Call Option Buyers
The Golden Rules for Covered Call Option Writers
Chapter 13: Put Options
Buying Put Options for Gains
Writing Put Options for Income
Considering Put Options for Protection
Chapter 14: Bullish Combination Strategies
The Bull Call Spread
The Bull Ratio Spread
The Synthetic Long
Chapter 15: Bearish Combination Strategies
The Bear Put Spread
The Bear Ratio Spread
The Zero-Cost Collar
Chapter 16: Neutral Combination Strategies
Pondering Neutral Points
Taking a Chance on High Volatility
Seeking Income with Low Volatility
Part IV: Strategies from the Greats
Chapter 17: Legendary Investing Strategies
Considering Characteristics of the Great Investors
Spotlighting Specific Investors and Their Tactics
Tracking and Analyzing the Pros
Chapter 18: High-Octane Speculating
A Few Important Lessons from Great Speculators
Speculating Approaches That Work
Chapter 19: Big Picture, Big Profits
Examining the Big-Picture Elements of the Economy
Pop! Breaking Down Bubbles
Making Sense of Megatrends
Tools, News, and Views That You Can Use
Chapter 20: Corporate and Political Skullduggery
Tracking Corporate Insider Trading
Comparing Insider Buying versus Insider Selling
Researching Political Insider Trading
Chapter 21: Technical Analysis
Surveying the Elements and Tools of Technical Analysis
Comparing Technical Analysis and Fundamental Analysis
Tracking Trends
Checking Out Chart Patterns
Investigating Indicators
Digging into Resources for Technical Analysis
Part V: The Part of Tens
Chapter 22: Ten Ways to Minimize Losses
Use Stop-Loss Orders
Employ Trailing Stops
Go against the Grain
Have a Hedging Strategy
Hold Cash Reserves
Sell and Switch
Diversify with Alternatives
Consider the Zero-Cost Collar
Try Selling Puts
Prepare Your Exit Strategy
Chapter 23: Ten Ways to Maximize Gains
Exercise Patience
Accumulate More Holdings
Try Trailing Stops
Use Stock Triggers
Make the Most of Margin
Look at Leveraged ETFs
Survey Optionable Securities
Buy Call Options
Sell Put Options
Construct a Synthetic Long
Chapter 24: Ten Traits of Successful Investors
Measuring Twice
Getting a Second Opinion
Showing Courage
Avoiding Greed
Doing the Opposite of What’s Expected
Specializing in a Sector
Reading Voraciously
Having Discipline
Regularly Monitoring Your Holdings
Accepting Mistakes Early
Part VI: Appendixes
Appendix A: Resources for Stock Investors
The Language of Investing
Investing Websites
Investing Magazines, Newspapers, Newsletters, and Books
Financial Organizations and Investor Clubs
Stockbrokers
Government Agencies
Other Investing Resources
Appendix B: Financial Ratios
Operating Ratios
Common Size Ratios
Liquidity Ratios
Solvency Ratios
Valuation Ratios
Dividend Ratios
About the Author
Cheat Sheet
Connect with Dummies
End User License Agreement
Guide
Cover
Table of Contents
Begin Reading
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Introduction
Today’s stock market has entered historic times for both good and bad reasons, so investors have to be sharper than ever. Knowledge and information can be more valuable than money. Plenty of investors have lost a fortune due to a lack of knowledge of what was happening. Conversely, plenty of people with limited funds have applied their knowledge and slowly built a fortune.
Money is only the fourth most important ingredient to your financial success; the first three are knowledge, time, and discipline. In High-Level Investing For Dummies, I emphasize those key points and much more. This book has everything from insights from history’s greatest investors to descriptions of the stock investing and speculating vehicles that seasoned investors and money management pros use to enhance their profitability.
To say I wish you great success is putting it mildly. I am grateful to you, the reader, for allowing me to be a part of something as intimate as your aspirations and goals. Furthering your financial success so that you can help yourself, your loved ones, and your honorable pursuits (such as charities or personal endeavors) is a personal honor for me.
Make it a great investing day!
About This Book
Out of all the worn-out slogans from the past hundred years, I think the best one for this book is “the more you learn, the more you earn.” I’m proud of my book Stock Investing For Dummies (four editions and counting!), and I think it’s a valuable addition to your library, but I couldn’t fit all the profitable information into it that I wanted. That’s why I’m so glad to be doing this follow-up book, High-Level Investing For Dummies. I can’t think of a better one-two combination in the stock investing world! Having this book in your possession suggests you’re a serious wealth-builder who understands that stocks, exchange-traded funds, and derivatives can be powerful and intricate parts of your strategies.
As both a long-time observer and participant in the stock market, I’ve seen many market conditions and learned that any time is a good time to profit from the market’s moves. The issue is not the market itself; the real issue is you and your knowledge! There are always wealth-building opportunities in both bullish and bearish markets, and this book will help you profit from all kinds of shifts in the market, whether they’re up, down, or even sideways.
Take this book and the information and guidance within it seriously, and your financial security (and net worth) will grow, no matter what’s happening in the stock market. You may not need to read every chapter to make you more confident as a stock investor, so feel free to jump around to suit your personal needs. Because every chapter is designed to be as self-contained as possible, it won’t do you any harm to cherry-pick what you really want to read. But if you’re like me, you may still want to check out every chapter, because you never know when you may come across a new tip or resource that will make a profitable difference in your portfolio.
Throughout this book, you see words like investor, speculator, and trader and also read about tactics and strategies that are long term or short term. You should understand that these terms are not interchangeable (I do my best to be precise with those terms).
One last note about this book: For the sake of the examples throughout, I don’t factor in brokerage commissions. This move keeps things tidy and makes the math easier for me!
Foolish Assumptions
My guess is that you got this book for one or more of the following reasons:
You read
Stock Investing For Dummies,
and you want more in-depth information and guidance.
You’re already an experienced stock investor, and you want a book that goes beyond the basics of stock investing.
You need more ideas and insights to make your stock investing strategies a little more effective, and you’re tired of hearing your Uncle Mo’s tips.
You have a financial advisor or broker already helping you, and you want to squeeze more value out of the relationship by asking the right questions and getting a better handle on the answers.
Icons Used in This Book
See those icons in the margins of this book? Here’s what each one means:
This icon marks a critical point I want you to store in your memory.
This icon flags a particular bit of advice that just may give you an edge over other investors.
Pay special attention to this icon because the advice can prevent headaches, heartaches, and financial aches.
The text attached to this icon isn’t crucial to your success as an investor, but it may help you talk shop with investing gurus and better understand the financial pages of your favorite business publication or website.
Beyond the Book
In addition to the material in the print or digital book you’re reading right now, High-Level Investing For Dummies comes with other great content available online. Check out the free Cheat Sheet at www.dummies.com/cheatsheet/highlevelinvesting to read about traits of successful speculators and useful investing sites and apps. You can also find free articles about option strategies, legendary investors, and more at www.dummies.com/extras/highlevelinvesting.
Where to Go from Here
You’re welcome to start at the beginning and read straight through. However, if you prefer to skip around and you already have a basic familiarity with stock investing, consider starting with Chapter 4. There, you find info on value investing, which should be at the core of most investors’ portfolios.
Next, why not read up on the great investors (Chapter 17) and speculators (Chapter 18) so you get a bird’s-eye view of those who were at the top of their game? I also cover exchange-traded funds (ETFs) for people who are bullish (Chapter 9) and those who are not (Chapter 10). Options are a fantastic way to boost your stock investing and speculating, and I devote an entire part to them (see Part III).
From there, follow your interests. You want great info to kick your stock investing up a notch? That info is in here! Check out the table of contents, use the index, or flip through the book to find what you need.
Part I
Getting Started with High-Level Investing
Visit www.dummies.com for great (and free!) Dummies content online.
In this part …
Find out what you must do before you invest your first dollar in stocks. Know what steps are necessary so your stock investing is successful.
Understand the risks and how to minimize them so you’ll have more winners than losers in your portfolio.
Get the scoop on diversification and allocation so your stock investing is consistently profitable regardless of what’s happening with the economy and financial markets.
Find great companies to invest in and pay as little as possible for their stocks. Check out what successful investors look for when they analyze a company.
Use brokerage orders and services to maximize your profits while minimizing your losses.
See how markets are interrelated. Know which investments can perform well while others are doing poorly so you can choose the right stocks in the right markets.
Chapter 1
Taking Stock before You Invest at a Higher Level
In This Chapter
Describing the basics of stocks
Delving into stocks’ dual nature
Selecting stocks and measuring their performance
Moving beyond stocks with ETFs, options, and high-level techniques
The beginning stock investor does what he or she can to choose a good stock. The higher-level stock investor knows a good stock but uses tools and resources to find either a better stock (with higher earnings and the like) or a good stock with more profit potential.
In addition, beginning and intermediate stock investors usually only go long in finding a stock to buy. But a higher-level stock investor can see profit in bad stocks and choose to profit by going short. A beginning investor sees that Sector A is good while Sector B has terrible prospects, and she buys a stock in Sector A. The higher-level stock investor may buy that same stock in Sector A but also considers getting an inverse ETF for Sector B.
When you add the strategies and resources in this book, you’ll definitely have what you need to take your stock investing to greater (more profitable) heights.
The basics of stock investing are covered in my book Stock Investing For Dummies (published by Wiley). This chapter really serves to highlight important points as you up your gain in the world of stocks.
The Basics: Defining and Categorizing Stocks
In our economy, companies in the private sector produce goods and services. As the economy grows, the companies that do a good job of providing goods and services that the general public consumes grow along with it.
Companies may be private or public:
Private:
A private company is one of the hundreds of thousands of proprietors and other business organizations that you transact with but typically cannot invest in conveniently.
Public:
Public companies, on the other hand, are business entities that are organized so that you can participate as an investor without needing to participate in the daily operations of the companies.
An investor can profit along with public companies by buying and holding their stocks. In the following sections, I provide a refresher on the definition of stocks and different stock categories.
Defining stock
Stock is a security that indicates limited ownership of a public corporation and represents a claim on a part of that corporation’s net assets and earnings. Stock may be common or preferred:
Common:
In this book, I primarily cover common stock, which entitles the stockholder (or stock owner) to vote at shareholder meetings (either in person or by mail or email communication) and receive any dividends that may be issued.
Preferred:
Preferred stock usually doesn’t give the holder voting rights, but it does provide some preferential treatment over common-stock holders, such as priority treatment in receiving dividends. Additionally, in the extreme event of the company’s bankruptcy, preferred-stock holders rank ahead of common-stock holders (and after creditors) in recouping money from liquidation.
To invest, you buy shares of the stock through a stock brokerage account (find out more about brokerage tools and tactics in Chapter 5). The minimum ownership amount is one share. When you buy or sell shares of stock, you pay a transaction fee (the commission).
Obviously, you buy stock because you expect the stock to rise (appreciate) in value as the rest of the investing public is attracted to the company and subsequently buys the stock, too. If all goes to plan, you’ll eventually be able to sell your stock for a gain (referred to as capital gain). In addition, many stocks provide income in the form of dividends, which are typically paid quarterly and have the potential to grow as well.
Checking out market capitalization
You often hear about stocks being large cap, mid cap, or small cap. In the world of stock investing, size (in terms of market value) does matter. A portfolio of large-cap stocks, for example, tends to be safer than a portfolio of small-cap stocks.
Market cap, which is short for market capitalization, is a reference to a stock’s market value. Calculating the market cap is easy; you multiply the company’s total number of shares outstanding by the share price. If Company X has 2 million shares outstanding and its stock is $10 per share, then the market capitalization is $20 million (2 million times $10). Although $20 million may sound like a lot, this stock is actually a micro-cap stock.
Here are the five basic levels of market capitalization:
Micro cap (up to $250 million):
These stocks are the smallest stocks and, all things being equal, are considered the riskiest (flip to
Chapter 2
for details on assessing risk). Some of these stocks are also referred to as penny stocks.
Small cap ($250 million to $1 billion):
Small-cap stocks are the bulwark for people seeking aggressive gains, especially in bull markets, but they come with greater risk. I go into detail on small-cap stocks in
Chapter 7
.
Mid cap ($1 billion to $10 billion):
For long-term investors, this category provides great potential compromise between the small caps and the larger companies. Mid caps are less risky than small caps but have more room to grow than larger companies.
Large cap ($10 billion to $50 billion):
This category is appropriate for conservative, long-term investors. This category may not have the growth potential of the lower cap levels, but these stocks are more reliable and tend to be the leaders in their marketplace.
Mega cap or ultra cap (more than $50 billion):
These stocks represent pieces of the biggest companies not only in their sectors but in the world. Mega-cap stocks tend to be in most portfolios and are the most widely held. They may not hold much growth potential versus other cap levels, but they’re certainly more predictable holdings.
Don’t choose a stock exclusively due to its size or market valuation. Do your due diligence in terms of choosing a stock for investment, and base your decision primarily on the company’s fundamentals (sales, earnings, market potential, and so on; see Chapter 4 for details). Let market cap be a factor if you’re down to two choices and you prefer either safety (higher market cap) or growth potential (lower cap).
Investigating the Dual Nature of Stock Investing
Stocks and their underlying companies are together, yet they have different personalities:
The company:
On one hand, you have the company itself. It’s the physical entity involved with sales and expenses, products, services, personnel, budgets, and a thousand other moving parts. It succeeds by providing for the wants and/or needs of customers in a competitive marketplace against other companies seeking to do the same and hopefully makes a profit doing so.
The stock:
On the other hand, you have the company’s stock. The price of the stock rises or falls on a given market day based on the cumulative buying and selling of its shares in the stock market.
Here’s where the dual nature of stock investing kicks in: The performance of the company and the performance of the stock are frequently at variance. In the short term, the discrepancy can make you scratch your head. The stock may go up even though the company isn’t having a good day. Or maybe the company is doing well, yet the stock isn’t. Sometimes you see the stock of a total-loser company go up, and you see the stock of a great company go down.
In the short term, the stock can rise or fall seemingly without any cause-and-effect relationship with the underlying company. But over time, the reality of the company and the value of the stock tend to move in the same direction. Long term, the stock prices of good companies go up. Long term, the stock prices of bad companies go down.
Both the seasoned investor and the serious speculator understand this concept if they’re truly analyzing the company and the stock. Short-term speculators and traders play the stock for short-term moves, but long-term investors and speculators play the company, so to speak.
Investors and speculators seek to profit from the disparity between the value of the company and the price of the stock:
A low stock price for a good company: If the underlying company is valuable and the stock is not, then an investor seeking a bargain would buy the stock, knowing that he or she is getting the company at a good price. Chapter 4 goes into greater detail about value investing, which focuses on investing in quality companies.
What if the price is low but the company is new? The speculator would buy shares of that obscure company when it’s a very low-priced stock, while the investor would wait until the company has proven itself with rising sales and profits.
Investing is a long-term pursuit (measured in years, not days or weeks). The investor looks at the company, what it offers, and whether long-term trends (supply and demand, demographics, and so on) favor it. Investing means “measure twice; cut once.” If you choose a good company, you can ignore the short-term scuttlebutt from the pundits, and you have an outstanding chance of truly prospering in the future.
A high stock price for a bad company:
If a speculator sees a high stock price, yet the underlying company has little or no value (or has terrible financial difficulties), then he or she sees a profitable opportunity in betting that the stock will go down (see
Chapter 8
about shorting stock).
Whether speculating is long term or short term, you’re really making a calculated bet. Maybe it isn’t a pure bet, but it’s certainly an aggressive move beyond what an investor would do.
If you’re starting out with stocks, consider investing. Analyzing a company for the long term is easier than trying your hand at the short-term gyrations of traders and speculators. Figuring out whether a company is good is much easier than figuring out which way its stock is heading tomorrow morning. Stock prices are subject to the whims of today’s stock movers and shakers, whereas a good, profitable company will gain adherents over time, which will lift its stock price in due course.
Choosing Stocks Wisely
Stocks are a great investment vehicle, but that doesn’t mean they’re great for everyone. And just because they’re good for you now doesn’t mean they’ll be good for you at another time in your life.
Fortunately, stocks are a varied bunch. There are stocks for investors seeking growth, and there are different stocks for those seeking income. In this book, I help you see the difference so you can choose wisely (Chapter 3 is a great place to start looking at diversification, allocation, and fitting in your personal factors). Here are some general recommendations:
For investors in their 20s, 30s, or 40s, growth stocks (like biotech or high-tech) are a good choice. Even some speculative choices are okay to consider.
Investors in their 50s and 60s should consider dividend-paying, conservative stocks (like utilities or food stocks).
More senior investors should check with their financial advisors about the suitability of stocks and to what extent they can be in their portfolios. Generally, seniors should consider large-cap stocks in stable industries that are known as stable dividend payers (such as utilities).
Regardless of the type of stock you’re considering, understand that stocks serve a long-term purpose in your overall wealth-building strategy, which means that you can’t ignore the factors in your situation before you buy your first share.
Measuring Stock Performance with Indexes
Market indexes help you judge how the market is doing so you can compare it to the performance of your portfolio or an individual stock. With this information, you can then judge the overall growth of your stock choices (or lack thereof). In addition, everyone wants to know whether the market is doing well during difficult times, in geopolitical conflict, and sometimes just following day-to-day events so they can gauge how well the economy is performing.
These indexes are the most widely followed and reported:
The Dow Jones Industrial Average (DJIA): Nicknamed the Dow, this is a price-weighted average of 30 major mega-cap stocks traded on the New York Stock Exchange and the Nasdaq. It was invented by Charles Dow in 1896.
Today, the Dow is the most-watched single measure of general stock market performance. Money managers often use it to gauge how well their portfolios are doing by comparison. However, many criticize the Dow for not being representative enough of the market, because it tracks only 30 large stocks.
For more information on the Dow, go to the S&P Dow Jones Indices website at www.djaverages.com.
The Standard & Poor’s 500 (S&P 500): The S&P 500, which is a much broader index than the Dow, contains 500 large-cap stocks chosen for their market size, their company leadership in their respective industries, and similar factors.
Because of its popularity and the wide distribution of the 500 stocks it tracks, the S&P 500 spawned a number of financial products that investors can utilize. Many mutual funds and exchange-traded funds (ETFs) are based on the S&P 500.
For details on the S&P 500 and related indexes, go to www.us.spindices.com/indices/equity/sp-500/.
The Nasdaq Composite Index: This is a market-value weighted index of the top stocks listed on the Nasdaq. This index is primarily used to track high-tech stocks and related stocks, so it tends to be associated with aggressive growth.
As with the S&P 500, many mutual funds and ETFs are based on this index, making it easy for investors and speculators to participate in this general area without needing to find a specific growth stock.
For more on this index, head over to www.nasdaq.com.
Going beyond Stocks: Exchange-Traded Funds and Options
Exchange-traded funds (ETFs) and options (calls and puts) can greatly enhance and enrich the stock investor’s (and speculator’s) wealth-building strategies.
ETFs give the stock investor a very convenient way to play an entire industry or sector; this is great when you can’t identify a single stock that you want to invest in to take advantage of bullish developments in a particular sector. With a few clicks, you can invest in a representative bundle of stocks in a given sector. For more on bullish ETF strategies, head over to Chapter 9.
Another great aspect of ETFs is that they give the stock speculator a way to make money from an industry or sector that is doing poorly or has a bleak near-term future. These bearish opportunities can become profitable plays if you use inverse ETFs (ETFs that move opposite to the underlying group of stocks or sector). You can find out more in Chapter 10.
If you want to add creative new ways to generate gains or income from the stock market (without necessarily buying or selling stocks), then consider call and put options and the myriad creative strategies that could put some ka-ching, ka-ching profits in your portfolio. I dedicate Part III to all things options (start with Chapter 11 to get the basics of options nailed down first).
Taking Tips and Techniques from Great Investors
If you want to achieve a higher level of investing or speculating success, it pays to study the greats. You’ve heard the advice “buy low, sell high,” but you can see how the greats take that point up a notch.
The great investors (see Chapter 17) buy low when they see profitable companies and/or industries whose stock prices are down sharply and offer a great buying opportunity. Great speculators (see Chapter 18), on the other hand, are happy looking at extreme bullish or bearish opportunities. When they see that everyone is ebullient about a stock, a sector, or the market in general, they look to make bets that it will fall after flying too high.
Don’t forget that profitable opportunities can show up when you see how different markets affect each other (either good or bad); find out about intermarket analysis in Chapter 6.
Choosing a good stock is great, but choosing a good stock that is ready to ride a megatrend is even better; find out more about megatrends and “the big picture” in Chapter 19. Chapter 20 gives you some insights about insiders (corporate and political) and their stock-picking moves. And although I am into fundamentals like most value investors, technical analysis will give you an added edge so you can better time your buy and sell transactions (see Chapter 21 for this).
Now go forth and prosper! (Or at least go to the next chapter.)
Chapter 2
Assessing Risk and Volatility
In This Chapter
Looking at types of risk
Lessening your risk
Getting the scoop on volatility
It is said that if you want a greater return on your investment (from an activity such as stock investing), you’ll have to tolerate a greater level of risk; if you don’t want to tolerate more risk, you’ll need to accept a lower level of return. Risk, one can safely say, is the flipside of successful investing. It is definitely a major part of speculating. Therefore, the more familiar you are with risk, the better your investing and speculating decisions. Given that, I consider this to be one of the most important chapters in this book.
Risk is simply the potential for loss of a part (or all) of your original investment. Volatility is merely the magnitude and speed of up or down moves of a stock (or other security or asset); it’s typically considered to be a negative, although it’s technically a neutral condition.
Delving into Different Kinds of Risk
Successful investors don’t just understand risk as a negative force or condition; they actually embrace it from a positive perspective. Remember the phrase “no pain, no gain”? A market or investment that is devoid of risk is frequently devoid of the potential for gain. In other words, risk is also opportunity! To start your understanding of all this opportunity, I introduce a number of types of risk in the following sections.
Risks to the value of your holdings
Your stock picks will have a batch of things swirling around them that will affect them (good or bad). You won’t worry about the good that may impact your stocks, but you should be aware of the bad.
Financial risk
Financial risk is the one investment risk everyone thinks of: “I put my money into that company, and it went out of business and I lost all my money!” Financial risk is tied to the individual success and financial viability of the entity itself (stock, mutual fund, and so on). How many investors lost money because they owned stock in companies that notoriously collapsed into bankruptcy, such as Enron or Bear Stearns?
You can avoid or minimize this type of risk if you just spend more time looking at the company itself and what it does (products, services, and so forth) and how it does it (are sales and profits good or rising?), among other considerations.
Your stock investment is safer if the fundamentals of the underlying company are strong. You can find out more about these fundamentals in Chapter 4.
Market risk
Sometimes nothing is wrong with your investment, but the market itself is having a rough time. Having the best cabin on the cruise doesn’t matter if you’re on the Titanic.
Perhaps the best and most infamous example is the 2008 financial crisis. Yes, there were plenty of bad investments that crashed and burned, but some darn good stocks went down along with the plunge. There was wholesale selling at the time on Wall Street — quality and other factors didn’t matter, and the pressure to sell was intense.
Diversification isn’t just being in different stocks; it’s also being in different markets. Sure, if the stock market is soaring and you’re 100 percent in stocks, you look like the genius at the cocktail party. However, if the stock market is tanking, you end up as the furtive, secretive one at the thrift shop. (See the later section “Minimizing Your Risk” for details on diversification.)
No matter how tempting it is to invest in one place, you should have money in different markets so you are never blindsided by that sudden bear market. In other words, consider putting your eggs in many baskets (or get an omelet grill).
Interest rate risk
Interest is essentially the price you pay for the use of money (going into debt). For most investors, interest rate risk occurs when a fixed-debt instrument such as a bond (corporate, municipal, U.S. government, and so on); bank certificate of deposit (CD); or other fixed-interest, long-term debt security is acquired for the investor’s portfolio and the market interest rates rise after the transaction.
For example, suppose you just bought a corporate bond that promises to pay you 3 percent interest for the next 20 years, when it will mature, and subsequently interest rates in the market rise to 4 percent, 5 percent, and beyond. Your bond — no matter the quality of the issue or the strength of the issuer (in this case, the company) — would fall in value, which could lead to a large loss. Interest rate risk is a real danger when you’re investing in a world of low interest rates (as it is in 2015) and the possibility looms that interest rates could rise.
As I write this, interest rate risk has a new wrinkle: the possibility of negative interest rates. Negative interest rates became a reality in Europe in early 2015. Not only are investors getting abysmally low rates, but they actually have to pay interest to hold debt! The bank actually charges you to hold money in the bank! It means that you have an account that pays no interest and regular bank fees for the simple act of having a bank account.
In the United States, consider having money in more than one financial institution as a practical matter. I keep money in a credit union, which keeps fees to a minimum, and the checking and savings accounts usually have no fees. Having both a bank account and a credit union account means that you’re diversified among financial institutions and have greater access to cash in the event of an emergency.
One of the reasons interest rates have become negative in a handful of countries is that investors want a safe haven for their money; the European Central Bank has flooded the economies of the continent with so much money that buyers of debt now have to pay to own government debt.
Keep an eye out for interest rates. If they do start to rise, then either put your money in investments that are variable and go up when interest rates rise (such as money market funds or variable rate bond funds) or keep a sharp eye out for bearish opportunities, as countries, industries, or companies may see their markets or stock prices plummet. The same general investing sites that track the financial markets (such as www.marketwatch.com and www.bloomberg.com) can help you watch interest rates.
Counterparty risk
Look, you got this book because you wanted access to next-level, ultra-hot information that even many financial pros don’t know, right? Well, the concept of counterparty risk is one that remarkably few financial advisors and other people with financial acumen know.
What is counterparty risk? It’s the risk that the value of your paper asset (stock, bond, currency, and so on) may lose its value due to the failed performance or promise of the company or governmental agency involved. Counterparty risk is associated with virtually every paper investment asset on the planet (yes, all stocks, bonds, exchange-traded funds, and regular mutual funds have this!). Believe it or not, even bank accounts and currencies (that’s right — the cash in your pocket, too) have counterparty risk. Check out these examples:
Stock:
If you own stock, the value of your stock is only as good as the performance of the underlying company. If it performs well (makes a profit), your stock will be valuable. But if the company performs badly (it loses money or defaults on its liabilities), then the stock will suffer. In the worst-case scenario, the company goes bankrupt and your stock becomes worthless.
Debt instruments:
How about debt instruments such as bonds and mortgages? Same here: The value of the debt is directly tied to the promise and performance of the issuing entity (corporation, government agency, and so on). The risk is that the issuing entity will default on the payment.
Bank accounts:
The money you hold in the bank has counterparty risk. What if that bank fails? In the event of a bank failure, government authorities (such as the Federal Deposit Insurance Corporation, or FDIC) take over the operation of the bank and determine what needs to be done to protect the interests of depositors and other customers. Sometimes the banking authorities will engineer a purchase of the bank to another bank that is solvent, which would help the customers of the failing bank regain banking services.
Currencies:
Even currencies (cash) have counterparty risk. If you hold that currency, what happens to the value of that currency if the issuing authority (the central bank) decides to excessively produce the currency? Then your cash holding would lose money. In the extreme case of hyperinflation, your cash would become worthless.
Because all paper assets carry counterparty risk (and you live in the age of excessive debt, financial bubbles, and expanding worldwide currencies), it makes sense to have some assets that are either not subject to counterparty risk or that may benefit from such developments. Given that, consider hard assets such as precious metals (gold, silver, and so on), collectibles, and real estate as a diversification away from paper assets. For more about precious metals, read my book Precious Metals Investing For Dummies (published by Wiley).
Keep in mind that because counterparty risk exists in virtually all paper assets, don’t fret too much about this particular risk unless there is an extreme condition involved, such as excessive debt. If you hold the currency or debt (such as government bonds) of a strong country (such as the United States circa 2015), then counterparty risk is remote. But if you hold the currency or government bonds of a troubled country (such as Greece or Venezuela in 2015), then counterparty risk is very real.
The bottom line is that counterparty risk won’t be an issue if you’re properly analyzing the underlying company or government agency of the stock or security in question, you’re doing fundamental analysis, and you’re aware of the financial strength. Find out more about this process in Chapter 4.
Political risks
As a guy who came to the United States from a faraway land, I discovered the pitfalls and land mines that come from politics and government run amok. In today’s interconnected world, the following are risks to be aware of to stay a step ahead in your wealth-building pursuits.
U.S. political and governmental risk
We’d like to think that markets in the United States are generally free of political interference or that companies need to worry only about sales and profits. However, companies can (and will) be affected by whatever is going on in the political landscape.
A company may be performing well and making great gains for its stockholders. But what if what the company does becomes politically unpopular? What if new regulations or proposed laws could have an adverse effect on either the stock or the industry?
Be aware of what’s going on with the country’s political and social moods and trends so you can either avoid potential risks or seize opportunities. In Appendix A, you can find some resources to track politics and other nonfinancial trends that may affect your portfolio. In addition, take a look at Chapter 21, which covers corporate and political skullduggery.
International political risk
The U.S. financial markets are not the only game in town (okay, they are the only game “in town,” but there are lots of other towns). Opportunities span the globe, but so do the risks.
Some of the most successful investors and speculators see bearish opportunities in countries that are experiencing some type of market upheavals or financial crises. There are also plenty of great opportunities for bullish investors in countries that are experiencing a turnaround in their economies or other potentially positive events. It’s just important to know the difference.
Here’s an example: In the 1990s, China made great strides in freeing up its economy and modernizing the financial markets to allow for stock investing. After literally decades of being ravaged by communist policies, China went toward a freer market. Most investors were still in wait-and-see mode, but some brave speculators started to test the waters, and they were richly rewarded with huge gains during 2000 to 2014, when the Chinese economy became a world-class economic juggernaut.
Meanwhile, investors in other countries, such as Venezuela, suffered as established markets became riskier; governments changed, and friendly investor policies became more hostile to wealth and capital formation.
The “smart money” keeps a careful watch on which way the winds blow before deciding to get in — or get out.
One of the best (safest) ways to invest internationally is through exchange-traded funds (ETFs) that focus on country-specific stock markets. Find out more about such ETFs in Chapter 9.
Risks to your earnings
Some risks and costs have a direct bearing on your day-to-day activities, but they can be manageable if you monitor your inflows and outflows, so take some time to review them (hopefully regularly).
Inflation risk
When people see rising prices for products and/or services, they refer to this increase as inflation. Actually, rising prices are not a problem; they’re a symptom. They’re the result of the real problem, which is an increase in the money supply. An expanding money supply means that more dollars (or euros, yen, or other units of currency) are chasing a finite basket of goods and services (or assets such as stocks or other securities). When central banks increase the supply of money and this money starts to circulate in a particular market (such as the consumer markets), prices tend to rise. What does this mean for investors?
Purchasing power risk (also called inflation risk) is the condition that the rate of inflation (typically the official rate of inflation, called the Consumer Price Index or CPI) is higher than your return in a traditional venue, such as a bond or savings account. If you’re earning 2 percent in a bank account and the inflation rate is greater than 2 percent, such as 3 percent, 4 percent, or more, then you’re experiencing purchasing power risk. This means that your investment isn’t keeping up with your ability to purchase basic goods and services because the prices of these goods and services are going up at a faster rate than your investment income.
If you have money in a fixed interest rate investment such as a bank certificate of deposit or a bond that is earning, say, 2 percent and the inflation rate is at 3 percent and rising, then you’re at risk. What good is a 2 percent rate of return on your investment if the inflation rate is at 3 percent or higher? Inflation can be an insidious force that harms people who are on fixed income or are receiving a fixed rate of return.
For investors in the United States, inflation hasn’t been much of an issue in recent years, but it’s always a possibility in any country that is printing (producing) its currency to excess. As I write this, countries such as Venezuela and Ukraine are experiencing some mindboggling inflation rates (50 percent and 25 percent, respectively). In 2015, most of the developed countries are expanding their money supplies at alarming rates, which means that inflation (international and domestic) is a real concern; investors need to plan accordingly.
Because inflation may be a growing concern in the coming years and many investments may be vulnerable to expanding debt (sovereign debt, corporate debt, and so forth), it may be a good idea to add investments that aren’t susceptible to inflation risk and risks associated with paper assets. A good consideration is hard assets such as physical gold or silver bullion. To find out how to safely add precious metals such as gold and silver to your portfolio, take a look at Precious Metals Investing For Dummies, published by Wiley (I wrote the book, so consider this a shameless plug).
Tax risk
As you probably know, gains are usually taxable, and losses tend to be tax-deductible (or have tax advantages). But taxes can make an activity a little riskier (or more costly), given the type of investor you are.
Think for a minute about the tax consequences of being a long-term investor versus a short-term speculator. Both investors are seeking big gains, but their approaches are very different, both in character and in tax consequences. Think about the tax impact even with the same gain — say, $10,000:
Long-term:
The long-term investor is, of course, holding the winning position in the stock in terms of years. Suppose that the period in question is two years. That $10,000 gain would be a long-term gain, and the federal tax is relatively low, say 15 percent. That means the tax would be $1,500 (15% of $10,000).
Short-term:
The short-term speculator realized the gain in only six months, so the $10,000 taxable gain is taxed at ordinary rates, which could mean 28 percent or more, depending on the investor’s tax bracket. In that case, the tax due would be $2,800 (28% of $10,000). The tax consequence here is that the short-term speculator may be thrilled at his quick gain but dismayed at paying an additional $1,300 in taxes (the tax man is celebrating, too).
Discuss the potential tax impact of your investment buying and selling decisions with your tax person before you actually make the transaction. (You were expecting that piece of advice, right?) Taxes have many issues and consequences beyond the scope of this section (and this book).
Individual risks
Assessing some types of risk means getting to know something quite intimate: your personal picture. No advisor or author can assess it better than you (and your mirror!) can. Here are some risks to review.
Personal risk
Sometimes the risk is not the investment, or the market, or economic conditions … sometimes it’s you! This risk is really about you and your personal situation.
How often have I seen people start investing in stocks only to have to discontinue their wealth-building pursuit — or worse, liquidate their portfolio — because they didn’t consider (or were not aware of) personal risks in their lives? I recall one investor who had to liquidate his portfolio because he was laid off. He didn’t notice the warning signs of difficulty in his companies or industries, and he didn’t have an emergency fund or keep adequate funds outside of his portfolios.
Personal risks can encompass many potential issues ranging from health issues (having inadequate insurance, for example) to not having side funds for a rainy day (or for a large, unexpected expense such as a major car repair or a leaky roof). A true wealth-building investment program is a long-term commitment that shouldn’t get derailed by those incidents and events that are part of life.
Analyze your life and ask yourself what plausible large expenses may come along. I always encourage everyone in my investing seminars to have an emergency fund. It should be 3 to 6 months’ worth of gross living expenses set aside in a bank account or money market fund. If your gross monthly expenses are, say, $3,000, then you should have $9,000 to $18,000 safely set aside in an emergency fund. Additionally, think how much more confident and calm you’ll be in making investment decisions when you know you have $10,000 in the bank. Having this cushion is more than a good thing for your finances; it’s good for you mentally! (If you need help with this analysis, check out the latest edition of Personal Finance For Dummies, written by Eric Tyson and published by Wiley.)
Emotional risk
Investing — especially high-stakes aggressive or speculative pursuits — can either really fray the nerves or get you excited, even when the market is on your side. You hear about dangerous emotions such as fear and greed, and those are certainly the twin evils that remind you that emotions can overcome your discipline and intellect.
Sometimes you hear about investors who are so emotionally attached to a losing stock that they lose the ability to make a logical or dispassionate decision. Stock investing and speculating need to be devoid of emotion (or as close as you can get) so that you can act rationally for your own economic well-being. Sometimes, a psychologist is a better advisor than a financial planner is.
If investing is too challenging for you on an emotional or personal level, you may be a candidate for some type of managed account (such as with a full-service broker) or stick strictly to mutual funds so that the portfolio management is left to dispassionate, hands-on professionals. Speak to your financial advisor about reviewing managed accounts or mutual funds that are appropriate for your individual goals.
Minimizing Your Risk
Minimizing your risk is not that hard, and you’ll pat yourself on the back when the unexpected does happen. The following sections note some things to consider.
Diversifying your portfolio
You’ve heard it a thousand times, so what’s one more? Be diversified. Have some money in cash, in bonds, in mutual funds, in real estate, in hard assets, and so forth. A good financial planner can easily help you plan and structure your finances to achieve this diversity (check Appendix A for resources).
Yes, you can diversify your portfolio yourself; just do your research. I cover the basics of diversification in greater detail in Stock Investing For Dummies, 4th Edition (written by yours truly and published by Wiley). In addition, check Chapter 3 for info on diversification and allocation strategies.
Allocating your assets
Allocation goes along with diversification (in the preceding section). Whereas diversification is about, say, having ten different investments, allocation is about how much of each investment you should have. Should nine of your investments be safe and stodgy and the tenth holding be the high-octane, “go, go!” stock? Maybe! All things being equal, you shouldn’t allocate too much of your portfolio or nest egg to a single stock or fund.
Commonsense diversification and sensible allocation help you significantly reduce your exposure to risk — especially in a world that continues to seem unstable and uncertain. Find more about diversification and allocation strategies in Chapter 3.
Hedging
As counterintuitive as it may sound, you should have positions that essentially run counter to your most profitable scenario. Consider it like insurance. When you buy a house, you also buy insurance that is tantamount to a bet against the house. You don’t buy homeowner’s insurance because you want your house to get damaged or burned down; you buy it just in case. Hedging works the same way in your portfolio.
Hedging strategies can be something simple, such as putting on stop-loss orders and other trade orders on your portfolio in your account (for info on brokerage orders and tactics, see Chapter 5).
Other strategies for hedging to minimize losses can take the form of securities that offer protection against losses, such as buying put options (see Chapters 13 and 15 for ideas), and other bearish strategies. Yet another way to minimize losses is to utilize exchange-traded funds that profit from down moves in the market or your stock (see Chapter 10).
Doing your homework
Some successful investors do well even when they haven’t properly diversified. How? They offset the risk that stems from a lack of diversification by being extremely well-informed about what they’re investing or speculating in.
I know one colleague who has inordinately large positions in precious metals mining companies. He isn’t well diversified, but he knows the industry inside and out. Even when the industry wasn’t doing well, his portfolio continued to do well because he chose quality companies and employed some hedging strategies such as buying and selling options (see the preceding section for more on hedging).
As the adage goes, the more you know, the more you grow. To know more and do your homework, check out the information sources in
