Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 9)

Common Stock

by

Charles Lamson

Common Stock represents an ownership interest in a corporation. This ownership interest is also known as an equity interest.

This equity interest gives the owner certain rights concerning the activities of the corporation:

• A vote at annual meetings
• Periodic financial updates from the corporation
• A say in the election of the company's board of directors

Some major decisions about the life of the corporation, such as mergers and so on, are decided by stockholder votes. The board of directors that represents the stockholders' interests handles all other major decisions.

It is not quite that pure. Stockholder rights groups accuse many corporations of loading the board of directors with members whose loyalty may lie with management rather than the stockholders. A good example of what can happen in these situations occurred during the  merger mania of the 1970s and 80s. Corporate leaders were given "golden parachutes" so that if the company was taken over by outside interests the executives would walk away with huge severance settlements.

A board of directors that was more sympathetic to management than shareholders might fight a merger that was good for the stockholders, but bad for management.

JUST A MINUTE

Most voting at annual meetings is done by mail, although, as a stockholder of even one share you are entitled to attend the annual meeting in person.

Some corporations with the approval of the board of directors, pay dividends. Dividends represent a share of the company's profit returned to the stockholders (owners). Other companies choose to invest profits back into the organization to finance growth.

Even though you own part of a corporation, you have no liability for the company's actions beyond the value of your stock.

PROCEED WITH CAUTION

Your liability is limited to the value of the stock, however, officers of the corporation may be held personally liable in some situations where they took actions that were illegal or knew of illegal activity within the company, but failed to do anything about it.

For example, if you own some stock in XYZ Corporation and read in the newspaper that they have been found guilty of hurting small puppies, your only potential loss is the value of your stock, which may drop to next to nothing, however, you are not going to be sued personally by puppy lovers.

This "liability shield" is the cornerstone of confidence in the stock market.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 51-52*

END

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 8)

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The Miracle of Compounding

by

Charles Lamson

You were already introduced to compounding in an earlier post, but I want to build on it a little more. It is important that you understand the power of compounding.

JUST A MINUTE Compounding is like the rapids on a river. Canoeing with the rapids is investing. Canoeing against the rapids is borrowing.

Compounding is the single most powerful tool in an investor's arsenal. Without it, investment becomes the equivalent of putting your money under your mattress.

Here is a radical example of compounding:

On Day 1 you give me a penny. On Day 2 you double it two cents. On Day 3 you double it again to four cents. And so on for 30 days. On the 30th day you will pay me almost $5.4 million!

This is compounding. In just 30 days, a penny grows to almost $5.4 million dollars. Of course, you are not going to get 100 percent interest unless you lend money in dark alleys and break people's kneecaps when they do not pay.

Nevertheless, compounding is the basic mechanism for creating wealth. It is what will help you achieve your goals.

How to Make Compounding Work for You

The example I used involves an initial deposit (1 penny) and interest only. What would happen if you added a penny each day in addition to the interest?

If you are clever in math, you might have figured this one out. Here is the problem restated:

On Day 1 you give me a penny. On Day 2 you give me two cents (your original penny plus 100 percent interest) and another penny for a total of three cents. On day 3 you give me six cents (three cents plus 100 percent interest) and another penny for a total of seven cents. And so on for 30 days. On the 30th day you pay me over $10.7 million (double the total in the original problem.) The only difference is you gave me an additional 29 cents over the 30-day period.

This illustrates an important point: compounding can be made to work harder by periodically adding to the balance. Let us use some real world examples.

Say you open an investing account with $50 earning 10 percent and every month you deposit another $50. In ten years your account will be worth almost $10,400 (ignoring taxes and inflation.)

If you could manage to make an additional $5 deposit each month bringing your total to $55, in 10 years your account would be worth $11,396---over $1,000 more. Your investment increased by $600 ($5 per month x 120 months),  but you earned $1,000.

One way to look at this is that the extra $600 you invested over ten years earned you a 66 percent return ($600 x 66 percent = $396).

This process also works on loans. If you make an additional $50 per month payment on your mortgage, it will be paid off much sooner. Why? Because that extra $50 goes to the principal of the loan, and thus there is a smaller amount used to compute interest charges.

The Miracle of Time

Part of the magic of compounding comes from how long the process is allowed to work. The more time you have to compound, the more money you will make.

JUST A MINUTE Time is one component of the investment formula. The other two components are amount invested and interest earned.

In the example above, you opened an investment account for 10 years. What would happen if you could let it work for 15 years or 20 years?

Here's the scenario: $50 invested at 10 percent interest and another $50 added monthly.

For 10 years the total is:     $10,372

For 15 years the total is:     $20,938

For 20 years the total is:     $38,314

This is why Little's Golden Rule of Investing is so important:

The best time to start investing was yesterday. The second best time is today. Tomorrow is better than nothing.

In summary, compounding is the best thing since sliced bread. It will work for you with your investments or it will work against you when you borrow. Either way, it is the force of the financial world.

END

JUST A MINUTE

Compounding is like the rapids on a river. Canoeing with the rapids is investing. Canoeing against the rapids is borrowing.

JUST A MINUTE

Time is one component of the investment formula. The other two components are amount invested and interest earned.

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 7)

Is 90 Days Really "Same as Cash"?

by

Charles Lamson

Time for a reality check. Do you honestly think businesses are primarily concerned with your well being? Of course not. Businesses are primarily concerned with making a profit. There is nothing wrong with making a profit---it is how they will stay in business. The conflict arises when businesses offer you great deals---just because they love you so much. These great deals often take the form of buy now and pay much later. A good example is the furniture business.

How many times have you seen a furniture store advertise "buy now and no payments or interest for one year"? Are you really getting an interest-free loan for a year? Of course not. You will pay interest, and quite a lot in many cases.

There are at least two ways you will pay for that year with no payments and no interest. First, when you do begin making payments, the interest rate can exceed 18 percent in some cases. The second way you will pay is  through an inflated purchase price, which has interest charges built into it.

Here is how it might work:

The store offers a sofa and chair for $1,000 retail. The storeowner paid  $500 for the items. They are offered for sale at $1,000 with no payment or interest for the first year, then 18 percent for the next three years. The owner sells you the sofa and chair on the above terms. Once you sign the contract (essentially a loan), she sells the note to a third party for $750. She pays off the wholesaler and has a gross profit of $250.

The third party holds your note and receives your payments. At the end of four years, you have paid over $1,600 for the $1,000 furniture and the third party has made an $850 profit. In addition, should you miss a payment or two you maybe liable for repaying the first year that was interest free.

Can you make these situations work to your advantage? The first alternative is somewhat unconventional, but certainly doable. If you have the money in hand to buy the furniture, offer the store $750 cash right now. You would be surprised at how many merchants will negotiate prices, especially for cash.

The second alternative is to agree to the stated terms but save up enough over the year to pay the $1,000 in full. This saves you the high interest charges. However, be very careful the contract does not have a prepayment penalty. (A prepayment penalty is a fee for paying off a debt early.)

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 18-19*

END

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 6)

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Cleaning up Debt

by

Charles Lamson

We are addicted to credit cards. We whip out the plastic without even thinking about how or when we are going to pay off the balance. In addition, the credit card companies keep sending them or upping our credit limits.

Without thinking about it, we are up to our wazoo in credit card debt. But when the bills do come, we notice that all they expect is this small minimum monthly payment. We can handle that.

What we may not notice is that we are paying 18 percent (or more) in interest and, if you look closely at your bill, you may find that the friendly minimum balance they want you to pay is LESS than the finance charges.

This means that if you only pay the minimum balance, you will never pay off the debt because all you are paying is interest. Your principal is never reduced.

PROCEED WITH CAUTION Be careful of the "transfer your balance" ads from credit card companies. After a short period at the advertised low rate, the interest charge will shoot back up.

Gather all of your credit card statements and any other high-interest debt you have and compare the interest rates. Make a list from highest interest to lowest and begin paying off from the top down. The first investment you are going to make is in yourself. You are going to stick those high-interest credit cards in your desk drawer and not use them again until you have paid off or substantially paid down what you owe.

The reason is obvious. If you are paying a credit card 18 percent on a $5,000 balance and earning 12 percent on a $5,000 investment, you are taking two steps forward and three back. It is actually worse than that.

You cannot make an investment that is not overwrought with risk that will pay you enough to offset the money gushing out of your checking account. It may not be as much fun as buying stocks, but there is nothing you can do that makes more financial sense than getting rid of high-interest debt. More importantly, the object of investing is not to break even, but to get ahead.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 17-18*

END

PROCEED WITH CAUTION

Be careful of the "transfer your balance" ads from credit card companies. After a short period at the advertised low rate, the interest charge will shoot back up.

ALPHA TEACH YOURSELF INVESTING IN 24 HOURS: AN ANALYSIS (part 5)

Nontraditional Investing

by

Charles Lamson

Nontraditional investments are included in this analysis because you will hear about them (or already have) and you need the proper information to help you decide if any of these are for you.

Hard Assets

Hard assets are further divided into two subcategories: real estate and precious metals.

Many people consider real estate an essential investment and will probably be offended at it being classified as nontraditional. They will certainly be offended to find it in the same category as gold  and silver.

Here is Little's reasoning. Hard assets such as real estate and gold have been considered good inflation hedges. History shows that in periods of high inflation, money is driven to assets that have intrinsic value (like gold and real estate). When confidence in the money weakens (during inflation), investors have looked to convert paper money into hard assets (like precious metals and gold coins).

JUST A MINUTE

Inflation is when too much money is chasing too few goods. It is characterized by sharply rising prices with no apparent increase in product value. The result is that money is devalued, or worth less. For example, if you were planning to live on $2,000 a month in retirement, inflation might make that $2,000 buy only $1,700 worth of goods. Your standard of living would drop $300 per month.

While there are no guarantees that high inflation will not return, it seems unlikely. The Federal Reserve Bank, which controls the money supply, has shown it is willing to apply the breaks to the economy if it seems to be heading for an inflationary period.

If you take the inflation out of the economy, hard assets like real estate and gold do not appreciate very rapidly as a rule. Let us look at real estate.

Real Estate

We all probably know someone who bought the right piece of property at the right time for the right price and made a killing. The average real estate investor is more likely to own residential properties that are rented out.

On page 12 of his book, Alpha Teach Yourself Investing in 24 Hours, Little writes:

I know several people who have been doing this for years and have been very successful. People always need a place to live and the cost of home ownership is going to be out of reach for a number of potential renters. There are plenty of tax advantages as well.

Precious Metals

As for gold and precious metals, Little goes on to explain on page 12:

...I do not have much positive to say. If you believe the global economy is going to collapse any minute, then you may want to own gold. On the other hand, if our society falls apart at the seams, you will want to get out of town fast. Any quantity of gold is going to slow you down.

If you feel you need precious metals in your portfolio, Little suggests you purchase a mutual fund that invests in mining company stocks.

Lifestyle Investing

The other category of nontraditional investments Little calls lifestyle investing. This group includes art and other collectibles. Little says on page 13, "I do not want to even consider this investing, but Americans seem to have this need to find things that give us pleasure, and then turn them into a business."

He goes on to say:

If you love art, love it for its beauty and the pleasure it brings to you. Keep your baseball cards to share with your kids. We have managed to ruin just about every hobby you can think of by putting a price tag on it.

PROCEED WITH CAUTION

Collecting dolls as an investment is using a hobby for a purpose other than that for which it was intended. Stick with stocks, bonds, and mutual funds for your true investment needs.

Arabian horses are beautiful animals. Not many years ago, people were going crazy over them. Investors who would not know a stallion from a mare were bidding up prices through the roof. What really makes this nuts is that Arabian horses have no utilitarian value. They are not like race horses that can win money and breed champions.

Beanie Babies, Pokemon whatevers---you name it and Americans (and others) will collect them and drive up prices. If you want to collect or raise or trade your hobby, do so and enjoy it, but do not plan on retiring off your beer bottle collection or that black velvet painting of Elvis in Viva Las Vegas.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 11-13*

END