Personal Financial Planning: An "How-To" Guide (part 46)

Some Key Measures of Performance

by

Charles Lamson

Professional money managers and seasoned investors use a variety of financial ratios and measures when making common stock investment decisions. They look at such things as dividend yield, book value, return on equity, earnings per share, and price/earning multiples to get a feel for the investment merits of a particular stock. In short, they use these and other ratios to help them decide whether to invest in a particular stock. Fortunately, most of the widely followed ratios can be found in published reports, so you do not have to compute them yourself. Even so, if you are thinking about buying a stock, or already have a position in common stock, there are a few measures of performance you will want to keep track of. These would include book value (or book value per share), not profit margin, return on equity, earnings per share, price/earnings ratio, and beta.

Book Value

The amount of stockholders' equity in a firm is measured by book value. This accounting measure is determined by subtracting the firm's liabilities and preferred stocks from the value of its assets. Book value indicates the amount of stockholder funds used to finance the firm. For example, assume Rose Colored Glasses (RCG) had assets of $5 million, liabilities of $2 million, and preferred stock valued at $1 million. The book value of the firm's common stock would be $2 million ($5 million - $2 million - $1 million). If the book value is divided by the number of shares outstanding, the result is book value per share. If RCG had 100,000 of common stock outstanding, its book value per share would be $20 ($2,000,000/100,000 shares). Because of the positive impact it can have on the growth of the firm, you would like to see book value per share steadily increasing over time; also look for stocks whose market prices are comfortably above their book values.

Net Profit Margin

As a yardstick of profitability, net profit margin is one of the most widely followed measures of corporate performance. Basically, this ratio relates the net profits of the firm to its sales, providing an indication of how well the company is controlling its cost structure. The higher the net profit margin, the more money the company earns. Look for a relatively stable---or even better, an increasing---net profit margin.

Return on Equity

Another very important and widely followed measure, return on equity (or ROE, for short) reflects the overall profitability of the firm. It captures, in a single ratio, the amount of success the firm is having in managing its assets, operations, and capital structure. Return on equity is important because it has a direct and significant impact on the profits, growth, and dividends of the firm. The better the ROE, the better the financial condition and competitive position of the company. Look for a stable or increasing ROE and watch out for a falling ROE, as that could spell trouble.

Earnings per Share

With stocks, the firm's annual earnings are usually  measured and reported in terms of earnings per share (EPS). Basically, EPS translates total corporate profits into profits on a per-share basis and provides a convenient measure of the amount of earnings available to stockholders. Earnings per share is found by using the following simple formula:

For example, if RCG reported a net profit of $350,000, paid $100,000 in dividends to preferred stockholders, and had 100,000 shares of common outstanding, it would have an EPS of $2.50 [($350,000 - $100,000)/100,000]. Note that preferred dividends are subtracted from profits because they have to be paid before any monies can be made available to common. Earnings per share are closely followed by stockholders because it represents the amount the firm has earned on behalf of each outstanding share of common stock. Here, too, look for a steady rate of growth in EPS.

Price/Earnings Ratio

When the prevailing market price of a share of common stock is divided by the annual earnings per share, the result is the price/earnings (P/E) ratio, which is viewed as an indication of investor confidence and expectations. The higher the price/earnings multiple, the more confidence investors are presumed to have in a given security. In the case of RCG, whose shares are currently selling for $30, the price/earnings ratio is 12 ($30 per share/$2.50 per share). This means that RCG stock is selling for 12 times its earnings. P/E ratios are important to investors because they reveal how aggressively the stock is being priced in the market. Watch out for very high P/Es---that is, P/Es that are way out of line with the market---because that could indicate the stock is being overpriced (and thus might be headed for a big drop in price). P/E ratios are not static, but tend to move with the market: When the market is soft, a stock's P/E will be low, and when things heat up in the market, so will the stock's P/E.

Beta

A stock's beta is an indication of its price volatility. It shows how responsive a stock is to the market. In recent years, the use of betas to measure the market risk of common stock has become a widely accepted practice, and as a result, published betas are now available from most brokerage firms and investment services. The beta for a given stock is determined by a statistical technique that relates the stock's historical returns to the market. The market (as measured by something like the S&P index of 500 stocks) is used as a benchmark of performance, and it always has a beta of 1.0. From  there, everything is relative: low-beta stocks---those with betas of less than 1.0---have low price volatility (they're relatively price-stable), while high-beta stocks---those with betas of more than 1.0---are considered to be highly volatile. In short, the higher a stock's beta, the more risky it is considered to be. Stock betas can be either positive or negative, though the vast majority are positive, meaning the stocks move in the same general direction of the market (that is, if the market is going up, so will the price of the stock).

Actually, beta is an index of price performance and is interpreted as a percentage response to the market. Thus, if RCG has a beta of say 0.8, it should rise (or fall) only 80 percent as fast as fast as the market---if the market goes up by 10 percent, RCG should go up only 8 percent (10 percent x .8). In contrast, if the stock had a beta of 1.8, it would go up or down 1.8 times as fast---the price of the stock would rise higher and fall lower than the market. Clearly, other things being equal, if you are looking for a relatively conservative investment, you should stick with low-beta stocks, on the other hand, if it is capital gains and price volatility you are after, then go with high-beta securities.

smart.sites Enter a stock’s ticker symbol or the company name and 411 Stocks, www.411stocks.com, pulls together a complete page of stock data: price, news, discussion groups, charts, and fundamentals.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 509-512*

end

smart.sites

Enter a stock’s ticker symbol or the company name and 411 Stocks, www.411stocks.com, pulls together a complete page of stock data: price, news, discussion groups, charts, and fundamentals.

End of Thirty Day Proactive Test and Beginning of Organizational Communication 12/28 by CharlesXLamson | Current Events Podcasts

End of Thirty Day Proactive Test and Beginning of Organizational Communication 12/28 by CharlesXLamson | Current Events Podcasts: In this episode, I wrap up my analysis of 7 Habits of Highly Effective People and begin a new in-depth analysis of a wonderful book called Organizational Communication, which is all about (you guessed it) organizational communication. So kick back, sip a beverage and enjoy the big show!

The Rant - Thirty Day Proactive Test (part 11) 12/27 by CharlesXLamson | Art Podcasts

The Rant - Thirty Day Proactive Test (part 11) 12/27 by CharlesXLamson | Art Podcasts: Leadership is a choice, not a position. Stephen Covey

 

The Rant - Thirty Day Proactive Test (part 9) 12/25 by CharlesXLamson | Art Podcasts

The Rant - Thirty Day Proactive Test (part 9) 12/25 by CharlesXLamson | Art Podcasts: The more people rationalize cheating, the more it becomes a culture of dishonesty. And that can become a vicious, downward cycle. Because suddenly, if everyone else is cheating, you feel a need to cheat, too. Stephen Covey

The Rant - Thirty Day Proactive Test (part 8) 12/24 by CharlesXLamson | Current Events Podcasts

The Rant - Thirty Day Proactive Test (part 8) 12/24 by CharlesXLamson | Current Events Podcasts: There are three constants in life... change, choice and principles. Stephen Covey

The Rant - Thirty Day Proactive Test (part 7) 12/22 by CharlesXLamson | Current Events Podcasts

The Rant - Thirty Day Proactive Test (part 7) 12/22 by CharlesXLamson | Current Events Podcasts: Listen with your eyes for feelings. Stephen Covey

Personal Financial Planning: An "How-To" Guide (part 45)

Online Investor Services

by

Charles Lamson

The Internet offers a full array of online investor services, from up-to-the-minute stock quotes and research reports to charting services and portfolio tracking. When it comes to investing, you name it and you can probably find it online. Unfortunately, although many of these are truly high-quality sites that offer valuable information, many others are pure garbage, so you have to use care when entering the world of online investing. But even if you confine yourself to the quality sites, the fact is all this information can be overwhelming and even intimidating. It takes time and effort to use to the net wisely. Let's take some time here to review the kinds of investor services you can find online, starting with investor education sites.

Investor Education

The Internet offers a wide array of tutorials, online classes, and articles to educate the novice investor. Even experienced investors will find sites that expand their investing knowledge. Although most good investment-oriented Web sites include many educational resources, here are a few good sites that feature investment fundamentals:

• The Motley Fool (www.fool.com) Fool's School has sections on fundamentals of investing, mutual fund investing, choosing a broker, investment strategies and styles, lively discussion boards and more.
• Get breaking Finance news and the latest business articles from AOL at www.aol.com/finance. 
• Zack's Investment Research (www.zacks.com), a free site from The Wall Street Journal, is an excellent starting place to learn what the Internet can offer investors.
• Nasdaq (www.nasdaq.com) has an Investor Resource section that helps with financial planning and choosing a broker.

Other good educational sites include leading personal finance magazines like Money (www.money.com), Kiplinger's Personal Finance Magazine (www.kiplinger.com), and Smart Money (www.smartmoney.com).

Investment Tools

Once you are familiar with the basics of investing, you can use the Internet to develop financial plans and set investment goals, find securities that meet your investment objectives, analyze potential investments, and organize your portfolio. Many of these tools, once used only by professional money managers, are free to anyone who wants to go online. You will find financial calculators and worksheets, screening and charting tools, and portfolio trackers at the Web sites of large brokerage firms, as well as other financial sites. You can even set up a personal calendar that notifies you of forthcoming earnings announcements and receive alerts when one of your stocks has hit a predetermined price target.

Investment Planning

Online calculators and worksheets can help you find answers to your financial planning and investing questions. With them, you can figure out how much to save each month for a particular goal, such as the down payment for your first home, a college education for your children, or to be able to retire by the time you reach 55. For example, Fidelity (www.fidelity.com) has a wide selection of planning tools that deal with such topics as investment growth, college planning, and retirement planning. One of the best sites for financial calculators is FinanCenter.com (www.financenter.com). It includes over 100 calculators for financial planning, insurance, auto, and home buying, and investing.

Investment Research and Screening

One of the best investor services offered online is the ability to conduct in-depth research on stocks, bonds, mutual funds, and other types of investment vehicles. Go to a site like www.quicken.com or www.kiplinger.com, click on the "investments" tab, and you can obtain literally dozens of pages of financial and market information about a specific stock or mutual fund. For example, you can find historical and forecasted information about a firm's earnings, earnings per share, dividend yields, growth rates, and more in both tabular and graphic formats; you can also track the behavior of a specific stock relative to a market index, or to one or more of its major competitors. And many of these sites have links back to the company itself, so with a couple clicks of the mouse, you can obtain the company's annual report, detailed financial statements, and historical summaries of a full array of financial and market ratios. Moreover, you will find sites that offer detailed reports produced by major brokerage firms (some of which require a nominal charge).

In addition to the types of research information described above, investors can also use various online screening tools to identify attractive and potentially rewarding investment vehicles. Most major sites, like Quicken, Morningstar, or MSN Money Central, offer screening tools. Basically these tools enable you to quickly sort through huge databases of stocks and mutual funds to find those that meet specific characteristics, such as high dividend yields or specific revenue growth. For mutual funds you might specify a certain type of fund, a particular industry or geographical sector, and low fees. Each screening tool uses a different method to sort. You answer a series of questions to specify the type of stock or fund you are looking for, performance criteria you desire, cost parameters, and so on. The screen then provides a list of stocks (or funds) that have met the standards you have set. You can then do more research (as described above) on the listed stocks (or mutual funds) to decide which ones you want to further pursue.

Portfolio Tracking

Almost every investment-oriented Web site includes portfolio-tracking tools. Simply enter the number of shares held and the symbol for those stocks or mutual funds you wish to follow and the tracker automatically updates the value of your portfolio every time you check. You can usually link to more detailed information about each stock or mutual fund. The features, quality, and ease of use of stock trackers varies, so check several to find the one that meets your needs.

Day Trading

As discussed earlier, trading stocks (and other securities) online has become very popular among investors---if for no other reason than the rock-bottom cost of executing such trades. Face it, it is an easy convenient, and low-cost way of trading securities. But for some investors, the attraction of trading stocks online is so compelling that they become day traders. The opposite of buy-and-hold investors with a long-term perspective, day traders buy and sell stocks quickly throughout the day. They hope their stocks will continue to rise in value for the very short time they own them---sometimes just seconds or minutes---so they can make quick profits. True day traders do not own any stocks overnight---hence the term day trader---because they believe the chance of prices changing radically overnight (from close on one day to the open on the next) can lead to large losses. While day trading is not illegal or unethical, it is highly risky. To compound their risk, day traders usually buy on margin to earn even higher returns. But as we have seen, margin trading also increases the risk of larger losses. Day traders typically incur major financial losses when they start trading. Some never reach profitability. Day traders also have high expenses for brokerage commissions, training, and computer equipment. By some estimates, they must make a 50 to 60 percent profit just to break even on fees and commissions.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 472-475*

end

The Rant - Thirty Day Proactive Test (part 6) 12/21 by CharlesXLamson | Art Podcasts

The Rant - Thirty Day Proactive Test (part 6) 12/21 by CharlesXLamson | Art Podcasts: Proactive people focus their efforts on their Circle of Influence. They work on the things they can do something about: health, children, or problems at work. Reactive people focus their efforts in the Circle of Concern--things over which they have little or no control: the national debt, terrorism, or the weather.

The Rant - Thirty Day Proactive Test (part 5) 12/20 by CharlesXLamson | Current Events Podcasts

In this episode I thank Vladimir Putin for making the show possible.

The Rant - Thirty Day Proactive Test (part 5) 12/20 by CharlesXLamson | Current Events Podcasts

Personal Financial Planning: An "How-To" Guide (part 44)

Brokerage Reports, Advisory Services and Investment Advisors

by

Charles Lamson

Brokerage Reports

The reports produced by the research staffs of the major (full service) brokerage firms provide yet another important source of investor information. These reports cover a wide variety of topics, from economic and market analyses to industry and company reports, news of special situations, and reports on interest rates and the bond market. Reports on certain industries or securities prepared by the house's backoffice research staff may be issued on a regular basis and contains lists of securities within certain industries classified as to the type of market behavior they are expected to exhibit. Brokerage houses also regularly issue reports, prepared by their security analysts, on specific securities, which include among other things their recommendations as to the type of investment returns expected, and whether to buy, hold, or sell the securities in question.

Advisory Services

A number of subscription advisory services---available both in print and online---provide information and recommendations on various industries and specific securities. The services normally cost from $50 to several hundred dollars a year. Although these costs may be tax deductible, only the most active investors will find them worthwhile, because you can usually review such materials (for free) at your broker's office, at universities and public libraries, or online. Probably the best known financial services are those provided by Standard & Poor's, Moody's Investor Service, and Value Line Investment Survey. Each offers an array of services. Standard & Poor's publishes a monthly stock guide and bond guide, each of which summarizes the financial conditions of a few thousand issues. Moody's also publishes stock and bond guides. And a number of reports are also prepared weekly, like Standard & Poor's Outlook.

Recommended lists of securities, broken down into groups on the basis of investment objectives, constitute still another type of service. In addition to the popular subscription services, numerous investment letters, which periodically advise advisors on the purchase and sale of securities, are available. Finally, by subscribing to weekly chart books, investors may also obtain graphs showing stock prices and volume over extended periods of time.

Investment Advisors

Successful investors often establish themselves as professional investment advisors. In this capacity they attempt to develop investment plans consistent with the financial objectives of their clients. You can obtain the services of a professional money manager in several ways: (1) you can hire an independent investment advisor (but they're usually pretty expensive and prefer to deal with well-healed clients); (2) you can go to the trust department of a major bank (many offer their investment services to the general public at very reasonable costs, and you do not have to die or have a trust account to obtain such services---all you have to do is enter into a simple agency agreement ); (3) if you deal with a full-service brokerage firm, you can check with your broker to see if they offer fee-based wrap accounts (in these portfolio management accounts, your brokerage firm takes over the full-time management of your investments, in return for a flat annual fee---but watch out, that annual fee can get pretty hefty); or (4) you might consider the services of a financial planner (preferably a fee-based planner who has a strong track record in the field of investments).

If you are thinking of using a professional money manager, the best thing to do is shop around---look at the kinds of returns he or she has been able to generate (in good markets and bad), and do not overlook the matter of cost---find out up front how much you will have to pay and what the fee is based on. Annual fees for advisory services, which may involve the complete management of the client's money, are likely to range from about 1 percent to as much as 2 or 3 percent of assets under management. Equally important, find out if the advisor has a specialty and, if so, make sure it is compatible with your investment objectives. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 465-467*

end

Thirty Day Proactive Test (part 4) 12/18 by CharlesXLamson | Art Podcasts

Thirty Day Proactive Test (part 4) 12/18 by CharlesXLamson | Art Podcasts



In this episode, I read poetry and wrestle with the problems of the world in a very special The Rant with Charles Lamson.

Thirty Day Proactivity Test (part 2) 12/16 by CharlesXLamson | Art Podcasts

Thirty Day Proactivity Test (part 2) 12/16 by CharlesXLamson | Art Podcasts

Personal Financial Planning: An "How-To" Guide (part 43)

Market Data

by

Charles Lamson

Usually presented in the form of averages, or indexes, market data describe the general behavior of the securities markets. The averages and indexes are based on the price movements of a select group of securities over an extended period of time. They are used to capture the overall performance of the market as a whole. You would want to follow one or more of these measures to get a feel for how the market is doing over time, and, perhaps, an indication of what lies ahead. The absolute level of the index at a given point in time (for the OTC market). These measures are all intended to keep track of behavior in the stock market, particularly, stocks on the NYSE (the Dow, S&P, and NYSE averages all follow stocks on the big board). In addition, several averages and indexes follow the action in other markets, including the bond, commodities, and options markets for mutual funds, real estate, and collectibles. However, because all those other averages and indexes are not followed nearly as much as those of stocks, we will concentrate here on stock market performance measures.

Dow Jones Averages

The granddaddy of them all and probably the most widely followed measure of stock market performance is the Dow Jones Industrial Average (DJIA). Actually, the Dow Jones averages, which began in 1896 are made up of four parts: (1) an industrial average based on 30 stocks, (2) a transportation average based on 20 stocks, (3) a utility average based on 15 stocks, and (4) a composite average based on all 65 industrial, transportation, and utility stocks. The makeup of the 30 stocks in the DJIA does change a bit overtime as companies go private, are acquired by other firms, or become less of a force in the marketplace. Most of the stocks are picked from the NYSE, but there are a few Nasdaq shares in there, such as Intel and Microsoft. Although these stocks are intended to represent a cross-section of companies, there is a strong bias toward blue chips, which is one of the major criticisms of the Dow Jones Industrial Average. Critics also claim that an average made up of only 30 blue-chip stocks---out of some five or six thousand issues---is hardly representative of the market. However, the facts show that as a rule, the behavior of the DJIA closely reflects that of other broadly based stock market measures---with the possible exception of the NASDAQ. Exhibit 1 lists the 30 stocks in the DJIA, along with some important dates for the Dow.

Standard & Poor's Indexes

The Standard & Poor's (S&P) indexes are similar to the Dow Jones averages to the extent that they both are used to capture the overall performance of the market. However, some important differences exist between the two measures. For one thing, the S&P uses a lot more stocks, the popular S&P 500 composite index is based on 500 different stocks, whereas the DIJA uses only 30 stocks. What's more, the S&P index is made up of all large NYSE stocks, as well as, some major AMEX and OTC stocks, so there's not only more issues in the S&P's sample but also a greater breadth of representation. And finally, there are some technical differences in the mathematical procedures used to compute the two measures, the Dow Jones is an average, whereas the S&P is an index. Yet in spite of these minor differences, movements in these two measures are in fact very highly coordinated and as a result, they are used in much the same way.

There are eight basic S&P indexes: (1) an industrial index based on 400 stocks; (2) a transportation index of 20 stocks; (3) a public utility index of 40 stocks; (5) a composite index for all 500 of the stocks used in the first four indexes; (6) the MidCap 400; (7) the SmallCap 600; and (8) the composite S&P 1500 made up of the S&P 500, 400, and 600 indexes. The MidCap index is made up of 400 medium-sized companies---those with market values that, for the most part range from about $500 million to $3 billion, or more, while the SmallCap index consists of small companies, with market caps of around $500 million or less.

The NYSE, AMEX, and Nasdaq Indexes

The most widely followed exchange-based indexes are those of the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq. The NYSE index includes all the stocks listed on the "big board." In addition to the composite index, the NYSE publishes indexes for industrials, utilities, transportation, and finance subgroups. The behavior of the NYSE Industrial index closely mimics that of the DJIA and the S&P 500.

The AMEX index reflects share prices on the American Stock Exchange. Made up of all stocks on the AMEX, it is set up in such a way that it directly captures the actual percentage change in the share prices. For example, if the price change in AMEX stocks from one day to the next were +3 percent, the AMEX index would likewise increase by 3 percent over the previous day's value. Like the NYSE indexes, the AMEX index is often cited in the financial news.

Activity in the OTC market is captured by the Nasdaq indexes, which are calculated like the S&P and NYSE indexes. The most comprehensive of these indexes is the Nasdaq composite index, which is calculated using virtually all the stocks traded on the Nasdaq system. The other Nasdaq indexes are the industrial, insurance, bank, computers, and telecommunications indexes. In addition, there is the Nasdaq 100 Index, which tracks the price behavior of the biggest 100 (nonfinancial) firms traded on the Nasdaq---companies like Microsoft, Intel, Oracle, Cisco, Staples, and Dell. The Nasdaq Composite is often used today as a benchmark in assessing the price behavior of high-tech stocks. The index is far more volatile than either the Dow or the S&P and way out-performed other market measures from 1995 to 1999---before taking a big dive in 2000, 2001, and 2002.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 461-464*

end

Thirty Day Proactivity Test 12/15 by CharlesXLamson | Current Events Podcasts

Thirty Day Proactivity Test 12/15 by CharlesXLamson | Current Events Podcasts: The 7 Habits of Highly Effective People, first published in 1989, is a business and self-help book written by Stephen Covey. Wikipedia

Remembering Bill Cooper (part 2) 12/14 by CharlesXLamson | Current Events Podcasts

Remembering Bill Cooper (part 2) 12/14 by CharlesXLamson | Current Events Podcasts

BLS-Watch with Charles Lamson 12/13 by CharlesXLamson | Current Events Podcasts

BLS-Watch with Charles Lamson 12/13 by CharlesXLamson | Current Events Podcasts: The Bureau of Labor Statistics is a unit of the United States Department of Labor. It is the principal fact-finding agency for the U.S. government in the broad field of labor economics and statistics and serves as a principal agency of the U.S. Federal Statistical System. Wikipedia

BLS-Watch 12/12 by CharlesXLamson | Current Events Podcasts

BLS-Watch 12/12 by CharlesXLamson | Current Events Podcasts

Personal Financial Planning: An "How-To" Guide (part 42)

Margin Trades: Buying Securities on Credit

by

Charles Lamson

When you are ready to buy securities, you can do so by putting up your own money, or by borrowing some of the money. Buying on margin, as it is called, is a common practice that allows investors to use borrowed money to make security transactions. Margin trading is closely regulated and is carried out under strict margin requirements set by the Federal Reserve Board. These requirements specify the amount of equity an investor must put up when buying stocks, bonds, and other securities. The most recent requirement is 50 percent for common stock, which means that at least 50 percent of each dollar must be the investor's own; the remaining 50 percent may be borrowed. Other securities besides stocks can be margined, and these have their own margin requirements; Treasury bonds, for example, can be purchased with a margin as low as 10 percent.

To make margin purchases, you must open a market account and have a minimum of $2,000 in cash (or equity in securities) on deposit with your broker. Once you meet these requirements, the brokerage firm will loan you the needed funds and retain the securities purchased as collateral. You can also obtain loans to purchase securities from your commercial bank, but the Fed's margin requirements still apply. To see how margin trading works, assume the margin requirement is 50 percent and that your brokerage firm charges 9 percent interest on margin loans (brokerage firms usually set the rate on margin loans at 1 to 3 points above prime). If you want to purchase a round lot (100 shares) of Engulf & Devour, which is currently trading at $50 per share, you can either make the purchase entirely with your own money or borrow a portion of the purchase price. The cost of the transaction will be $5,000 ($50 / share x $5,000). If you margin, you will put up only $2,500 of your own money  (50 percent X  5,000 shares) and borrow the $2,500 balance. This is done for two cases: (1) a $20 per share increase in the stock price, to $70 per share, and (2) a $20 per share decrease in the stock price, to $30 per share. It is assumed that the stock will be held for one year and all broker commissions are ignored.

The use of margin allows you to increase the return on your investment when stock prices increase. Indeed, one of the major attributes of margin trading is that it allows you to magnify your returns---that is, you can use margin to reduce your equity in an investment and thereby magnify the returns from invested capital when security prices go up. The return on your investment when the stock price increases from $50 to $70 a share is 40 percent without margin and 71 percent with margin. However, when the stock price declines from $50 to $30 per share, the return on your investment will be a negative 40 percent without margin and a whopping 89 percent loss with margin. Clearly, the use of margin magnifies losses as well as profits! If the price of our stock in the example continues to drop you will eventually reach the point at which your equity in the investment will be so low that the brokerage house will require either to provide more collateral or liquidate the investment. The risk inherent in buying on margin make it imperative that you thoroughly acquaint yourself with the risk-return trade-offs involved before using margin in your investment program.

Short Selling: The Practice of Selling Borrowed Securities

Most security transactions are long transactions; they are made in anticipation of increasing security prices in order to profit by buying low and selling high. A short sale transaction, in contrast, is made in anticipation of a decline in the price of a security. Although not nearly as common as long transactions, short selling is often done by the more sophisticated investor as a way to profit during a period of declining prices. When used by individual investors, most short sales are made with common stocks. When an investor sells a security short, the broker borrows the security and then sells it on behalf of the short seller's account---short sellers actually sell securities they do not own. The borrowed shares must, of course, be replaced in the future. If the investor could purchase the shares at a lower price, a profit will result. In effect, the objective of a short sell is to take advantage of a drop in price by first selling high and then buying low.

Short selling is perfectly legitimate; there's nothing illegal or unethical about it. Indeed because the shares sold are borrowed securities, numerous rules and regulations protect the party that lends the securities and govern the short-sale process. Once regulation, for example, permits stocks to be sold short only when the last change in the market price of the stock has been upward. Another safeguard is the retirement that all proceeds from the borrowed securities be held by the brokerage firm---the short seller never sees any of this money! In addition, the short seller must deposit with the broker a certain amount of money (equivalent to the prevailing initial requirement) when the transaction is executed---so even a short-sale transaction involves an investment of capital.

A short-sale transaction can be illustrated with a simple example (one that ignores brokerage fees). Assume that Patrick O'Sullivan wishes to sell short 100 shares of Advanced Buggy-Whips, Inc. at $52.50 per share after Pat has met the necessary requirements (including making a margin deposit of $52.50 x 100 x 50% =  $2,625), his broker borrows the shares and sells them, obtaining proceeds o $5,250 (100 shares x $52.50/share). If the stock price goes down as Pat expects, he will be able to repurchase the shares at the lower price. Now suppose the price drops to $40 per share, and he repurchases the shares at the lower price. Now suppose the price drops to $40 per share, and he repurchases the 100 shares. Pat will make a profit because he will have been able to replace the shares for four thousand dollars (100 shares x $40 per share, and he repurchases the 100 shares. Pat will make a profit because he will have been able to replace the shares for $4,000 x $40 per share), which is below the $5,250 received when he sold the stock. His profit will be $1,250 ($5,250 - $4,000), if on the other hand, the stock price rose to, say, $60 per share, and Pat repurchased the stocks at that price, he would sustain a loss of $750.00) Because of the high risk involved in short sales, you should thoroughly familiarize yourself with this technique and all of its pitfalls before attempting to short sell any security.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 456-459*

end

Personal Financial Planning: An "How-To" Guide (part 41)

MAKING TRANSACTIONS IN THE SECURITIES MARKETS

by

Charles Lamson

In many respects, dealing in the securities markets almost seems like you are operating in another world---one with all kinds of unusual orders and strange-sounding transactions. Actually making securities transactions is relatively simple once you understand the basics---in fact, you will probably find it is no more difficult than using a checking account! Indeed, while making money in the market is not all that easy, making transactions is.

Stockbrokers

Stockbrokers, or account executives and financial consultants, as they are also called, purchase and sell securities for their customers. Although deeply ingrained in our language, the term stockbroker is really somewhat of a misnomer, because such an individual assists you in the purchase and sale of not only stocks, but also, bonds, convertibles, mutual funds, options, and many other types of securities. Brokers must be licensed by the exchanges and must abide by the strict ethical guidelines of the exchanges and the SEC. They work for brokerage firms and in essence are there to execute the orders placed. The largest stockbrokerage firm, Merrill Lynch, has brokerage offices in virtually every major U.S. city (and many foreign countries). Orders from these offices are transmitted by brokers to the main office of Merrill Lynch and then to the floor of one of the stock exchanges or the OTC market, where they are executed. Although the procedure for executing orders on organized exchanges differs a bit from that in the OTC market, you as an investor would never know the difference, because you would place your order with the broker in exactly the same fashion.

Selecting a Broker

If you decide to start investing with a so-called full-service broker, it is important to select someone who understands your investment objectives, and who can effectively help you pursue them. If you choose a broker whose own disposition toward investing is similar to yours, you should be able to avoid conflict and establish a solid working relationship. A good place to start the search is to ask friends, relatives, or business associates to recommend a broker. It is not important---and often not even advisable---to know your stockbroker socially because most, if not all, of your transactions/orders will probably be placed by phone. In addition, a strict business relationship eliminates the possibility of social concerns, interfering with the acheivement of your investment objectives. This does not mean, of course, that your broker's sole interest should be commissions. Indeed, a broker should be far more than just a salesperson; a good broker is someone who is more interested in your investments than his or her commissions. Should you find you're dealing with someone who is always trying to get you to trade your stocks, or who is pushing new investments on you, then by all means, dump that broker and find a new one!

Full-Service, Discount, and Online Brokers

Just a few years ago, there were three distinct types of brokers---full service, discount, and online---and each occupied a well-defined market niche. Today, the lines between these three types of brokers are no longer clear cut. Most brokerage firms, even the most traditional ones, now offer online services to compete with the increasingly popular online firms. And many discount brokers now offer services once available only from a full-service broker, like research reports for clients. The traditional full-service broker offers investors a full array of brokerage services, and margin loans. Such services are fine for those investors who want such help---and are willing to pay for them! In contrast, those investors who simply want to execute trades that are not interested in obtaining all those brokerage services should consider either a discount broker or online broker. Discount brokers tend to have low overhead operations and offer fewer customer services than full-service brokers. Those with the very lowest commissions and who offer hardly any of the normal broker services, other then executing trades, are called deep discounters. Many discount brokers, however, do provide research and other services, but charging the broker's Web site---and placing the desired buy or sell order. The brokerage firm then executes the order at the best possible price and confirms the details of the transaction by phone, email, or regular male. Depending on the size of the transaction discount brokers can save investors from 30 to 80 percent of the commissions charged by full-service brokers. 

With the technology that is available to almost anyone today, it is not surprising that investors can just as easily trade securities online as on the phone. All you need is an online broker (also called Internet or electronic brokers) and you, too, can execute trades electronically. The investor merely accesses the online broker's Web site to open an account, review the commission schedule, or see a demonstration of the available transactional services and procedures. Confirmation of electronic trades can take as little as 10 seconds and most occur within one minute. Online investing is becoming increasingly popular, particularly among affluent, young investors who enjoy surfing the Web---so much so, in fact, that it has prompted virtually every traditional full-service broker (and many discount brokers) to offer online trading to their clients.

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Brokerage Services

While discount or online brokers offer little more than execution of trades, that is certainly not the case with full-service brokers. Indeed, these brokers offer their clients a wide variety of brokerage services. For that reason, selecting a good brokerage firm is often just as important as choosing a good broker, because not all brokerage firms provide the same services. Try to select a broker with whom you can work and who is affiliated with a firm that provides the type of services you are looking for. Many brokerage firms, for example, provide all sorts of information, ranging from stock and bond guides to research reports on specific securities or industries. Some have a research staff that periodically issues analyses of economic, market, industry or company behavior and events, and relates them to its recommendations for buying or selling certain securities. As a brokerage firm client, you can expect to recieve monthly bulletins discussing market activity and possibly even a recommended investment list. You will also receive an account statement describing all your transactions for the period, commission charges, interest charges, dividends and interest received, the securities you currently hold, and your account balances.

Most brokerage offices provide up-to-the-minute stock price quotation and world news. Stock price information can be obtained either from a quotation board (a large screen that electronically displays security transactions within minutes of the occurrence) or from the computerized telequote system. World news, which can significantly effect the stock market, is obtained from a news wire service. Most offices also have a reference library the firm's clients can use. Another valuable service offered by most major brokerage firms is the automatic transfer of surplus cash left in a customer's account into one of the firm's money funds, thereby allowing the customer to earn a return on temporarily idle funds. Brokerage houses will also hold your securities for you, as protection against their loss, the securities kept in this way are said to be held in street name. Some of these services are also offered by discount brokerages.

Investor Protection

As a client, you are protected against the loss of securities or cash held by your broker by the Securities Investor Protection Corporation (SIPC)---a nonprofit corporation authorized by the Securities Investor Protection Act of 1970 to protect customer accounts against the financial failure of a brokerage firm. Although subject to SEC and congressional oversight, the SIPC is not an agency of the U.S. government.

SIPC insurance covers each account for up to $500,000 (of which $100,000 may be in cash balances held by the firm). Note, however, that SIPC insurance does not guarantee that the dollar value of the securities will be recovered. It only insures that the securities themselves will be returned. So what happens if your broker gives you bad advice, and, as a result, you lose a lot of money on an investment? SIPC will not help you, as it is not intended to insure you against bad investment advice. Instead, if you have a dispute with your broker, first discuss the situation with the managing officer at the branch where you do your business. If that does not do any good then write or talk to the firm's compliance officer and contact the securities office in your home state. If you still do not get any satisfaction, you may have to take the case to arbitration, a process whereby you and your broker present the two sides of the argument before an arbitration panel, which then makes a decision about how the case will be resolved. If it is binding arbitartion, and it usually is, you have no choice but to accept the decision---you cannot go to court to appeal your case. Many brokerage firms, in fact, require you to resolve disputes by going to binding arbitration. Thus, before you open an account, check the brokerage agreement to see if it contains a binding arbitration clause.

Odd or Round Lots

Security transactions can be made in either odd or round lots. An odd lot consists of fewer than 100 shares of stock, while a round lot represents a 100-share unit or multiples thereof. The sale of 400 shares of stock would be considered a round-lot transaction, but the purchase of 75 shares would be an odd-lot transaction; trading 250 shares of stock would involve two round lots and an odd lot. Because the purrchase or sale of odd lots requires additional processing and the assistance of a specialist (an odd lot dealer), an added fee---known as an odd-lot differential--- is often tacked on to the normal commission charge, driving up the costs of these small trades. Indeed, the relatively high cost of an odd-lot trade is why it is best to deal in round lot whenever possible.

Brokerage Fees

Brokerage firms receive commissions for executing buy and sell orders for their clients. Brokerage commissions are said to be negotiated, which means that they are not fixed. In practice, however, most firms have established fee schedules that they use with small transactions (on larger, mostly institutional trades negotiation of commissions actually does not take place). Although these fees are not really negotiated they do differ from one brokerage firm to another; thus it pays to shop around. Also, if you are an ""active trader," generating a couple thousand dollars (or more) in annual commissions, then by all means try to negotiate a reduced commission schedule with your broker. Chances are, they will probably cut a deal with you---the fact is, brokers much prefer traders to buy-and-hold investors, because traders generate a lot more commissions. Generally speaking, brokerage fees on a round lot of common stock will amount to approximately 2 to 4 percent of the transaction value. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005,  LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 451-454*

end

smart.sites

Confused about which broker is right for you? Use The Motley Fool’s checklist, 10 Ways to Size Up a Broker, at the Fool’s Discount Brokerage section, www.fool.com.

Personal Financial Planning:An "How-To" Guide (part 40)

THE OBJECTIVES AND REWARDS OF INVESTING

by

Charles Lamson

People invest their money for all sorts of reasons. Some do it as a way to accumulate the down payment on a new home; others do it as a way to supplement their income; still others invest to build up a nest egg for retirement. Actually, the term investment means different things to different people. That is, while millions of people invest regularly in securities like stocks, bonds, and mutual funds, others speculate in commodities or options. Investing is generally considered to take more of a long-term perspective and is viewed as a process of purchasing securities wherein stability of value and level of return are somewhat predictable. Speculating, on the other hand, is viewed as a short-term activity that involves the buying and selling of securities in which future value and expected return are highly uncertain. Obviously, speculation is far more risky than investing.

If you are like most investors, at first you will probably keep your funds in some form of savings vehicle. Once you have sufficient savings---for emergencies and other purposes---you can begin to build up a pool of investable capital. This often means making sacrifices and doing what you can to live within your budget. Granted, it is far easier to spend money than to save it, but if you are really serious about getting into investments, you are going to have to accumulate the necessary capital! In addition to a savings and capital accumulation program, it is also important to have adequate insurance coverage to provide protection against the unexpected. For our purposes here, we will assume you are adequately insured and that the cost of insurance coverage is built into your family's monthly cash budget. Ample insurance and liquidity (cash and savings) with which to meet life's emergencies are two investment prerequisites that are absolutely essential for the development of a successful investment program. Once these conditions are met, you are ready to start investing.

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But How Do I Get Started?

Contrary to what you may believe, there is really nothing magical about the topic of investments---in fact, as long as you have the capital to do so, it is really quite easy to get started in investing. The terminology may seem baffling at times and some of the procedures and techniques quite complicated. But do not let that mislead you into thinking there is no room for the small, individual investor. Nothing could be farther from the truth! For individual investors have a wide array of securities and investment vehicles to choose from. Further, opening an investment account is no more difficult than opening a checking account.

How, then, do you get started? To begin with, you need some money---not a lot; $500 to $1,000 will do, although $4,000 or $5,000 would be better (and remember, this is investment capital we are talking about here---money you have accumulated above and beyond any basic emergency savings). In addition to money, you need knowledge and know-how. You should never invest in something you are not sure about---that is the quickest way to lose money. Learn as much as you can about the market, different types of securities, and various trading strategies. Taking a course on personal finance is a good start, but you may want to do more. For one thing, you can become a regular reader of publications such as Money, The Wall Street Journal, Barron's, and Forbes. Also, try to stay current with major developments as they occur in the market; start following the stock market, interest rates, and developments in the bond market.

Gitman & Joehnk, writers of Personal Financial Planning, on page 435, strongly suggest that, after you have learned a few things about stocks and bonds, you set up a portfolio of securities on paper and make paper trades in and out of your portfolio, for 6 months to a year, to get a feel for what it is like to make (and lose) money in the market. Start out with an imaginary sum of, say, $50,000 (as long as you are going to dream, you might as well make it worthwhile). Then keep track of the stocks and bonds you hold, record the number of shares bought and sold, dividend received, and so on. Throughout this exercise, be sure to use actual prices and keep it as realistic as possible. You might want to use one of the portfolio tracking programs offered at such Web sites as www.quicken.com or www.moneycentral.msn.com; there are some powerful Internet sites out there that make it very easy to track the behavior of a portfolio of securities. The advantage to creating a paper portfolio is clear. If you are going to make mistakes in the market, you are much better off doing so on paper. Also, if your, parents, relatives, or friends have done a lot of investing, talk to them! Find out what they have to say about investing, pick up some pointers, and possibly even learn from their mistakes. Eventually, you will gain a familiarity with the market and become comfortable with the way things are done there. When that happens, you will be ready to take the plunge.

At that point, you will also need a way to invest---more specifically, a broker and some investment vehicle in which to invest. The stockbroker is the party through whom you will be buying and selling stocks, bonds, and other securities. If your relatives or friends have a broker they like and trust, have them introduce you to him or her. Alternatively, visit several of the brokerage firms in your community; talk to one of their brokers about your available investment funds and your investment objectives.

As a beginning investor with limited funds, it is probably best to confine your investment activity to the basics. Stick to stocks, bonds, and mutual funds. Avoid getting fancy, and certainly do not try to make a killing each and every time you invest---that will only lead to frustration, disappointment, and very possibly, heavy losses. Further, be patient! Do not expect the price of the stock to double overnight, and do not panic when things fail to work out as expected in the short run (after all, security prices do occasionally go down). Finally, remember that you do not need spectacular returns in order to make a lot of money in the market. Instead, be consistent and let the concept of compound interest work for you. Do that and you will find that just $2,000 a year invested at the fairly conservative rate of 10 percent will grow to well over $100,000 in 20 years! While the type of security in which you invest is a highly personal decision, you might want to give serious consideration to some sort of mutual fund as your first investment. Mutual funds provide professional management and diversification that individual investors---especially those with limited resources---can rarely obtain on their own.

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*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS 434-435*

end

smart.sites

With so many investing Web sites, how can you find what you need? Start with An Opinionated Guide to the Web’s Best Investing Sites, www.winninginvesting.com, for links to useful Web sites listed by category. An added benefit: most are free.

smart.sites

Zacks Investment Research (www.zacks.com) offers a comprehensive “Investing 101” tutorial and a glossary of financial terms.