Stock Trading Blog
The markets have predicted a 50-50 chance that the Fed will raise rates again this December and investors are on the fence as to how this could benefit them. The election cycle has complicated matters leaving many investors on the sidelines until the vote comes in and uncertainty abates a little in the markets.
Last December the Fed raised the Federal Funds rate by 0.25% marking the first increase since 2006 in what was widely believed to be a series of hikes. However, the markets plummeted early in 2016 following the hike and the Fed’s statements have changed from hawkish to dovish with little consistency. Keeping a rate hike on a set schedule is critical to maintaining stability in the markets, but another rate hike in December without seeing a rise in inflation could also tip the scales in a bearish direction.
Regardless of the Fed’s decision next month, investors need to have their portfolio’s prepared for the worst while still positioning it to take advantage of any potential gains.
The relationship between interest rates and stocks
Interest rates impact the cost someone pays for the use of another person’s money. When the Federal Funds rate goes up, it increases the cost banks are charged in order to borrow from the Federal Reserve. The goal is to reduce the money supply in an attempt to curb inflation.
Increased rates have widespread implications though. Higher rates means that borrowers pay more for loans and reduces the amount of money they are able to spend on other goods and services. For businesses, that means there is less capital to put towards investments or growth and reduces earnings due to the increased amount spent on interest payments.
When earnings go down, so do stock prices. So when interest rates go up, the immediate effect is usually a decline in stock values since profits take a hit due to the increased borrowing cost. It also makes more conservative asset classes like treasuries and bonds more desirable since yields go up. Stocks have more risk, while bonds have less.
Stocks need to be more valuable than the less risky bonds and treasuries in order to be more desirable to investors. For investors, that means a stocks return needs to be equal to or greater than the risk-free rate plus a risk premium. For example, let’s say the risk-free rate is 2% while XYZ’s risk premium is 8%. That means investors will expect the stock to generate a 10% return in order to be desirable. If the risk-free rate rise due to a Fed hike to 3% then the stock would need to produce a return of 11% to get the same result. As rates go up, stocks need to produce higher and higher return in order to compensate for the risk.
Not all stocks are affected the same by higher interest rates. Increased rates also mean greater returns on money market accounts and other conservative asset groups. This benefits financial companies the most like banks and insurers who keep significant sums of money in liquid assets in order to make loans and pay out insurance claims.
Investors who worry that a rate hike might hurt their portfolio might consider picking up some financial stocks to hedge against higher interest rates. Investors should also note that once the rate hikes stop, a new equilibrium will settle over financial markets with stocks compensating for the changes and producing higher returns in the long run.
There’s no worse feeling than watching a stock in your portfolio drop in value day after day with no end in sight. If it falls less than 10%, you say the markets are just going through a small correction. After it drops 20%, you tell yourself that it must have finally bottomed, but when it keeps falling, you may start to panic.
There’s one inevitable truth all investors must face: eventually, you will own a losing asset. The key to successful investing isn’t knowing when to buy a stock, it’s knowing when to sell it. That holds true whether the stock goes up or down, but understanding when you need to cut a losing investment loose is what separates good investors from great investors.
It comes down to simple math. If a stock drops 10%, you need to gain 11.11% in order to break even. After a 20% loss, the break-even point jumps to 25%, and if it has lost 50%, it’ll need to double in value just to prevent a loss.
In order to make a rational decision on whether you should keep a stock or sell it, you’ll need to answer three questions first.
Why Did You Buy the Stock?
If the reasoning behind why you bought the stock has changed, then you might consider getting rid of it – especially if its declining in value. If you bought a stock because it had a high dividend yield and management cuts the dividend, then the stocks circumstances have changed. If the stock is dropping in value along with most other stocks, it’s likely a macroeconomic reason and doesn’t affect the fundamentals of the stock you own.
Does Your Portfolio Need to be Re-Balanced?
Every so often your portfolio needs to be readjusted to keep in line with your risk tolerance. Some stocks gain more than others and subsequently take up more weight in your portfolio. As your risk tolerance changes, you may need to adjust how much money you have allocated to riskier stock picks. Investing in high risk speculative companies may be exciting, but too much of them in a portfolio can spell disaster.
Can You Use the Loss to Offset Gains for Tax Purposes?
If you have a losing stock in your portfolio, you might consider using tax-loss harvesting to reduce the amount of taxes you’ll need to pay at the end of the year. Selling a stock at a loss allows you to offset your income up to $3,000 in a single tax year. It might not be a profit, but at least it helps you reduce your tax burden.
One warning for those of you struggling to cut your losses: don’t bail out your money by throwing more money at a losing stock. Averaging down by purchasing more shares of a stock after its declined in value is dangerous. The idea is to lower your average cost per share, which on the surface seems like a good strategy. The problem is that averaging down can be a panicked reaction to seeing a stock drop in value. If its for fundamental reasons, then you’ll end up in a cycle of averaging down until you have a much larger percentage of your portfolio in that stock than you wanted just to bail out your original investment.
Investing the stock market takes discipline in order to be successful. Jumping in blind with no more idea of what to do other than “buy low, sell high” is the quickest way to lose your money. Without some guidelines to help you out along the way, it’s easy to make mistakes and get discouraged.
The good news is that investing isn’t rocket science. Even the smartest Ivy League college graduate knows that successful investing means following the rules. So before you start navigating the waters of Wall Street, here are 10 rules that every investor should be obeying:
- Know What You Own – The hottest new tech company may be all Wall Street and your friends are talking about but if you don’t understand what it is they do or how they actually make a profit, take a pass on it.
- Cash Is Also An Asset Class – Too many investors think that they need to be all-in in order to be a successful trader. Keeping cash on the sidelines though means that when an opportunity presents itself, you can act quickly without having to sell out of another investment before you’re ready.
- Diversify, Diversify, Diversify – This rule cannot be understated. Don’t keep all your eggs in one basket; diversify your investments to avoid getting hit by a single event that only affects a limited part of the stock market.
- Stay Calm And Keep Investing – Panicking when the market is behaving erratically is the quickest way to big losses. Don’t get sucked up in the hype and remember when everyone is selling, you should be buying and vice versa.
- Don’t Fall In Love – Remember that stocks are just investments. You may really like a certain company, but if a better opportunity comes along, you can’t be afraid to chase it down.
- Filter Out The Noise – Wall Street always has a new crisis or a new big opportunity for you to worry about. Ignore the pundits and stay focuses on the fundamentals.
- Explain Why You Own A Stock – Know why you want to own a particular stock. Is there a reason you think it’s going to appreciate? Before buying, be able to explain to a stranger why you think the stock is worth owning.
- Due Diligence – It might not be fun, but sticking to your due diligence will keep you from making costly mistakes. Always do your homework before buying a stock or could end up with an ugly surprise down the road.
- Don’t Be Afraid To Cut Your Losses – It’s never fun to admit defeat and even less fun to sell a stock at a loss. But if you own a loser, you need to cut it loose before it does more damage to your portfolio.
- Hogs Feast, Pigs Get Slaughtered – Once a stock you own has made the profits you expected, it’s time to move on. Don’t hold on and try to squeeze every last drop of profits from a stock or you could end up losing all the gains you thought you had in the bag.
It’s a lot easier to maintain discipline by following these simple rules for trading. As you become more experienced with trading, you may decide on a few more rules to help you stay focused as well. As long as it helps you become the best investor you can be, rules are a great way to keep your portfolio in check.
Owning a winning stock that’s worth more than when you originally purchased it is a great feeling. As long as it keeps going up, you’ll want to hold on for the ride. But knowing the right time to sell a stock is arguably more valuable than knowing when to buy one.
It might seem counter-intuitive to sell a winner, but there’s one key point you need to keep in mind: until you actually sell a stock and pocket those profits, you haven’t actually made any gains. On paper it may look like you’re successful, but don’t let that distract you from the fact that those gains aren’t real. If you sell a stock at a profit and it keeps rising, you still made a profit. But if you hold a stock too long, it can decline in value faster than you think erasing those gains in the blink of an eye.
There’s an oft-repeated phrase in Wall Street circles, “bulls make money, bears make money and pigs get slaughtered. Experienced investors know how to buy a stock before it becomes too expensive – smart investors know how to sell a stock before it falls.
Signs it’s time to make an exit on a stock you own
One of the first things you’ll want to do when buying a stock is to have an exit strategy already mapped out. Know beforehand what price you expect it to hit and when you think the stock will have made its possible gains. Once the stock hits that price, you’ll know that it’s time to go ahead, take your profits and move on.
Of course there are times when a stock’s outlook changes by the time it hits the price target you placed on it. Sometimes the stock is still undervalued with room to run. In those cases there’s nothing wrong with placing a new price target on the stock and continuing to hold it. But usually as a stock appreciates in value it becomes more expensive to own.
Once a stock approaches parity and there’s no hidden value left in it, the stock may simply stagnate. It won’t go up, but it doesn’t retreat either. There’s an opportunity cost to holding on to it. In these cases selling the stock in favor of something that’s currently growing is the best course of action.
Paying attention to your investments is important. Sometimes a company announcement of surprise economic data can change your original plan with a stock making it more or less valuable than you thought. The market is a living breathing organism that’s constantly in motion so staying on top of the latest developments will help you spot potential pitfalls before they become serious problems.
Remember that you can’t lose money by selling a stock at a profit no matter what it does afterward. Don’t be afraid to sell a winner and move on to another undervalued opportunity or you could end up costing yourself higher returns in the long run. Greed is the biggest killer of value in most investor portfolios – take the win when it’s there, don’t second guess your decisions and you’ll be well on your way to becoming a successful long term investor.
There’s one simple rule when it comes to investing: buy low and sell high. It’s a simple enough philosophy in theory, but much harder to implement in practice. In order to actually make a profit, you need to purchase a stock at a cheaper price than when you sell it. The problem lies in knowing what price a stock should be trading at and when you should buy it – and conversely, when you should sell it.
Knowing what price a stock should be valued at is something Wall Street analysts excel at uncovering. Through rigorous research they are able to estimate data in advance and place target prices on stocks so investors know where a stock will be trading at in the future. It may seem like pseudo-science to guess what the future will bring, but the actual methods for predicting where a stock will be trading aren’t quite as complex as you might think. With a little due diligence, you’ll be able to track your own stock picks and make estimates as to where they’ll be trading a year from now or even longer.
The 4 Elements of Setting a Target Price
In order to place a target price on a stock, you’ll want to know four fundamental pieces of data: sales, profit margin, earnings-per-share, and valuation multiple. These four items will allow you to make predictions about where a stock is headed and understand exactly why the stock will be trading at a given price in the future.
You can a company’s sales (revenue) history on its Income Statement. Going back 10 years and comparing its quarterly revenue will give you a pretty good idea of its sales growth rate and allow you to calculate where sales will be in the future.
Estimate Profit Margin
Much like calculating future sales, you can find historical net profit margin information on the Income Statement. To find the net profit margin, you need to know the company’s operating expenses, cost of goods sold (COGS), interest and tax from revenue and dividend’s from preferred shares (be careful not to include dividends from common stock). Once you have that figure, simply divide net profit by revenue to get the total net profit margin.
Once you know the company’s net income, you’re ready to convert it into earnings-per-share (EPS). To calculate it, you need to subtract preferred dividends from net income and then divide by the number of shares outstanding. As with sales and profit margin, you can also get an idea for the company’s long term EPS history as well to get an idea of how fast EPS growth is.
Decide on a Valuation Multiple
Finally, you’ll need to place a valuation multiple on the stock to determine its value. This is done via the price-to-earnings ratio (P/E). You can get an idea of what multiple to use by looking at the company’s 10-year average P/E or base it off of its competitors and industry average. Once you figure out what P/E to use for the stock, all you need to do is multiply it with the estimated EPS and that will give you your stock target price.
Remember that even the best analysis can be proven wrong if a company changes the way it does business, changes how it figures taxes or makes new acquisitions. As a result, you’ll want to keep your target price analysis to 12 months and not try to estimate too far out unless you have an in-depth understanding of how that business operates.
Once you can determine your own target prices though, you’ll be able to make better investment decisions and avoid jumping into stocks that don’t have any room for price appreciation. It’s also a good way to time your trades – once you hit your target price, you know that you can sell it unless new data shows a change in the stocks target price.
In order to determine a stocks value, analysts pour over company financial statements in order to find trends, strengths and weaknesses. They break down the data and present it to investors through different ratios designed to help them make quick comparisons and make predictions about where a stock is headed.
These financial statements include the balance sheet, income statement and cash flow statement. They reveal information about the financial health of the company including efficiency, profitability, liquidity, and numerous other details.
Let’s take a closer at each financial statement and see what kind of information we can find.
The Balance Sheet
This statement contains details on a company’s assets, liabilities and shareholder’s equity. It will tell you what kind of assets it owns and what types of debt the company owes. The numbers on the balance sheet will always add up according to the following equation: assets = liabilities + shareholder equity.
This relationship means that assets (what the company owns) must be paid for using either debt financing (liabilities) or investor money (shareholder equity). Key things to note on the balance sheet include the following:
Cash and cash equivalents: This is most liquid money a company has and is beneficial for paying off unforeseen expenses.
Total assets: The total of all assets listed on the balance sheet. This number should be higher than total liabilities – ideally with room to spare.
Current liabilities: Debt or expenses that is due within 12 months. A good thing to watch for is how cash and cash equivalents compares to current liabilities.
Long term debt: The interest and principal on issued bonds.
Total liabilities: All the debts and expanses of a company. This figure should be lower than total assets.
The Income Statement
The income statement is also known as the profit and loss statement and generally contains information about the company on a quarterly basis. It tells you what kind pf profits the company makes, the profit margin and the expenses being paid – either on a regular basis or a one-time charge.
The income statement is vital for figuring out the company’s earnings-per-share and can be used to place target prices on a stock. Comparisons made to prior time frames give analysts the ability to see how a company is performing quarter-over quarter or year-over-year.
The Cash Flow Statement
The most often overlooked statement is the cash flow statement which tells investors how a company is spending its money on a quarterly and annual basis. Cash flows can be broken own by where its being generated: from operations, from investment activity and from financing.
This statement is critical for determining a company’s free cash flow – a statistic used to calculate how much money a company has accounted for capital expenditures. Put another way, free cash flow shows investors how much excess money a company can generate to make new acquisitions or invest in new opportunities.
Many financial ratios are calculated using a mix of all three financial statements. Once you understand how to read them, you can make historical comparisons on your own and make predictions about where a company is heading. Knowing what the financial statements mean for a company gives you the ability to make smarter investment decisions and avoid costly mistakes.
Once you’re confident trading stocks, you may want branch out into options trading. Adding options to your investment strategy can add depth to your portfolio, boost gains and reduce risk. You may already know how puts and calls work. Now you need to figure out how to use them effectively to take advantage of all the benefits option trading possesses.
A covered call is bullish option strategy that helps reduce downside risk. It works in conjunction with owning the underlying stock but limits overall upside. Let’s use a hypothetical stock as an example:
Let’s say you own 100 shares of XYZ stock trading at $25 and you think the stock is going to go up in the next few months but you want to protect yourself if the stock drops as well. You sell a call for $50 a few months out at $30 per share and pocket the $50 gain.
If the stock closes higher than $25 but less than $30, the call will expire worthless and you’ll keep the $50 profit plus you’ll still own 100 shares of XYZ. If the stock climbs above $30 per share, you’ll be forced to sell the call at $30 but you keep the $50 profit plus the $5 gain in the stock’s rise for a total of $550. That means you lose out on any upside beyond $30 so if it suddenly umps up to $40 per share, you won’t get the $10 increase past $30.
Because you sold a call for $50, this also helps reduce downside risk by making your breakeven price $24.50. If the stock falls below that price then you’ll realize a loss, but there’s a bit of wiggle room where you’ll still have a gain even if the stock does nothing or even drops a little.
There are two types of spreads: bullish and bearish. In this type of option strategy, you use two options with the same expiration date but different strike prices. This can be a good way to reduce the cost of entering into a trade or betting on a potential rise or drop in price without actually buying a stock or selling it short.
Let’s use an example to illustrate how this works:
XYZ stock is currently trading at $25 per share and you think it might go up in the next few months but aren’t willing to buy 100 shares of the stock. You could purchase a call option for $250 a few months out at $25 and sell another call for $50 at a higher strike price of $30. Your total cost for entering into this trade is $200 making this the total amount you could lose.
Your total possible profit is $500 minus the $200 cost of purchasing the two options. Using this strategy allows you to leverage your money and increase profits while reducing your total monetary investment while doing so. This works the same way with bear spreads as well except instead of using calls you would use puts.
Covered calls and spreads are simple option strategies that can help your investment portfolio reach its full potential. But there are dozens of possible combinations and strategies you can use in addition to these. Once you get a feel for spreads and covered calls, you may want to look into more complicated strategies that can help you profit no matter what direction the market goes – up, down or even when it does nothing at all.
As a beginning investor, you might already have some familiarity with mutual funds, stocks, ETF’s and even options. Most online brokers have services that allow you to trade a combination of those assets and you likely understand how to put basic combinations together as part of your investment strategy.
But trying your hand in the commodities market is a different story.
Commodities trade on the futures market – a market that obeys rules that are very different from the ones you might be used to with stocks and options. You’ll also need to find a broker that allows futures trading. Because of the complexities involved, many online brokers won’t deal with futures contracts so doing your homework before opening an account is critical.
Playing the Futures Market
A basic futures contract is simply an agreement to buy or sell an asset on a future date for a predetermined price. Let’s use a hypothetical situation as an example of how this works.
XYZ Copper Mining is a company that wants to make sure the price of copper doesn’t go down in the future. The company might agree to sell copper 3 months out at today’s price. If in 3 months the price of copper drops, the company won’t be affected by the loss since they already agreed to sell at a higher price.
While much of the commodities market is made up of hedge contracts like in this example, other traders act as speculators, betting on whether prices will rise or fall in the future. Commodity investing could be a way of managing overall portfolio risk, while others may simply be placing a bet on prices in the hopes of quick gains.
Technically, futures contracts are for the physical delivery of a commodity. While investors can choose to deal with just the contracts, its important to note that delivery and storage costs are all part of the equation when determining where prices will go.
Futures contracts come with far more risk than trading stocks or options, though. While margin accounts may allow you to leverage your portfolio to a degree, futures contracts are designed with leverage in mind. Contracts are leveraged at 10:1, 20:1 or even 200:1 ratio depending on the underlying asset involved.
With leverage so high, a small percentage change can result in huge gains or losses. A 5 percent loss in the contract may be the equivalent of a 50 percent loss on your investment. Volatility this high means that you won’t be able to hold positions for a long time. Even if you end up being right about price in the long term, even a few days of volatility could cost you your entire investment.
Opening up an account to trade futures isn’t the only way to invest in commodities. Mutual funds and ETF’s that trade only commodities are another option, as are companies that rely heavily on commodities, such as mining companies. While these types of investments might not be “pure plays” on a commodity, they’re far less risky and could be the right move if the idea of losing your entire investment in one day feels unacceptable.
If you’re like most investors, you probably have at least some kind of experience with mutual funds. A 401k or 403b company sponsored retirement plan uses mutual funds almost exclusively as an investment vehicle while most people use mutual funds for their IRA or Roth IRA. Beginning investors tend to start out with mutual funds as a way of gaining experience in the stock market and build up starting capital before opening up a brokerage account to trade stocks as well.
But mutual funds haven’t delivered the kind of performance that investors have been seeking over the past decade or so. Management fees and sub-par portfolio gains have led to a massive exodus away from mutual funds into exchange-traded funds (ETF’s) where investors have more direct control over their portfolio’s and pay fewer fees along with it.
In 2015, Wall Street saw $150 billion leave the mutual fund industry while ETF’s saw inflows of $150.6 billion. Investors are viewing ETF’s as better alternatives to mutual funds despite the fact that the mutual fund industry is by far larger with $11.5 trillion in assets under management whereas ETF’s have only $2.1 trillion. But before you jump ship from mutual funds into ETFs in order to chase better gains and lower fees, there are some stark differences that you need to know.
A side-by-side comparison between Wall Street’s favored investment vehicles
Mutual funds are actively managed, diversified investment vehicles that are designed to track a specific benchmark. They usually have a team of analysts that make stock selections for the portfolio and have the ability to make adjustments throughout the year as the economic environment changes.
Mutual fund strategies are usually given away by their name. Take a hypothetical fund we’ll call XYZ Blue Chip Growth Fund. Just from the name, we know that this fund invests in large cap companies and takes a growth investment strategy into account when making its stock selections. Management will do its best to track an index that follows along the blue chip growth stocks and will charge investors a fee for doing so.
At first glance, ETF’s look to be very similar to mutual funds. Most are designed to track a specific index and hold a basket of stocks in its portfolio. But ETF’s are passively managed meaning no manager will track the individual stocks or make adjustments to the portfolio. They come with lower fees than a mutual fund but run the risk of holding poor stocks in the mix.
ETF’s are more liquid than mutual funds though. Mutual funds trade once per day at the end of the day while ETF’s trade much like stocks do. But ETF’s with low trade volume can present a problem for investors with higher intra-day volatility.
Once you start to branch out in your investment experience, you’ll find that there are a lot of vehicles out there for you to pick from. Trading individual stocks after only holding mutual funds can be a stressful endeavor especially if you aren’t used to high levels of volatility in your portfolio. While some investors are favoring ETF’s over mutual funds, others look to ETF’s as a way to bridge the gap between funds and stocks. Using ETF’s for diversification purposes or as a way to slowly dip your feet into the market can be helpful.
Both ETF’s and mutual funds have a place in an investment portfolio and shouldn’t be viewed as an either/or scenario. A healthy balance of both is the key to maintaining a successful investment account.
The globalization of financial markets has made it possible for investors to be a part of nearly any type of publicly traded company in the world. If you have a brokerage account where you can buy or sell stocks, you may already be trading ADR’s without even realizing it. While similar to stocks, there are some differences you’ll want to keep in mind to be a successful investor.
ADR stands for American depository receipt, a financial instrument that allows foreign companies’ stock to be traded in US markets. They can be traded like stocks through buying and selling and some even have options contracts available on them.
One key difference is the fact that an ADR is a certificate that represents a specified number of shares in the foreign company. This was done as a way of circumventing the complexities of dealing with foreign exchange costs that can fluctuate independently of stock prices. Because ADR’s can represent differing amounts of stock depending on the underlying issuer, investors should look up what the value of an ADR is before buying it. Some ADR’s are a simple 1 to 1 exchange while other ADR’s can represent a handful of shares.
Diving into the world of ADR’s
Investors typically won’t trade stocks with questionable practices or confusing financials which is why ADR’s are sponsored by US-owned banks. These issuing organizations agree to offer ADR’s on a foreign companies stock in exchange for the proper financial documentation. They also decide how to value the ADR relative to the company’s local currency. Because of the exchange rate, some foreign stocks may only be worth a few pennies in US currency. The sponsoring bank will take this fact into consideration and price the ADR at an appropriate price to reflect its actual value.
ADR’s are issued in one of three ways: Level 1, Level 2, and Level 3. Level 1 issued ADR’s aren’t required to disclose as much financial information as the other two levels and is generally done just to gauge US interest in the company’s stock. Level 1 ADR’s are very similar to stocks that trade on the “pink sheets” and you should exercise extreme caution before investing.
Level 2 and Level 3 ADR’s trade on recognized US exchanges like the NYSE and the NASDAQ. These issues get more visibility and gain benefits such as being able to raise additional capital in exchange for
more detailed financial disclosures to the sponsoring bank and stock exchange.
Investors interested in trading ADR’s can find out more about them from BNY Mellon or JP Morgan. These two sites will give you detailed information such as how many shares of stock an ADR represents on a foreign stock.
If an ADR offers a dividend, there may be additional tax concerns investors should be aware of as well. Each country has different rules regarding dividend taxation that can completely eliminate any benefit you would otherwise receive.
Finally, ADR’s can be more complicated than US stocks making them fit only for investors who are able to put in the extra work before investing. Make sure you do your due diligence before incorporating ADR’s into your investment portfolio.
If you’re like most Americans, you’re probably wondering if you’re contributing enough for retirement. After you build up an emergency savings account and start investing in your company’s 401k or 403b plan, you might be considering opening up an IRA or Roth IRA account. Both will help you stash away funds for retirement, but each has a different approach for taxing contributions and withdraws that can make picking the right plan a difficult decision.
Both types of IRA plans are designed to be individual retirement accounts that can be used in addition to other types of accounts such as company sponsored retirement plans. Both have specialized tax treatment as well but work with different rules. The best way to figure out which type of IRA is best for you depends greatly upon your current income and your expected income once you finally retire.
The Traditional IRA
Most Americans are at least somewhat familiar with the traditional IRA plan. It works a lot like your company’s retirement plan except only you make contributions into the account. Contributions made into an IRA are pre-tax contributions which means you can use it to lower your overall tax burden by whatever amount you have invested into the IRA in a given year. As of 2016, the contribution limits for a traditional IRA are $5,500 or $6,500 if you’re over 50 year of age under the catch-up contributions provision.
A traditional IRA may make sense if you expect to earn less income in retirement than you currently earn now. That way you can lower your taxable income immediately and defer taxation for when you withdraw it in retirement when you might be subject to a lower tax bracket. Like most retirement plans, you’ll be subject to a 10% penalty tax for any withdraws before reaching 59 ½ years old.
The Roth IRA
A Roth IRA differs from a traditional IRA in the way contributions and withdraws are taxed. In a Roth IRA, contributions are not made pre-tax and cannot be deducted. However, withdraws after reaching 59 ½ years old are completely tax-free – both contributions and gains. In other words, you pay taxes upfront in a Roth IRA but get to take out funds without incurring additional taxation.
Because of the way Roth IRA’s are structured, they are ideal if if you expect your income to stay the same or increase in retirement. It can also be a much better better deal considering that you’ll be able to take out profits on your investments without having to pay additional taxes. For example, let’s say you invest $10,000 into a Roth IRA which grows into $100,000 by the time you retire. Since you’ve already paid taxes on the original $10,000 contribution, you’re free to take out all those gains without having to pay any more taxes.
While it may seem that a Roth IRA is the better type of account, there are limitations which may prevent you from being able to invest. Unlike a traditional IRA, Roth IRA contributions may not be made if you exceed a certain level of income. For single filers as of 2016, the limit is between $184,000 and $194,000 while married filers are limited between $117,000 and $132,000. A simple way of deciding which account is best for you is to follow these income limits – if you earn less than the limit, a Roth IRA is probably the better choice for you whereas if you earn more than the limit, a traditional IRA will be your only option.
Becoming an experienced investor usually follows a certain path. You might have started out by investing in mutual funds and progressed into opening up a brokerage account that lets you trade individual stocks. You’ve learned the basics of stock diversification and have no hesitation when it comes to placing stop and limit orders on stocks you’re trading. Now you’re ready to take the next step.
Adding options trading to your investment strategy can help you boost returns, mitigate risk and hedge your positions. A stock option lets you leverage your money by controlling 100 shares of stock per contract. That means your potential gains or losses can be much higher than you’ll find by just trading stocks s you’ll need to be aware of the potentially increased volatility in your account. Unlike stocks, options have an expiration date so your strategies will need to have a time element to them as well. Used correctly, options can help you round out a portfolio and even reduce the amount of risk you’re exposed to.
Buying and Selling Call Options
A call option gives you the right, but not the obligation to buy a stock a specified price for a limited period of time. If the stock increases in value, you can exercise the option and make a profit. If the stock doesn’t increase in value, or even loses value, then you don’t have to do anything with the option. You can let it expire worthless and limit your loss to the cost of purchasing the call option.
Let’ take a look at how call options work:
Let’s say you think XYZ stock will go higher in the next few months but you don’t want to purchase 100 shares of stock. XYZ is currently trading at $50 per share and you decide to purchase a call option at $52.50 that expires in three months for $35. That means that if the stock hits $52.85 or higher, you’ll make a profit. If the stock doesn’t hit this price within three months, then you’ll lose the $35 it cost to buy the call.
You can also sell call options. That means instead of having the option of buying a stock, you are under the obligation to sell it. Selling a call without owning the stock is considered extremely high risk because there’s no limit to what kind of losses you might incur.
Using the previous example, let’s say you thought XYZ was going to go down instead of up so you sell a call option and immediately make $35. As long as the stock doesn’t go higher than $52.85, you will end up with a $35 profit. However, if the stock rises higher than that, it will reduce your profit until you owe whatever the difference is. If the stock ended at $60, you would owe $750 minus the $35 you received when you sold the call.
Buying and Selling Put Options
A put option gives you the right, but not the obligation to sell a stock at a specified price for a limited period of time. Buying a put means you believe a stock will decrease in value within a specified amount of time.
Let’s use our earlier example but make it a put instead of a call:
XYZ stock is trading at $50 per share and you think it will go lower in the next three months. You purchase a put option at $48.50 that expires in three months for $35. If the stock drops below $48.15, you’ll make a profit. Otherwise, you’ll be limited to the loss of the put option – $35.
Selling a put option means you think the price of a stock could increase. You’ll be under the obligation to purchase 100 shares of stock at a specified price. Unlike selling call options, selling a put does have a limit to how much risk you’ll be subject to since a stock can only go down so far.
If you thought XYZ might go up, you might consider selling a put. Let’s say you sold a put at $50 on XYZ for $35. Like selling a call, you would immediately pocket the $35 gain. If XYZ then increases in value or holds at $50, the put would expire and you would keep the $35 gain. If the stock drops though, you would be obligated to purchase 100 shares at $50 per share regardless of what price the stock actually fell to.
By combining buying and selling both calls and puts, you can set up unique strategies with its own risk/ reward potential. One of the most common strategies is known as a covered call where you buy 100 shares of stock and then sell a call option at a higher price. That way you hedge against downside risk at the cot of limiting your total upside potential since you would be obligated to sell the stock once it hit a specific price. Once you get used to basic options strategies, you can begin utilizing more complex scenarios that can take your investment trading to the next level.
Before the advent of the day-trader and Regulation Fair Disclosure, investing was simple. You bought a stock and held it until you retired or closed out your account. Large cap, well established companies that payed a dividend were ideal. Stocks like Exxon Mobil, Johnson & Johnson, US Steel and other well known brands were common picks and held in most investment portfolios.
But that strategy doesn’t seem to followed by anyone on Wall Street these days. How often have you heard someone advocate buying a stock and holding it for a decade or longer? It could be that such advice simply isn’t newsworthy and therefore doesn’t get as much attention, but there could be a deeper reason why this strategy is no longer followed.
Modern Portfolio Theory
The standard investment model is Modern Portfolio Theory. It’s goal is to maximize returns based on an expected level of market risk. Investments are chosen along the “efficient frontier” – those that fall into the efficient part of the risk/return spectrum.
The assumption that investors are risk adverse is the basis for the theory. Therefore investors will take on more risk only if the potential reward increases. In this manner, a portfolio’s expected return can be calculated as the weighted sum of each individual assets expected return.
Take a hypothetical portfolio made up of four equally weighted stocks with differing returns:
(25% * 5%) + (25% * 12%) + (25% * 8%) + (25% * 20%) = 11.25%
Risk is ascertained by comparing standard deviation’s of each potential portfolio. If portfolio A had an expected return of 10% and a standard deviation of 8% while portfolio B had an expected return of 10% and standard deviation of 9% then investors would naturally choose A because it has the same reward but lower risk.
Another common investment strategy is known as sector rotation. The stock market has been observed following a relatively predictable pattern called the business cycle. As the economy goes through different phases of growth and contractions, different sectors of the economy outperform and under perform accordingly.
Investors who follow sector rotation may swap out stocks once a year or so as the economic environment changes aiming to reinvest in a sector that’s ideally positioned to outperform. Most mutual funds follow this type of investment strategy to some degree.
While more advanced investment strategies are preferred now, some part of the old “buy and hold” method still makes sense. Investment results are usually compared to a benchmark like the S&P 500 with some outperforming and others under performing. If an investor’s strategy is long term enough, they should be able to withstand market crashed because they have enough time to recoup those losses and then some.
If you had invested 30 years ago and held on through all the ups and downs since, you would currently have a gain of more than 844%. Some investors believe that it’s actually more efficient to simply ride the market over a long period of time without trying to pick and choose investments. In truth, the best result may come from a combination of the two theories
There’s one simple rule if you want to be a successful investor – buy low and sell high. It sounds simple enough, but it’s a lot harder to implement in practice. Fund managers constantly compete with the market in attempt to generate higher returns than the benchmark on which they are based – usually the S&P 500.
But in some circles, trying to beat the market is believed to be a futile exercise. Despite the huge market that exists for fund managers to attempt to beat indexes like the S&P 500, most fall short. In fact, if one were to have invested in the S&P 500 30 years ago and held it to today, they would up more than 844%.
With that in mind, one fund manager thought to create an investment that didn’t try to beat the market. Instead he designed the index fund – an investment vehicle that mimicked the performance of the S&P 500 following its ups and downs without any attempt at hedging risk.
Keeping a long term view
John C. Bogle was the founder of The Vanguard Group and designed the first index fund in 1975. His idea was to avoid charging investors large fees and concentrate on simply mimicking the S&P 500 instead of trying to beat it. In this way he could pass off those savings to clients and put up higher returns than most of his competitors.
It was an innovative way of looking at the market and focused on long term investment goals instead of gaming the market. His strategy held that it was better to hold on through bear markets and take full advantage of the following bull market instead of trying to avoid losses and missing out on the rebound.
John Bogle made a distinction between investment and speculation by maintaining that investors had a long term viewpoint while speculators focused on short term gains.
Bogle had four key points that needed to be considered when investing:
Don’t rebalance – Bogle held that rebalancing took away from the point of letting market fundamentals do their job.
Don’t invest overseas – Contrary to popular belief, Bogle said that investing in the US made more sense for investors instead of investing in unknown foreign companies.
Diversification means stocks and bonds – Bogle maintains that a portfolio of 60% stocks and 40% bonds is the ideal allocation for investors and should get them the best result.
Keep it simple – Like his index funds, Bogle believed investing was actually a rather simple matter of letting the market guide your investments without interference.
It’s important to note that Bogle’s investment strategy isn’t for everyone. Investors aren’t able to hedge their portfolios putting them at risk for short term fluctuations. Because of this, index investing should only be done by those who have a high risk tolerance and aren’t planning to withdraw their money within the next several years. Those near retirement should keep index fund exposure to a minimum and put the majority of their portfolio in more conservative assets.
There’s one word you’ll hear repeated in the investment world over and over again – diversification. It’s the idea that you shouldn’t hold all your eggs in one basket – in case it falls, you won’t break everything all at once. It’s a good idea and one that most investors try to follow.
The problem is that a lot of investors don’t really know what needs to be diversified. Obviously holding a single stock is more risky than holding a portfolio of ten stocks, but simply adding more to the equation isn’t the end of the process. There are several things you’ll want to mark off your checklist before you can consider yourself truly diversified.
The Diversification Checklist
When you’re designing your investment portfolio, you’ll want to make sure you don’t expose yourself to more risk than you need to. In other words, you don’t want to double up on a particular risk without being aware that you’re doing it. There are four main considerations to keep in mind when you’re choosing your investments.
The first thing you’ll want to diversify is the market sectors you’re invested in. There are numerous sub-sectors, but there are eight major economic sectors:
- Health Care
- Information Technology
When you’re setting up your portfolio, it’s a good rule of thumb to make sure you don’t have more than 20% into any one sector. That way if one sector becomes bearish, you aren’t overly exposed to downside risk.
Another important consideration is market capitalization – the overall size of the company. Small cap stocks tend to be more volatile than larger cap stocks while large cap stocks may be subject to geographic risks due to the size and breadth of their operations. By holding a variety of sizes, you’ll be able to take advantage of the growth commonly found in small cap stocks while also holding more stable large cap’s to balance out your portfolio.
The third part of diversification concerns geographic diversity. If you hold stocks that all operate in just the US, you run the risk of being affected by risks local to the US economy. Interest rates, currency values and political changes are all risks associated with geographic location. To minimize risk, you’ll want to spread out investments beyond the US to include other countries.
Finally, you’ll want to invest in more than type of asset class. If you hold only stocks, you’ll be exposed to risks that only affect the stock market. By branching out to include bonds, commodities and currencies, you’ll never be overly exposed
No matter how diversified you get though, you can’t eliminate all risks. Systemic risks can affect the entire financial marketplace. You can mitigate the loss by staying diversified, but you can still be adversely affected. But these events are hard to predict – take the financial crisis in 2008 that took Wall Street down in a matter of weeks. The best thing you can do is simply diversify your investments and keep a long term approach to your financial goals.