Stock Trading Blog
Unless you’ve been living under a rock, you’ve probably noticed that interest rates on the rise again. It’s been years since investors had to be concerned about interest rates when choosing investments, and some may be out of practice. But concerns are floating around on Wall Street about what rates might do next.
At first glance, higher rates might lead one to think that stocks will go down. After all, with higher rates comes higher interest payments on debt obligations – something essential for financing day-to-day business operations. But in practice, the markets don’t behave so predictably. In fact, it’s often the unseen tertiary effects of higher rates that impact stocks more so than the actual increase in rates themselves.
Catalysts to watch out for
There are a number of factors investors need to keep a close eye on in regards to where interest rates are heading. While the usual suspects like inflation and GDP will play the largest role in determining how far interest rates rise, there are other considerations at play.
A healthy economy is a balanced one. Inflation around 2%, unemployment near 3.5%, and a GDP that clearly sends a message of strength, but not so high as to induce fears of overheating. If these conditions are met, then interest rates themselves won’t really matter. But the markets rarely stay at such levels.
Inflation can be difficult to control or predict, and interest rates are the primary tool used to combat too-high or too-low inflation data. Inflation tends to hurt the value of the dollar and erode its value as a standard of currency. But rising interest rates to combat inflation can also mean higher demand for the dollar.
Looking ahead to the next twelve months, the value of the dollar will likely play one of the biggest tell-tale signs in determining whether or not higher rates are a good or bad thing. In the late 1970’s inflation began to rise, and interest rates along with it, until they hit well over double digits. But the subsequent boom of the 80’s led well into the decade after, with growth catching up to inflation and interest rates, balancing the economy out once again.
One important note investors should keep in mind is that interest rates by themselves don’t actually have much of an impact on the stock market as a whole. Certain industries like financials tend to benefit from higher rates, but the market seems to be able to absorb the impact of higher rates quite well.
It’s the speed at which interest rates rise that becomes a problem for companies to manage. As long as the Fed keeps interest rate increases at a reasonable pace, stocks shouldn’t see a noticeable dip in performance. In the long term, the actual level of interest rates won’t matter very much. While investors shouldn’t completely ignore what interest rates are doing, avoiding panicked decisions based on rate changes is key to maintaining profits in your portfolio.
Energy is a global need that will always be in demand in some way or another. It’s not a defensive sector like consumer staples or utilities though – energy is highly cyclical and tied to global economic supply and demand. As such, energy companies tend to undergo regular ups and downs along the business cycle.
The energy sector has largely been the realm of oil, gas, and coal, while green energy has been relegated to speculative investments fit for those with a high risk tolerance. A few years ago, green energy like solar was a daily headline, but since OPEC began cutting oil production and oil prices began to rise again, alternatives have fallen by the wayside.
But alternative energy isn’t gone – in fact it’s the only obvious long-term choice for global sustainability. With the coal industry gasping its last breath, green energy companies are poised to take over the power vacuum that coal will leave behind.
Predicting the future of energy
Since the advent of the industrial age, coal has been the primary energy source for every country. Even looking back at the last decade, coal has been vital for energy production. But the industry may have finally been supplanted by something else. Coal is responsible for less energy these days, and few new investments are being put into coal production. As a polluting fossil fuel, coal isn’t a popular form of energy either.
One of the reasons coal has previously been so popular is how cheap it is. In fact, the biggest argument against other energy sources like solar has been their reliance on government subsidies in order to make them competitive with coal. But technology has been improving for decades, and green energy isn’t the unrealistic cost/benefit outlier it used to be.
As of 2016, coal prices averaged around $0.05 cents/kWh, with natural gas hovering around $0.03 cents/kWh. But a commercial PV solar company beat that at $0.029 cents/kWh without subsidies – officially making solar the cheapest energy source.
As costs go down, the end of coal’s reign might seem obvious, especially considering the negative impact it has on the environment. But there’s another major obstacle for alternative energy to overcome: energy storage. Solar and wind power is largely dependent on weather conditions. A large amount of unobstructed sunlight is necessary for solar installations, which makes sense for places like Phoenix but becomes less reliable in places like Seattle. Wind power relies on relatively high and consistent sources of wind. Because alternative energy is so reliant on weather and geography, worldwide implementation is a challenge.
New advances in battery technology led by companies like Tesla Motors are making the alternative industry more competitive though. Within the next decade, coal might only have a small regional impact on the globe while solar and wind provide the majority of power.
Despite the current market focusing on oil prices, the future of energy is still in alternatives like solar and wind. Long-term investors should ignore the short-term news and focus on longer fundamentals. Companies like First Solar will likely grow larger and become increasingly important in the energy grid space.
There’s few things more exciting for an investor than being one of the first to own shares of a newly issued stock. Oftentimes these stocks can climb quickly, resulting in gains of 10%, 20%, 50% or more in a short amount of time – in a matter of weeks or even days. But they can also turn the other way and never again find themselves at the same value of their original issue price.
While finding a fair value for a stock that’s been trading for years is relatively easy to pinpoint, trying to analyze a stock with no trading history is more difficult. There’s no regression analysis that can be done and no historical earnings record to pour over. However, that doesn’t mean a fair valuation can’t be found – one just needs to know how to apply the metrics.
Finding a fair value for a new stock
An IPO (initial public offering) is what happens when a company sells shares of stock and becomes publicly traded. The company will then use that capital to invest in capital infrastructure or investment in order to grow the company.
But pricing an IPO requires a bit of thought in order to get an accurate number. It might seem arbitrary, but there’s some reasoning behind these prices. Getting an exact figure isn’t realistic, but one can at least understand how prices are derived.
Like all economics, supply and demand plays a role in pricing. In this case, it’s the market demand for certain industries. If tech is popular and a tech company goes public, it may be priced higher than a mining company going public.
Of course one of the best ways to get a good idea of value is to look at comparable companies. Comparing the new issue to its closest competitors will give you an idea of how much the stock should be trading for. If the industry average price-to-earnings ratio is 15, then you know that the new stock should have a price-to-earnings of around that figure.
Another important consideration is the company’s growth prospects. If growth is projected to be high, the IPO should reflect that growth, and vice versa. This can be hard to gauge, so a brief look at the industry’s current health and the company’s plan for growth is a must for due diligence.
Finally, investors need to be honest about the marketability of the stock itself. A company with a new product or ground-breaking business model will add value to the stock, whereas a company that’s just trying to accumulate more capital will attract less attention.
IPO’s are highly risky investments due to the uncertainty surrounding valuation. Investors should note that IPO’s are generally issued when market demand is high, not when demand is weak. This means IPO’s will naturally get a boost from current demand, which may not reflect their fundamental value. Caution should be exercised when considering adding an IPO to your investment portfolio.
President Trump recently announced a trade tariff imposed on steel and aluminum imports aimed primarily at China. It places a 25% tariff on steel and a 10% tariff on aluminum, which is designed to combat the US trade deficit and protect domestic steel and aluminum production.
However, steel companies immediately tanked following the announcement, while other nations voiced their concerns over the tariffs and the effect it will have on other industries and trade agreements. But there’s a bigger issue involved with tariffs that isn’t so obvious — and its effect could have lasting consequences on the US economy and stock market.
The role of the tariff
Tariffs are designed to protect domestic industries which may be suffering due to a foreign competitor. In theory, if competition is strong enough, it could impact the domestic workforce and lead to layoffs and increased unemployment. Tariffs are also used as a type of trade weapon. For example, if a country unfairly taxes or places a tariff on one country’s exported goods, they might turn around and place a retaliatory tariff on that country’s goods.
One of the issues Trump brought up when signing the steel and aluminum tariff into law was the trade deficit of the US. As of 2017, the total US trade deficit stood at $566 billion. It imported around $2.89 trillion in goods and only exported $2.33 trillion. But this deficit is one of the most misunderstood economic terms.
A trade deficit is not a real deficit in terms of money. The US doesn’t actually lose money. It just means the US imports more goods than it exports. But part of the reason actually has to do with the value of the US dollar. Because the dollar is used as a global standard and has been slowly growing stronger over the past several years, it makes US manufactured goods more expensive relative to other countries’ currencies.
A strong domestic currency goes hand in hand with a weaker manufacturing base and export industry. Some countries thrive with the opposite situation – having a weak domestic currency but relying heavily on a strong export industry and manufacturing base.
Unfortunately, a tariff artificially alters this natural supply and demand in the global marketplace. As a result, US manufacturers may be better protected, but the costs for steel and aluminum will increase. And that price increase will likely get passed along to the consumer.
At face value, tariffs aren’t generally perceived as a positive thing. Based on the stock market’s reaction to the latest trade tariff, investors are likely finding themselves agreeing with that sentiment. While Trump’s tariff was designed to help the US steel and aluminum industry, it might end up doing more harm than good, with higher prices getting passed along to other goods and services and ultimately costing the US economy more than simply allowing the trade deficit to continue.
Investors are constantly searching for ways to predict market behavior. They pour over any and all evidence looking for patterns and indicators that might help them spot opportunities or avoid costly mistakes. Some of these correlations are noted in lagging, current, or future economic indicators such as employment levels, GDP data, retail sales, and others. But there are few indicators that investors can look at to predict future crashes with any real degree of accuracy.
However, there is one oft-ignored piece of data that investors can use as a potential warning sign – the margin debt level. It tells investors how much leverage is currently being applied in the markets by calculating how much debt is being used in brokerage accounts. The more leverage that investors use, the riskier the position. If the market begins to decline, investors will scramble to sell as fast as possible to reduce the total amount of loss, often creating a panic resulting in large corrections or even a full recession.
Margin levels and market crashes
There’s a historical correlation between high margin debt levels and market crashes. One of the most famous is the the crash leading up to the Great Depression. Margin debt levels during the late 1920’s were largely blamed for the crash, with investors left exposed and struggling to cover their losses but unable to do so. During that time, margin requirements were as low as 10%, meaning investors could leverage up to $9 for every $1 invested. Contrast that with today’s margin requirements which average between 30% and 40%.
According to the NYSE, margin levels as of November 2017 are at record highs, with margin debt hitting more than $580 billion. If you track the performance of the S&P 500 and margin debt levels, you’ll see a strong positive correlation, which tells us that margin levels and stock performance seem to go together. This increased leverage helps accelerate buying on the way up and selling on the way down.
The real issue with higher margins is that as margin levels increase, so too must stock performances, in order to justify paying a greater amount of interest on loans. As debt grows, unrealistic market expectations and a disconnect from value begins to form, leading to dangerously volatile markets.
Much like stock market performance and P/E ratios, margin levels can remain high for years before actually correcting lower. While stock market peaks and high margin debt do go hand-in-hand, this isn’t a very efficient indicator. The market often continues to break through to new highs even during periods of high valuations or high debt levels, leaving investors who were on the sidelines missing out on huge gains.
The best way to handle increasing debt is simply to limit how much you apply to the markets and ensure that your positions are hedged, in case the worst case scenario happens. That way you still take advantage of all the upside opportunities without taking on excess risks to do so.
Investors generally think of options as a tool to boost profits by speculating on whether a stock will move higher or lower. And while options can be used in that manner, they can also be used to hedge a portfolio and actually reduce risk.
Options come in two forms: calls and puts. A call gives investors the right, but not the obligation to purchase 100 shares of stock, while a put gives investors the right, but not the obligation to sell 100 shares of stock. You can also sell calls and puts, which mean you have the obligation to sell or buy at a specific price, should the option be exercised, while keeping any profits from the upfront sale.
Used separately or in combination, these four option types can keep your portfolio’s returns as high as possible, while keeping risk as low as possible.
Simple option strategies you can employ to reduce risk
One of the most commonly used option strategies is also one of the best risk-reduction tools available to everyday investors – the covered call. A covered call is simply when an investor sells a call, meaning they have the obligation to sell 100 shares of stock at a specific price should the stock rise to that price point, while simultaneously holding 100 shares of the same stock.
For example, let’s say you own 100 shares of XYZ at $50 per share. You decide to reduce your risk of holding the stock by selling call at $55 per share and pocket the profits on the sale of $200. If the stock stays below $55 per share, nothing happens – the call expires worthless and you keep the $200. If the stock climbs above $55 per share, you must sell XYZ stock. That means you won’t be able to take advantage of any upside beyond that price, but you still profit $700 – $500 in gains from the stock rising from $50 to $55 and $200 from selling the call.
Another low risk strategy aimed at taking advantage of possible opportunities is selling a naked put. In this strategy, you sell a put – once again profiting up front – while taking on the obligation to buy 100 shares of a stock should it fall to a predetermined price. Using this strategy allows investors to speculate on possible value stocks without having to buy the stock outright and miss out on other potential opportunities.
Taking from our previous example, let’s say you decide XYZ stock is a good buy if it falls to $45 per share, but you don’t want to buy 100 shares at its current price. You sell a naked put for $200 at $45 per share and pocket the $200, which is kept regardless of whether the option is exercised or not. If the stock does nothing, you keep the profit and the option expires worthless. However, if the stock does drop to $45 or below, you’ll be obligated to purchase 100 shares at $45 – even if the stock falls below that level. The upside is that if you find out a stock is worth purchasing at that value, then it’s still a good buy, even if you would’ve otherwise purchased it cheaper.
By incorporating options into your investment portfolio, you open the door to a plethora of new trading strategies and risk-reducing investments. Combination strategies like the covered call can help you reduce risk and boost returns in stocks that don’t vary in price quickly while naked puts allow you to speculate on stocks without immediately taking on the risk of buying the stock. Options can be used to both boost returns and manage risk even in conservative portfolios.
Investing when inflation is a concern usually leads to a more volatile marketplace. Not only is inflation a pernicious profit-erasing force, it’s also highly misunderstood by investors. Inflation and uncertainty seem to go hand-in-hand, but investors who understand what inflation’s real impact is could find themselves taking advantage of big opportunities.
On the surface, inflation is a relatively easy concept to understand. It dilutes the value of the dollar over time, so purchasing power goes down as a result. The only real way to combat inflation is to earn a return in excess of the rate of inflation. There are several ways to accomplish this, and it all depends on how high the inflation is and how fast it’s rising.
Inflation’s impact on the stock market is somewhat mixed. One of the first things inflation does is cause interest rates to rise, which in turn negatively impacts bond prices. Normally bond prices and stock prices are positively correlated, so one might think that when bond prices go down, stocks should as well. But in practice, this relationship doesn’t always work.
Historically, inflation seems to have no obvious effect on stocks. Companies seem to be able to absorb the impact of higher rates quite well and don’t suffer any long term damages, although some short-term volatility can happen. This non-impact seems counter-intuitive, given that inflation and higher interest rates also mean higher rates on business loans and other financing operations, which slash total earnings.
However, inflation also means that the economy is strong. A healthy, growing economy, even with rising inflation, can often be more beneficial to stocks than the negative impact higher rates have. A steady increase in inflation can actually be a good thing for stocks, but a quick rise can be devastating.
If inflation rises too quickly, companies aren’t able to adapt as well and earnings suffer more than expected. Purchasing power rapidly diminishes and the danger of stagflation – an environment that combines high inflation with low growth – becomes more likely. This can lead to a long-lasting detrimental effect on an economy, such as Japan’s economy during the late 80’s and all through the 90’s.
One of the most common hedges investors turn to when inflation is rising is gold. Because the precious metal isn’t tied to any currency, it tends to hold its value quite well, regardless of inflation. But gold only works as a hedge if the rate of inflation is higher than the rate of return investors can earn elsewhere. If interest rates are able to keep up with inflation, then gold loses its appeal, since investors can easily keep up with relatively risk-free assets like treasuries. It’s only when interest rates aren’t able to keep pace that gold’s value really shines through.
Diversification is always a good idea for investors, but during periods of high inflation, a diverse portfolio could be the best protection you have. The careful dance between inflation, stock returns, interest rates and commodity values means casting a wide net ensures you’re taking on as little risk as possible. Gold is the best choice when inflation is rising faster than interest rates can keep up with, otherwise a diverse stock portfolio is the best way to handle an inflationary market.
There’s no worse feeling than checking your portfolio and discovering the market is in the midst of a panicked sell-off. Watching a stock (or many stocks) you own drop further and further with no discernible end in sight can be a heart-wrenching experience. But, like all things, sell-offs are only temporary.
While broad market selling can be disconcerting for any investor, successful investors understand how to navigate the rapids and avoid making costly mistakes. Your first reaction might be to sell your holdings as soon as possible to avoid taking even greater losses, but history has demonstrated that that might be the worst possible decision you can make at that time. While selling a stock might be necessary, there are better methods for dealing with turbulent markets.
Noted CNBC personality Jim Cramer has a saying about volatile markets, “No one ever made a dime by panicking.” Other investors have a similar take on the subject, like Warren Buffett, who says when everyone else is selling, that’s when you want to be buying. But you don’t have to be a famed investor in order to take advantage of sell-offs – anyone can learn how to handle these crises and come out the other end with minimal losses.
The first thing you need to do when markets are in a free-fall is figure out why the sell-off is happening. You can’t make an educated decision about what to buy or sell if you don’t know why the markets are behaving erratically. Often, the markets are falling for reasons that don’t fundamentally affect the stocks you hold in your portfolio.
Markets often undergo regular corrections that aren’t tied to a bigger problem other than the fact that stocks are overheated. Other times, computerized trading causes temporary “flash crashes,” which don’t mean the stocks you hold are flawed. Even when a macroeconomic event causes the market to reverse course, not every sector of the economy will be impacted. For example, if the global economy begins to slow down and stocks began to retreat, other sectors like consumer discretionary, pharmaceuticals and utilities will actually outperform.
Many times, when a sell-off happens, it only makes fundamentally sound stocks cheaper for investors who know buying during a panic can be an opportunity. Investors who stick to their long term strategies will be able to weather the storm and turn panic into profit.
Understanding that corrections are a natural part of the stock market is essential in order to stay the course. The most important thing investors need to takeaway from a sell-off is that bear markets are only temporary, no matter how aggressive they are. Staying calm and making decisions based on fundamental analysis, not technical selling activity, is the best way to ensure you keep stocks that shouldn’t be sold and eliminate only those stocks that are fundamentally flawed.
If you’ve been paying any attention to the markets lately, you’ll have noticed that volatility is back. The major indexes saw record single day drops only to recover just days later. While computerized trading was part of the problem, there was still a building volatility caused by an rapid rise in bond yields that sent the markets plummeting lower.
Most investors understand the inverse relationship bonds and yields have, but the relationship between stocks and yields is less clear. The mixed data has some investors confused about how the two actually interact, but after last week, it’s clear that investors will need to pay attention to rates when making investment decisions.
The relationship between yields and stock prices
When bond prices go down, yields go up and vice versa. The same relationship can be said of stocks and yields too, although the correlation isn’t as strong. Historically, stocks trend upwards, albeit with short term corrections and bear markets thrown in the mix. The question of when and how yields play a role requires closer examination to get an answer.
It’s important to note that the actual value of bond yields is irrelevant to stocks. The market can adapt to any level of interest rates and yields – it’s the rate of change that matters. Too fast of a rise doesn’t give companies enough time to hedge their bets and make appropriate plans regarding business loans and other operational expenses.
Over time, even if interest rates and yields trend higher, stocks will continue to march forward. A good example of this was the performance of the markets during the 1980’s. Inflation, interest rates, and yields were above historical averages, yet the stock market wasn’t adversely affected. In fact, it performed quite well during this time – the Dow Jones nearly doubled in value.
The last thing to consider is how inflation enters into the equation. Generally speaking, if yields and interest rates are rising, it’s because inflation is also rising. The difference between the rate of inflation and interest rates is where the real influence in stocks occurs. If interest rates are higher, there’s no discernible impact on stocks, but if inflation is higher then corporate earnings get squeezed and stocks fall.
One thing that investors will want to keep a close eye on is dividend paying stocks. While the markets in general can absorb higher rates, dividend stocks will have a harder time. When yields on less risky assets like bonds go up, dividend stocks begin to lose their appeal. After all, why take on more risk if you aren’t reaping a higher reward?
In practice, getting the right balance between yields, inflation and stock values is a constant challenge that falls to the Fed to deal with. That’s why the market pays close attention to what the Fed has to say about rates and future plans. Investors need to understand how these factors play a role in how the markets perform in order to be successful over the long term.
The stock market has been anything but predictable over the past week, with large drops and gains in a single trading day. Volatility is rising and investors are scrambling for solid ground. Safe haven assets are usually one of the first things investors flock to, along with dividend-paying stocks.
But while most stocks tend to be positively correlated with the broader indexes, others are inversely correlated with the markets. When the markets go down, these stocks will actually go up and vice versa. While holding a portfolio of these types of stocks isn’t recommended, having one in the mix when volatility spikes could be a good way of hedging your bets and avoiding huge losses should the markets turn bearish.
It’s all about the beta
One of the most common figures investors look at when picking stocks is the beta. This important piece of data is a measurement of volatility compared to the broader market portfolio. In other words, it tells investors how volatile a stock is compared to an index such as the S&P 500.
Beta is calculated using regression analysis to determine how much the stock swings compared to changes in the broader indexes. More accurately, beta is arrived at by dividing the covariance of the stock’s returns and the benchmark’s returns by the benchmark’s variance over time. But investors really don’t have to worry about coming up with this figure on their own – the beta is easily found on any basic stock screener.
A beta of 1 means that the underlying stock will move in line with the broader index. If the index goes up 1 percent, the stock should go up 1 percent, as well. A beta higher than 1 indicates a greater swing in the stock’s return compared to the market and a beta of less than 1 indicates a lesser swing. By this logic then, a beta with a negative number means the stock will actually perform inversely with the broader index.
Stock’s with a negative beta aren’t terribly uncommon. For investors looking for one, sectors that aren’t cyclical such as pharmaceuticals and utilities usually have at least one stock with a negative beta. Other sectors that may contain a stock with a negative beta are consumer discretionary and even mining industries.
Certain sectors aren’t correlated with the economy or the stock market at all. Pharmaceuticals and biotech companies, for example, perform equally well whether the economy is booming or not because the demand for drug products isn’t correlated with economic strength. But because they aren’t correlated with the markets, investing in one with a negative beta because you want to protect your portfolio against corrections and high volatility might not be the best idea. The stock may behave seemingly randomly, making it difficult to work with as a hedge play.
There’s no lack of coverage for investors who like to take their investment portfolio into their own hands. Carefully picking individual stocks and designing a custom, self-built portfolio gives investors a great sense of accomplishment and satisfaction. But unless you know what you’re doing, your portfolio may end up doing more harm than good.
Diversification is touted as the number one rule when it comes to investing and portfolio design is no exception. But diversification can be harder to attain than investors sometimes think. For example, an investor might add Caterpillar to their portfolio without realizing that it does a lot of business overseas, making it subject to foreign exchange risks.
Many investors are beginning to doubt the traditional buy-and-hold model of stock selection in favor of simply buying an index investment and riding up the volatility. In the past 90 years, the S&P 500 has registered a return of 9.8 percent, while most investor’s struggle to maintain a return of more than 8 percent. The case against stock picking is getting stronger.
The dangers of great investors
Many investors idolize certain other investors who have historically outperformed the stock market, like Warren Buffet, Ray Dalio and others. But there’s a problem in the logic that “because they did it, so can I.” Like anything with a large enough sample size, there will inevitably be outliers – those who under-perform relative to the market, and those who outperform compared to the market.
Just because there’s a fund manager who has consistently beat the S&P 500 by 10 percent or more over the past decade, doesn’t necessarily mean they have a secret investment formula. In fact, odds are there will be at least one fund manager who has consistently higher-than-average returns.
This skewed logic means everyday investors believe they too can beat the markets by investing like other great names in the industry. But past performance isn’t indicative of future performance. What worked yesterday may not work tomorrow. Considering the time commitment and difficulty of building an investment portfolio and monitoring it in the hopes of beating the market, many are ready to simply let the market decide instead.
Investing in an index like the S&P 500 over a long time frame, like 30 years or so, may be a better strategy for many investors. As long as one can handle the inherent volatility that comes with investing in indexes, it could be the ideal way to invest for someone who has a longer time frame to retirement. However, when investors have 5 years or less until retirement, stock picking may be a better option, since they might not be able to fully recover from catastrophic losses in time.
Investors don’t have to look at designing an investment portfolio as simply a black and white endeavor. That is, you don’t have to either stock pick or invest in an index – you can always mix the two ideas. Investing part of your portfolio in a general index fund and holding it over the long term while also keeping a diversified portfolio of stocks (at least 10, and no more than 25) is a good way to keep all your options open.
Unless you’ve been hiding under a rock, chances are you’ve heard of Bitcoin. It’s the latest investment darling for many – a crypto-currency that can be used to verify fund transfers without the regulation of a central bank. Bitcoin started off the year as one of the hottest new investments, soaring to nearly $20,000 before falling fast to it’s current price of around $8,000.
If the extreme volatility makes you concerned about its effectiveness as an investment, you’re not alone. Many such as JP Morgan’s CEO Jamie Dimon have criticized the crypto-currency as nothing more than a scam or a bubble. As such, there are those who have decided the best policy is to simply avoid Bitcoin investments. Unfortunately, that may not be enough to fully insulate your portfolio from Bitcoin’s effect.
Bitcoin’s rapid popularity has ushered in new investment products geared toward helping investors gain access to the crypto-currency without having to directly own it.
The added volatility of Bitcoin could translate into larger movements in your own portfolio. The creation of Bitcoin-based assets like Bitcoin futures could lead to more diverse products, including crypto-currency mutual funds or Bitcoin ETFs.
Since volatility is so high in Bitcoin and other crypto-currencies, investors could see huge swings in value in a single day. If that happens, investors might have to cover those losses by freeing up cash through equity sales. Once investors begin to sell equities to make up for the losses in crypto-currencies, the stock market could start seeing more volatility, as well.
Another major risk of Bitcoin and other crypto-currencies is the companies that accept Bitcoin as a method of payment, like Overstock.com. Rapid declines in value could easily wipe out gains with products being sold for essentially pennies on the dollar. That will impact earnings and cause the stock to fall as a result. Even investors who are actively avoiding crypto-currencies could find themselves victims through the stocks they own, if those stocks deal in crypto-currencies.
Banking companies may also find themselves affected by Bitcoin. Because crypto-currencies aren’t regulated, they can disrupt economic models, creating ineffective models for the money supply and economic activity. As crypto-currencies become more entrenched in the global economy, banks may find themselves indirectly invested in these currencies, as well.
While added volatility might seem like a downside to Bitcoin, it could actually be a benefit for savvy investors. Because drops might not be related to a fundamental reason in equities, but rather as a result of Bitcoin’s losses impacting other areas of the market, stocks could drop below their intrinsic value, creating opportunities for investors. Investors shouldn’t completely ignore the impact Bitcoin is having, regardless of their personal belief in the product.
If you’re looking for advice on portfolio strategies, you don’t have to look far. There are recommendations for virtually every type of asset available, which makes it sound like your portfolio needs to look like something only a hedge fund manager could run. While portfolio design can get complicated, it doesn’t have to be. There are lots of easy options you can emulate, no matter how much you have to invest.
Before you put together a portfolio though, you’ll need to first identify what your investment goals are, what your timeline is and how much risk you’re willing to take on. For our purposes, we’re going to assume you have a long time horizon and can afford to take on a little more risk. If that doesn’t sound quite like you, just take our designs and modify them a little to reflect a more conservative approach.
Portfolio Design 101:
In this section we’re going to look at three different levels of investment design, ranging from under $10,000 to more than $250,000.
Designing a portfolio with $10,000 or less
If you’re just starting out, you probably don’t have a lot of cash to throw around just yet. But don’t worry, that doesn’t mean there isn’t a strategy to help you get there. At this level, trying to trade stocks is probably going to be too risky. Instead, concentrate on finding one or two no-load mutual funds to help build your investment base. A fund that specializes in large cap growth is usually a must-have pick leaving you the option of something else to round it out – just make sure you don’t choose something too restrictive like a sector fund.
Designing a portfolio between $10,000 and $100,000
Once you finally hit the $10,000 threshold, you can start to think about trading stocks individually in a brokerage account. You may choose to sell stock mutual funds and invest directly yourself, or you can choose to double up and keep both. You might even mix up the two – keeping a portfolio of domestic stocks in your brokerage, while trusting international and bond investments to mutual funds. If you’re feeling confident about your trading ability, you can even pick up options as part of your investment strategy.
Designing a portfolio with $100,000 or more
Once you accumulate more than $100,000 in your investment portfolio, diversification becomes more important than ever. Keeping assets spread out not just in terms of stock sectors, but account types will ensure a smooth running portfolio. Having a brokerage account, 401K, IRA and an emergency savings account is a great basic set-up that will keep you on track toward retirement.
Keep in mind that these suggestions are only that – suggestions. There’s nothing wrong with changing them to suit your specific needs or desires. For example, if it’s important to you to keep a part of your portfolio in gold, then always having a small 5 percent gold portfolio along with everything else is perfectly acceptable.
Every investor that’s traded stocks for a while knows the feeling of watching a stock suddenly and unexpectedly drop overnight. One minute, you’re looking at solid fundamentals and making a case for why the stock could move higher and, the next, you’re watching investors dump shares in a panic while the stock drops to gut-wrenching levels.
There’s good news though – oftentimes these seemingly unexpected events can often be predicted by following up on certain tell-tale red flags. You can’t just buy-hold-and-ignore your stock picks. It’s important not only to pay attention to recent news and events, but be familiar with how to read financial statements. Most of the time, this is where you’ll find hidden red flags that let you know a stock should be avoided.
Watch for the signs
There are a number of things that can come up in a stock that should immediately alert investors that something is going terribly wrong. While many can be found in financial statements, other things, like unexpected events, need to be taken into consideration. Any reports of accounting manipulation or mismanagement should be easy red flags, but usually the signs are available beforehand for those who know what to look for.
One of the easiest red flags to spot is companies that have several consecutive earnings misses. Missing a quarter once in a while is normal and can be attributed to any number of things, like mergers, acquisitions and more. But missing several quarters in a row tells you that something is wrong with the company and it’s not being corrected.
Another more subtle red flag is rising account receivables or inventories. This trend can be a sign of financial manipulation – a reason for immediate selling – or that something is wrong with sales. Consumer tastes may be changing and the company isn’t keeping pace or the product isn’t in high demand anymore, leading to an increase in inventories. If inventory is growing faster than sales, it’s time to get out.
Finally, one-time line items should be viewed skeptically. These items might read as restructuring costs, which can mean the company is aware of its own financial difficulties and is trying to delay revealing it. Many times, a history of one-time charges is actually a recurring trend and investors could be holding a ticking time bomb.
While these red flags almost always spell disaster for a stock, it doesn’t mean there aren’t other hidden dangers masquerading as something innocent. Even the most experienced investors and analysts can be fooled. Staying diversified is the best defense against uncertainty. Even if the worst happens to a stock, if it’s only a small part of a larger portfolio, you can escape catastrophic losses.
As an investor, there’s nothing more exciting than watching an asset you own climb higher and higher. There’s a sense of confidence in your decision-making and feeling of invulnerability when it defies expectations and breaks through to new highs on a near-daily basis. But, as with most things, if it seems too good to be true, it probably is.
While markets and assets can break out and hit new highs due to positive economic fundamentals or catalysts, investors should think critically when an asset grows beyond its reasonable limits. It’s not always easy to spot these false winners, especially when everyone around you is buying. But knowing what to look for could save you from making a big mistake in the long run.
Key signs of a bubble forming
There are certain characteristics of bubbles that investors can look for to avoid falling into the trap. Most investors are familiar with the tulip craze – the first known bubble that happened in the Dutch Republic back in the early 1600’s. Investors were buying tulip bulbs en masse, sending valuations sky high, despite the fact that there was no underlying fundamental support for the price people were paying for them.
One of the key characteristics of a potential bubble is its uncertainty. Investors might have a hard time figuring out exactly what the potential upside is or what the real intrinsic value of the asset actually is. There’s usually some degree of vague valuations and seemingly arbitrary estimates. Analysts might cite supply and demand forces for example, but can’t pinpoint exactly what the forces translate to in monetary terms.
Another big danger that generally goes hand in hand with bubbles is the use of leverage. When investors can put down just a fraction of what’s needed to control a much larger share ownership, the risks increase exponentially. Interestingly, margin levels in the stock market are often used as predictors of an upcoming market crash or bearish reversal.
Finally, investors can usually see a bubble forming when the majority keep buying an asset and ignore any and all warnings to the contrary. This irrational behavior is seen is every bubble, as investors feel like an asset will never drop because it’s so popular and/or keeps going higher. But when everyone is buying, smart investors know it’s time to sell.
It may be tempting to try to time a bubble as an investor – buy knowing its overvalued, but selling before the bubble collapses – but it’s best to simply stay away. You could get lucky and make a quick profit, but there’s a high chance you could get burned instead and lose more than you can afford to. The best advice for investors who spot a potential bubble is to steer clear and stick with assets that have clear fundamentals for going higher.