In this guide we will lay out the basics of why you want to invest your money based on the value that you get from your investment and why an approach like Warren Buffet’s almost always outperform in the long run. We will talk about value investing in the broad sense as well as the traps you want to avoid. We will not get too deep into technicalities like return on equity and working capital although we will briefly mention them. We will especially talk about how you as an investor can manage your money for the better and how you can build your nest egg – slowly.
(Note: If you would like to know more about the financials of Tesla Motors please read this article.)
To invest your money is both easy and hard at the same time. If you just want to invest somewhere you can do that with the click of a button, but if you want to invest wisely it’s a little bit harder. To invest wisely you have to go through the financial statements that are found in the quarterly or annual reports of the companies that you are interested in. When that is done, you need a framework for telling if the stock is worth buying or not.
When we first started investing many years ago and then sold our holdings at a profit, we thought that we ruled the world. There was nothing stopping us from making a killing in the stock market. We bought shares like there was no tomorrow. The only question that was relevant to us was how much money we could possibly deploy for our next speculation.
But then something happened. The market fell.
When it did there was no bottom to our losses. Everything that we had gained during the previous years was now lost and then some.
Wise from our experiences we laid out another strategy, one that was based on value instead of spectacular growth. One where a steady cash flow was more important than spikes in earnings.
This is why we write this guide. To prevent others from making our mistakes and to teach them how to be prudent with their hard earned money. This is especially true if you like sleeping well at night without any financial worries.
We caution you to take a more prudent approach with your cash and do your due diligence before you buy or sell any security. Never buy securities without asking for advice from a qualified adviser. You should always ask yourself if the investment decision you are about to make is justified by the fundamentals. If it is then go ahead, if it’s not then wait until it is.
There are many examples of occasions where the market has been severely wrong. We see them almost every day. These occasions ultimately create good buying and selling points for every shrewd investor out there. But you have to remember being patient.
Here we are going to talk about allocating your portfolio. What proportion of stocks to bonds you should keep and how to deal with the urge to speculate.
There is nothing giving you more thrill than seeing the ball fall at the right number when you’re at roulette table at the casino. This feeling of exhilaration is very strong and also very addictive. But it deceives you. The next time you will not be that lucky and when looking at it objectively, you have the odds stacked against you. After all, that is how the casinos around the world are making their money, by making sure that they will win more times than they will lose.
The same is true for investing. You can see a speculative stock go up two or three times in price over a short period of time. But to believe that you are consistently able to time the market so that you always buy low and sell high is just unrealistic. Sure you may be able to have a few quick wins, but they will almost invariably be accompanied with losses that exceed your gains.
You therefore have to have a system in place that prevents you from speculating. Keep a proportion of your portfolio – the smaller the better – aside for your speculation, but never mix money you gain from speculation with money for investment. What we suggest is keeping a proportion of 10 per cent or less aside for speculation. That way you can participate in the excitement, but you will never let it overtake your life.
Furthermore, there is a misconception out in the public that says that investing is like betting in the casino. We would like take a different view. Where betting is ultimately dependent on luck, the same cannot be said about investment. Investing is about putting money to work and getting a reasonable reward in return.
The safer this return is the better.
Regarding portfolio allocation it depends on the where in the market we are. In normal times the prices of bonds are the opposite of the prices of stocks. Therefore you should try to keep an equal balance between the two.
However, at times the prices of stocks are depressed while the prices of bonds are high. In such a situation it makes sense to increase the stock proportion in your portfolio. We suggest that you never exceed 90 per cent stocks when they are undervalued and that you don’t exceed 90 per cent bonds when stocks are overvalued. That way you will keep an even balance in your portfolio at all times.
Ultimately it depends on how high corporate- and treasury bond yields are compared to the average yield on stocks. As we write this interest rates are chillingly low. In fact they are so low that treasury bonds do not correspond to our of a good investment. Instead you have to look into the world of investment grade corporate bonds. These are rated by rating agencies according to how likely they are to continue paying out their return. An investment grade bond has at least a rating of BBB.
Here we will discuss what to do when the market plummets and the need to resist any urge to sell good investments just because the market has been going down. Similarly, we will also discuss the psychological urge to buy more stock when prices have been going up.
When the market goes up it is very easy to buy more securities in the hope that they will continue to go up. That may very well happen for a while. But then reality sets in and the security that you bought for dear money will sense gravity and eventually fall to the ground.
The lesson learned over and over again is that there is always a fair price of the securities that you buy. This means that it is wrong to look at a rising price in the market as a vindication of having made the correct decisions regarding a security. If anything, a rising price signify that what you are about to buy has become more expensive and that you will get less value out of it in the long run.
In the same way, a falling price signify a cheaper security and gives you the opportunity to buy more of the stock than before. The only reason to buy or sell any security is if the fundamentals of that security have changed. If they have then, by all means, go ahead and buy or sell. If the fundamental situation does not change then you are better off holding onto your securities.
The financial media is to blame for much of the hype that has surrounded the stock market in recent years. Often media don’t reflect that investing in essence is a rather boring activity. This is especially true when we are talking about value stocks.
The average investor would actually be better off had the securities in his or her portfolio been unquoted. That way he or she would be sure not to fall into the mass hunt that has proliferated in the financial media. The media often portray the business of investing as a kind of safari where it is all about killing big animals.
The true business of investing is very different. It is not a question about winning against the pros, it is about beating yourself in your own game. If you take a long term view and buy stock at a regular basis and reinvest your dividends in a disciplined manner, you are almost certain to succeed.
That is not to say that you should forget about the ups and downs of the stock market all together. If you see that your stock plummets, you need to sit down and harshly once again check the fundamentals. Are the steady earnings constant or are they slipping? Has the company taken on more debt? Does it finance its dividends with borrowed money? If it does then the market is right and you have to sell, but if it isn’t then you should take advantage of the low prices and buy more stock.
This is why we recommend holding on to your stocks for at least 5 years. That way with the dividends reinvested you should see a real accretion of your wealth during this period.
To sum this up: the more the market falls, the more value you will get out of your securities. Do not fall into the trap of selling just because everybody else is selling.
Here we will discuss the merits of mutual funds and index funds and how they can help the lay investor to grow his/her wealth.
One of the most common ways of investing is to leave the hassle of finding investment-worthy stocks to others. There were more than nine thousand different mutual funds in the US alone in 2014. As an aggregate they are almost perfect, but only just. Their biggest drawback is that they charge a hefty fee for the sake of looking after your money. You can pay anywhere from 0.25 percent all the way up 1.5 percent depending on what type of mutual fund it is.
This brings us to another aspect of stock picking which is that past performance almost never is a good guide for future rewards. A mutual fund may start out small, but inevitably, as the fund grows in size, it will attract more money. When the fund attracts more money it has a set of bad decisions to make:
Thus, there simply are no good options for the money managers who manage big accounts. So what they tend to do is that they indulge in the process of “herding” which means that most mutual funds buy the same kinds of stocks and at similar proportions as everyone else.
Another thing that may affect the long-term performance of the fund is that a top stock picking manager may be recruited to a competing fund. Good managers with good track records are almost always sought after, which is another reason that these are paid so well.
For the lay investor there is another possibility which is to buy an index fund. The upside to these is that management fees are low – it is not very complicated to buy equal amounts of the S&P 500, for instance. Another positive is that the fund will always follow the index – no worse or no better – which is good because it is fiendishly difficult to beat the index over time. Another plus is that you will always receive the aggregate dividend yield that the index pays. For somebody who is not very interested in stocks this is an almost ideal solution.
The downside is of course that they are boring. You will be able to look at the performance of the index to tell yourself how much money you have made recently. There will be no excitement when a stock finally takes off and you see that its price increases by the day. Likewise you will probably not see your stocks go down too much in value either. If you just want to participate in the stock market without doing the extra work it takes to analyze individual stocks, this may be the solution for you. As we shall see, the work of a financial analyst is very different.
In this chapter we will look into what determines the value of a security. How the operational cash flow, the assets on the balance sheet and the debt ultimately decides what kind of return you will get from your security.
If you have ever seen an annual report you will see that it contains a lot of information. If it’s a retail company you will likely find sales volumes in different regions of the company, if it’s a mining company there are many pages about reserves and resources and if it is a technology company there are probably discussions about their recent technological advances.
But what we are interested in as investors are the financial statements. You will see that they are divided into three parts:
The income statement is about how much money the company has made in the period (1) and how much money it has paid in taxes (2). When you subtract (2) from (1) you end up with the Earnings that the company has made in the period.
This Earnings number is then divided by the total number of shares to find the Earnings per share during the reporting period.
When you then look at the current price of the stock and divide it with the Earnings per share, you will get the price to earnings ratio or the P/E ratio. If you on the other hand are using last year’s P/E number you are in effect calculating the trailing P/E ratio and similarly if you are using an estimate of analysts expectations of next year’s earnings, you are determining the forward P/E ratio.
What this all boils down to is that it tells you something about about how much profits a share in the company will buy. A common share in a company is nothing but a stake in the profits.
There is a problem with P/E ratio however and that is that the number does not take into account the earnings over time. To do that we have to calculate an average over the past years’ earnings and adjust for inflation. Then we can use this average number just as we did when we calculated the real P/E-ratio. This is called Cyclically Adjusted Price to Earnings (CAPE) ratio and was introduced by the economist Robert Shiller in his book Irrational Exuberance from 2000.
The balance sheet is where the company is stating all its belongings and debts. The belongings are called Assets and are further divided into Current- and Non-current assets where the current assets are assets that can be sold over the next 12 months and the non-current assets cannot. On the one hand you have the assets (a) and on another you have the liabilities (b). Then you subtract the liabilities from the assets to end up with the Shareholder’s equity which is precisely defined as the Total assets minus the Total liabilities.
Then we prefer to divide the short-term liabilities, the long-term liabilities and the total liabilities with the shareholders equity to figure out if the debt is sustainable or not. If it is not then the company runs the risk of seeing the debt eat in to their earnings due to amortization. This will of course create a vicious circle.
When is the debt too much?
The debt levels vary significantly across different sectors. Some types of businesses are very capital intense and therefore highly leveraged (or running on borrowed money). Other businesses don’t need so much money, but can rather start to churn out money with a laptop computer from home. So it’s difficult to make a definitive statement about much debt is too much. For a mining company or a shipping company which are very capital intensive may see debt levels (i.e. total liabilities to shareholders’ equity) of more that two whereas a startup tech company may have very low debt levels.
The cash flow statement is where the cash that has goes in and goes out of the company during the reporting period is reported. The statement is divided into three different categories. These are usually divided into cash flow from Operational activities, Investment activities and Financing activities. The free cash flow is the money that the company can use for discretionary purposes, i.e. paying out dividends to shareholders.
The free cash-flow is defined by subtracting Investment in plants and equipment (CAPEX) under Investment activities from the Operational cash flow. The formula looks like this:
Another thing that is important is how much the company pays out in dividends, i.e. the dividend yield. You want to look for companies that pay a good dividend, but also has a history of increasing that dividend over time. Most companies that are doing well in this respect also has good cash flow coverage of their dividend. It makes sense, otherwise they would not be able to sustain their dividends.
A warning here is in place. Just because the company has a high dividend does not mean that the dividend is safe. For instance, the major oil companies nowadays almost exclusively has a high dividend yield, but that is more a reflection of the risk that you are running when investing in those companies. One way to check this is to make sure that the dividend is fully covered by the free cash flow.
The lower the P/E-ratio and the higher the dividend yield is, the more value you will get out of your investment. In mature companies this may be difficult, but in the small-cap space finding so-called “double-sevens” is most definitely feasible. A “double-seven” is a a company with a P/E ratio of 7 as well as a dividend yield of 7. The trouble here is that the cash flow is not as stable for a small-cap stock and may vary a little bit more than for more bigger companies, but anyway they are worth looking into.
We also want to mention the Return on equity or the ROE. The ROE is defined as the companies’ net income over the period divided by the shareholders’ equity. This is a measure of how much profit the company makes per dollar of shareholder investment. For a good profitable business an ROE of at least 17 percent should be sought after.
The last thing that we want to mention is the net net working capital. The net net working capital has been popularized by legendary investor Benjamin Graham who figured out a good way of valuing stocks in the stock market. The method involves taking the Working capital (current assets less current liabilities) and then subtracting any additional debt.
We can then divide the net working capital with the total number of shares to end up with a number for the intrinsic value of the shares. In the 1920’s and 30’s these numbers were at times surprisingly close to the quoted value and extraordinary bargains could be found. In today’s stock market these extreme values are seldom found because, let’s face it, a stock that is priced for its net working capital is priced for liquidation. In today’s market liquidations are rare and the costs associated are huge. They also take a long time to unwind.
The upside of this is of course that if you buy a stock that is priced by its Net Working Capital you are protected by their assets value (like plants and buildings) which effectively puts a floor beneath the price.
To conclude we would like to emphasize that what matters is the consecutiveness of the earnings in relation to their price. We would therefore propose the following list when we select a stock:
This chapter will contain a few real life examples of what we are teaching. We will in particular look at some of the stocks that we picked out in our small-cap screen at the end of last year.
We will compare two small-cap stocks that trade on the New York Stock Echange: “The Buckle” (BKE), an apparel company and “Cummins Inc.”, a company that manufactures natural gas engines.
What we did here was that we used data from the annual reports, Yahoo and Morningstar to come up with this:
What is clear from the data is that the earnings are pretty constant over the three years. They are decreasing slightly, but not so much that it justifies the stock to go from 53.39 USD in December of 2014 to 24 USD on this Friday the third of October. That is a good sign.
If we then calculate the cyclical P/E ratio we see that the averaged earnings over the last three years puts cyclically adjusted price-to-earnings ratio (CAPE) at 7.32. We see that the dividend yield is OK and we have a good free cash flow to pay for the dividends.
In all, when we are analyzing the stock we conclude that the market has weighed too much importance to the decreased earnings in 2015. The prudent thing would therefore be to buy more of the stock rather than selling. Therefore our recommendation for this stock is BUY.
If we then look at Cummins Inc. instead we see this:
What we see here is that the earnings are increasing over the years, but are they increasing too much? We see that the price has gone from 89 USD to 128 USD over the last year while the earnings have increased from 3.70 USD per share to 4.5 USD per share. The increased earnings do not reflect such an explosive increase in the price and the cyclical P/E ratio is much higher today than at the beginning of the year.
Taken altogether we do not recommend buying this share at this point. It is simply too expensive. If you already own it, by all means keep it, and reinvest your dividends so that you will receive a higher dividend next time. Another possibility would be to take some profits so that you can invest in other companies. In the small-cap space there are plenty of stocks with sufficiently low P/E ratios at all times. Therefore, if you look at a sufficiently low P/E ratio and a good dividend yield, you will always be able to find good investment options in this field.
In this guide we have been trying lay out the basics of value investing. We have been trying to answer the questions of what a good investment is, what constitutes value in an investment and how to deal with your non-discretionary spending whilst investing them in the market.
Value investing is not something that will make you rich quickly, but rather a technique for the turtles. The power of it comes from the “compound interest” that you will experience when you reinvest your dividends in the same stock. If you have bought shares in a good value company with a steady earnings, you will see that your wealth increases exponentially with time.
To the questions of what to buy and when to buy we have given real life examples which makes it easier for you to follow along.
This time I will look a bit more in depth on how to use Microsoft Excel for financial calculations.
How can I use Excel to get the best out of my data?
Chances are that you are going to have to look into the data that you have entered again in a year or two years.
So how do I organize a spreadsheet so that I can see what I’ve done when I come back?
Excel is a very powerful tool once you know how to use it.
The secret is called labeling and with that I mean to properly label all the cells in order to easily be able to go back and change.
But to start off this chapter I will discuss some financial metrics and why they are important.
So why is it an exciting time to study finance?
The reason is that we had a financial crisis in 2009 and still to this day we are seeing the repercussions of that meltdown.
We all got into a lot of trouble and the financial institutions that we depend on for our daily lives lost a lot of money.
Some of the questions that people are asking themselves in the aftermath of the financial crisis are:
These are questions that people in finance and economics assumed they had the answer to for years, but now they are getting more cautious.
What I will be talking about in this chapter is:
There are many forms of business, but the most common is Sole Proprietorship where just one person owns the company.
This particular form is easy to start and the least regulated kind of business there is.
Another advantage is that there is single taxation. You only get taxed on whatever your income is.
On the downside, it is quite difficult to raise funding.
Another thing is that you as a private person have unlimited liability. This means that if you get sued you can not only all the assets in the company, but also your personal belongings.
Finally, it is pretty difficult to sell your ownership compared to if you, for example, own a corporation. If you have shares in a corporation, you can just sell them on the market.
When many own the company it is called a Partnership or a Corporation.
A General Partnership means that you invest and work for the company whereas a limited Partnership means that you just invest.
A Partnership is easy to start and it is more regulated than a Sole Proprietorship.
If you have a Partnership it is somewhat difficult to raise money.
There is also the same problem as with a Sole Proprietorship – there is unlimited liability. So if you get sued, the court can take all your Partnership and personal assets.
It’s difficult to sell ownership if you want to.
But on the positive side: In a Partnership there is Single Taxation just as in Sole Proprietorship.
A Corporation is when instead of having a person owning the business there is a separate legal “person” who owns it.
On the negative side with this form of ownership:
On the positive side with a Corporation:
Regarding the last point, there are two kinds of financial markets:
If you buy shares in the Primary market, the shares are issued by the corporation and sold to you.
This means that the shares (or securities) are issued by the Corporation.
Now, if you own the shares, you can go and sells them to whoever you want and you do that in the secondary market.
This means that after the sale in the Primary market, you can buy or sell shares, debt or equity to your liking in the secondary market.
Why is a Corporation a better form a better form of ownership than a Sole Proprietorship or a Partnership?
It’s because of the limited liability of a Corporation. If you get sued, the courts will only take assets belonging to the Corporation and not your car.
The main reason why a Corporation is the better alternative, however, is that it allows you to finance your idea far easier.
In other words it is pretty easy to get funds (equity or debt).
So if I were to summarize why a Corporation is the better alternative:
Because this article is about corporate finance, I will now get into the structure of a corporation (Figure 1.)
At the top of the Corporation there are the Shareholders. When you own a stock of Corporation, you are the owner of that Corporation and owners vote and bring in a Board of Directors.
The Board of Directors then hire the managers. The managers are then working inside the company and running the company.
Finally, it is the managers who employ the employees who work in the company.
Because this is a finance class we will of course discuss the role of finance inside a corporation (Figure 2.)
Above the horizontal line in Figure 2. is the Board Of Directors. Below the line is inside the corporation.
The role of the Chief Financial Officer is then to supervise the corporation’s financial activities.
To his/her help, he/she has these people to help:
On top there is the CFO or Chief Financial Officer.
Below there is the Treasurer and below him/her there are different people like Cash Manager who supervise the cash flows of the company.
The Credit Manager who look into questions like if the company is going to extend credit to certain customers.
Capital Expenditures is about what kind of projects or machinery the business might engage in. They do that by using cash flow analysis.
Financial Planning is about figuring out the company ‘s needs for issuing debt or stock to raise cash.
Then there is the Controller under whom there’s the accounting part of the Corporation.
The equation goes like this:
Asset = Liability + Equity
The equation is the fundamental part of Accounting and as such it has been around for more than 600 years.
What does it mean?
1./ If you have an asset – in the example I use a house – worth $200,000 and your loan on the house is $150,000 (liability), then you have $50,000 left in equity.
Imagine that a company buys trucks for its operations, buying other businesses, real estate or even inventory: Those are all assets.
What this means is that if you have a good new idea you can either pay for it yourself, you can borrow the money or use some combination of the two.
2./ The idea behind buying an asset is that you will make money in the end.
If for instance we use the example of a company buying delivery trucks – then the company needs to pay for it in order to get cash back in return.
The GAP definition of an asset is that it will provide a probable future economic benefit to the owner.
A liability is a promise to pay back the loan plus interest on that loan.
If the Company defaults on its loan, the house will go to the bank. That is a contractual obligation.
If you default on the loan, the bank gets paid first. That is also true in business. The person or the entity that has loaned the money gets paid first.
In the example above, there is $50,000 in equity.
If the bank is only able to get $100,000 for the house – that doesn’t cover the debt, but it’s all they get – you will get nothing.
If anything is left over, you will get it.
The way to think about it is whatever is left over after you pay all the Bankers.
The definition of finance is as follows:
What this means is:
The third point comes from the fact that finance is all about the future and since the future is unknown finance is difficult.
What we do in finance is that we are looking into the future and doing lots of estimates to decide what to do.
The goal of financial management is to maximize the current value per share of existing stock (market value of equity).
Theoretically this is a good goal because the owners own the company and the financial manager works for the owners.
However, there are a few problems and let’s look at a few of them:
1./ The Agency Problem with Corporations
This is what the Agency Problem means:
The shareholders own the company and are what is called “principal”.
The managers run the business and are what is called “agents”.
According to the definition an “agent” is working for somebody and in this case for the shareholders or the “principal”.
The agent is supposed to act in the best interest of the principal.
But because the agent is inside the company the agent has custody of the assets.
Managers do not always act ethically or legally.
2./ Financial-, Accounting- and Management-Gurus invent ways to circumvent laws that protect the owners.
There are many examples in financial history of companies having gone out and borrowed money in the market.
This money has then been accounted for as debt on the balance sheet just as it should be (a liability).
But then they bought the debt back and recorded the debt as an asset on the balance sheet instead.
This is fraud and illegal.
Another example is insurance companies that invented policies that circumvented the regulations and the law.
This was also illegal.
3./ Financial markets are efficient.
The definition of finance depends on financial markets being efficient.
What that means is that the assets are accurately priced in the market.
Obviously, we all know that this is not always true, but as a general rule it should hold.
However, there have been two major bubbles over the past 20 years:
When you have a bubble, the market is telling you that the companies, or more broadly, the assets involved are worth a lot of money, but they are not.
What can happen then is that the bubble pops and loses all its inflated value at once.
This way a lot of people can lose a lot of money quickly.
If there is a manager inside a company and he/she is trying to maximize the value of the company, but the market value is not fair, the goal itself cannot be achieved.
That means that everyone is left guessing what the market value of the company is.
Here’s an example of a house in 2003 to 2007:
The market was telling the participants that houses worth more and more during the bubble years, but they were not as we could see when the bubble popped in 2007.
The process can be summarized like so:
There are of course several reasons why you would want to study finance.
First of all we have the Personal side:
What are the careers that you can have in finance?
In this class we are going to study corporate finance, but there are other areas of finance as well:
In finance cash flow is everything.
This is an example of how cash can flow through a corporation:
In the figure it says A. The Firm issues securities. That can be the company having an initial public offering or an IPO.
Then people in financial markets decide to buy some stock so the cash goes from right to left and into the business.
Then we have B. Firm invest in assets which can be that the company buys for example machines or buildings.
Why is the company buying the assets? They of course do it to get a return on their investment.
Then we have C. Cash flow from Firm’s assets. This means that the company has earned a return on its investments and now the cash is flowing in three different directions:
The take home message here is that in finance what matters is Cash flow and not accounting numbers.
This article is based on the excellent work of the man behind the Youtube-channel Excelisfun.
How come Warren Buffett is such a fantastic investor?
To answer that question we first need to look into what Warren Buffett has actually done.
He studied at Columbia University under the legendary Benjamin Graham where he learned the fundamentals of value investing.
What a value investor does is that he or she is looking for securities which prices are below its intrinsic worth.
What matters is the price. Buffett knows that if he can buy a well-run company for pennies on the dollar, sooner or later the market will appreciate its error and see the price of the security rise.
That is value investing and that was exactly what he did in the early days of his investing career.
For instance he bought a 5% stake in in American Express in the mid-1960’s for $13 million dollars.
There are of course a few metrics that he looks at when investing in a company:
Good luck with your investments. If you want to look at value metrics of small-cap stocks you can look here.
How come some people always seem to be able to put a cooler on their nerves and consistently make money trading?
Is it because they have special abilities that you don’t have and never will have? Or is it because they are unbelievably lucky when it comes to trading and always bet on the right horse?
No. It’s because behind successful trading there are rules that they strictly adhere to.
These rules don’t come out of the blue, and have in fact often been learned the hard way by people in the business.
It may seem easy to stick to a number of rules, but I can tell you from my own experience that it is not.
This is why I’m writing this article. So that you don’t have to make the same mistakes as I have throughout the years and can start right away being what you really want to become – a successful trader.
I call my method the 1,2,3-method.
By adhering to my rules you can completely remove the emotions that inevitably surround the business of trading and focus on identifying the right moments to enter and get out of a trade instead.
The method is modified from Quint Tatro’s trading method which he has shown to be very successful in his career.
In this post I will lay out the fundamentals of a successful trading strategy and show you how you can consistently make money in the market.
As a minimum you need an internet connection, a trading account and some money on that account.
The trading account does not need to be advanced. The only thing required is an account that automatically buys and sells your stock at a given price level.
How much money you have is up to you, but I would advice against trading with less than $200,000.
If you have less than that you can still trade, but it’s difficult to use the economies of scale that present themselves when you have those $200,000 in your account.
In other words, you can trade for fun with less than $200,000, but not for a living.
You then need to use software that represent the different charts that you will use as a basis for your trading.
The best free software that I have found is called FreeStockCharts.com and that allows you to customize the charts in a way that best suits you.
They also have a paid version which obviously is better, but if you are just starting out you don’t need anything else than the free version.
In essence it’s about quantifying your risk.
Let’s say that I’m prepared to lose $500 on each trade.
Then I look at the chart and identify the price level where I want to get in as well as the point where I deem my trade to be a failure.
That is where I put my stop.
I then buy exactly so many stocks that my final loss will be $500 if things go bad.
That way I know before hand how much money I will lose if things don’t turn out the way that I want.
That means that I have mentally prepared myself for a loss of $500.
It’s the equivalent of betting on the race track, because if the horse that I have bet on will not win, my money is lost.
That is one of the advantages betting on the race track has over trading the market.
If the stock goes the other way (which it should given the odds), I take a third off the table when prices have advanced 1 x the risk.
For example, if I get in at $10.00 and my stop is at $9.00, then 1 x is at $11.00.
The second third, I take off the table at $12.00 and the final third at $13.00.
By knowing beforehand when and where I will leave the trading, I don’t have to play with my own emotions.
Trading is difficult enough as it is. Don’t let yourself be your worst enemy.
That’s it. Enjoy your trading.
This post is a follow up on my guide on how to use technical analysis in trading.
Today I’ve tried to explain how I personally approach trading and I do it with a method that I call the 1,2,3-method of trading.
It’s about recognizing that you are your own biggest enemy and that you have to manage your own risk.
You do that by taking the emotion out of your trades.
First I identify where my trade is no longer regarded a success. That is where i exit.
Today I want to answer a question about useful money investment and saving tricks.
There are a couple of things that you need to think about when it comes to your personal finances:
With that out of the way we can now begin to look at the specifics.
a. Don’t keep a credit card. It may be convenient to be able to buy what you want at all times, but in the end it’s not worth it because you are paying a huge premium for that luxury.
b. Instead try to attach your salary to a debit card in a savings bank. That way, each dollar, euro or rupee you spend will come directly from your savings account. This not only saves the extra fees you pay for with a credit card but also allows you to directly control your spending.
c. Increase your salary. If you feel that your earnings are too small compared to your expenses, you need to find extra income. There is no way around it. The good news is that you can do this quite easily. If, for instance, you live in a house, I can guarantee you that there’s loads of stuff just lying around. You can sell it at Ebay.
As I’ve mentioned here before, the best way to invest your if you are not interested in the ups and downs of the stock market is to buy an Index Fund. An Index Fund is cheap – you will only pay between 0.1 percent and 0.2 percent a year in fees – and you will always stay exposed to the market. Over time the price difference will pay off and you will become rich.
You also need to protect a portion – I would say about 10 percent – from inflation. Now the classical method of doing this is by investing in physical gold, but nowadays there are Exchange Traded Funds (ETFs) that you can buy.
However, you don’t have to buy gold, but can buy Treasury Inflation Protected Securities (TIPS) instead. The return of those are indexed to inflation so that will receive a higher return with higher inflation.
Today I’ve been talking about different saving tricks by not paying for a credit card and by attaching your salary to a debit card instead. That way you will more control on your personal finances.
You are young and you are already wealthy with your dividends. Congratulations.
It seems as though you are getting a return of 2.6 percent from the dividends which seems reasonable.
What you haven’t told us is how you got the money. Did you invest it yourself or did you inherit it?
If you invested it, then, as other people here have said, just continue what you did to get to this point.
If you inherited, you need to educate yourself a little bit.
There are two major ways that you can invest your money:
As I mentioned above, the trouble with stock picking is that it is tedious and time consuming.
Even if buy companies that seem to offer good value you will never be sure that they will advance.
That is why my advice is an Index Fund – one that buys all the stocks in the Index.
Because they are so cheap – you will only pay between 0.1 and 0.2 percent in charges a year – over time your money will grow nicely.
If you add in extra money each month and keep it for more than 20 years, you will not only get rich but also outperform most money managers.
The only downside that I can see with an Index Fund is that it is boring – you will always follow the index.
You will never be able to brag to your colleagues or neighbors about how much your portfolio has appreciated.
But that may not be so bad in the end.
When I say that you should not buy bonds at this time there is one exception: TIPS.
TIPS are bonds that indexed to the inflation.
That way you can hedge against the possibility that money will inflate away and you will lose all your money.
My advice would then be to buy 75 percent of an Index Fund and 25 percent TIPS.
That way you will be guaranteed a certain income while at the same time being well exposed to the stock market.
Don’t worry if the market begins to go down.
It only means that your underlying stocks have become cheaper and that you can buy more for the same amount of money.
When I first started out with investing I didn’t know anything at all about investing and financial metrics.
The company that I was working for was a startup in a highly specific scientific field and of course I bought into the idea that we would all become rich eventually.
Unfortunately that did not pan out the way that I had planned and I lost money together with all the others.
So instead I began to research the best way to invest my money. It turned out that the approach that I had taken was akin to betting at the lottery.
Sometimes you win, but because the odds are stacked against you, in the end you will lose your money.
So it was clear that I needed to do something different.
My research led me to the classic value investors, but they were embroiled in a language that I did not understand.
What that meant was that I needed to go deeper in my research to really understand the concepts and terms involved in value investing.
So in this series of articles I will try to elucidate what some of the “value” terms really mean.
I will begin with the metrics mentioned above and I start off with working capital:
The first thing that you need to do is to download your favorite company’s annual or quarterly report.
Either you can find this on the company’s web page or you can download it from EDGAR website (because all companies trading om the US stock exchange are forced to release their numbers publicly).
If you then go to the Balance Sheet of your favorite enterprise, you will find the assets and the liabilities.
These are then further divided into current assets and liabilities and total assets and liabilities (Figure 1).
The current proportion of the assets is what the company has in cash or can turn into cash within short notice.
The current proportion of the liabilities is the debt that the company needs to pay within a year.
The working capital is then calculated as current assets minus current liabilities.
What it means is how much money the company has to pay its bills during the year.
If this number is negative then the company somehow needs to raise cash during the year.
That can happen either by an Initial Public Offering (IPO) or by a direct investment from external sources.
You can also calculate a working capital ratio as current assets divided by current liabilities.
If this ratio is greater than 1 then the company has enough money to cover its bills.
If it is less than 1 then they need external financing.
A negative working capital, or a ratio below 1, is most of time a warning signal for a conservative investor.
The second metric that you hear a lot in the financial press is the free cash flow.
So what is the FCF and why is it important?
To calculate the FCF you will need to go to the cash flow statement of the company that you are interested in.
You will see that it is divided into three different sections:
The FCF is then defined as the operational cash flow minus capital expenditures (CAPEX).
So what is CAPEX and where can I find it?
Under the Cash flow from investing activities you will find a section called “Additions to operating assets and facilities” (or something equivalent).
This is CAPEX and it represents the cash that the company pays out in order to maintain or expand its productive assets.
So in effect, the free cash flow is the cash the company generates after paying its bills on its productive assets.
The FCF is the cash that the company can use for paying dividends or share buybacks. In other words measures to increase shareholder value.
If the Free Cash Flow is negative the company does not generate enough money to pay its dividends. It therefore needs to borrow the money from someplace else in order to stay afloat.
What is net income and how is it calculated?
To find the net income you need to go to the Income statement in the annual report.
There you will different item like the Total revenue which is the total amount of sales that the company generated for the period.
The next thing that you will find is the Total expenses. These are deducted form the Total revenues in order to get the Net income.
Thus the Net income is a measure for the profit the company has made during the reporting period.
What does the ratio between the Net income and Total revenue tell me?
It’s a measure of the profitability. For a manufacturing company, the ratio between the two is usually an indication of its comparative strength and weakness.
I would consider a figure above 5 percent satisfactory.
What is then the Return on equity, what does it say and how is it calculated?
This is a measure of the return on the invested capital or in other words the company’s profitability.
The number is calculated by taking the Net income and dividing by the Book value.
The Book value is turn calculated by taking the Total assets minus Intangible fixed assets (goodwill and patents) and Total liabilities.
A high Return on equity usually goes along with a high annual growth rate in earnings per share.
Today I’ve been looking at the working capital and tried to give a definition of what it means.
A positive working capital tells the investor that the company can pay its bills for the year while a negative working capital says that it cannot pay its bills.
I’ve also gone through Free cash flow which is the money generated by the company when all bills on productive assets have been paid.
I have also talked about Net income to Total revenue and what it means for the profitability of the company.
Today I want to answer a question about only having limited funds to invest. “I only have $500 to invest. How do I make the best of it?”
You buy an index fund. The positive thing about those is that they are reasonably cheap and you get exposed to all the stocks in that index all the time. That way you don’t have to worry about “beating the market” or “picking the right sectors”. The fund performs as the index – that is the whole idea.
The only real downside that I can see with an index fund is that they are boring. You will never be able to tell your friends how well your stocks are performing, because they perform just as well as the index itself.
If we assume that the stock market will return 7 percent a year, which is not unreasonable, over 20 years you will have doubled your money twice ($500 => $2000).
However, over the years the cost advantage will bear fruit and you will be able to see your investment grow substantially. Hold it over 25 years, add new money each month and you will be wealthy in the end.
Today I’ve been talking about investing only limited funds. My conclusion is that it is best to buy an index fund. They are cheap and you get exposed to the over all stock market like this.
Do you ever wonder how some people somehow seem to building wealth without putting any effort into it?
They have the means to carry out all sorts of things without being stretched financially.
It turns out that you don’t have to be a genius to figure this out. Anyone with a basic understanding of simple math can do it.
It comes down to two very simple formulas:
It basically means that you should save a certain amount of your earnings each month.
Of course not so much that it infringes on your basic necessities, but still a significant part of what you earn should be put aside. Each month. All the time.
This means that you need to look into each part of your economy and identify unnecessary spending to try to cut down on it.
Of course there are things that you need, but then I’m sure there are other expenses that can be labeled as “discretionary” and sometimes downright “silly”. Try to cut down on those.
Each dollar saved is a dollar earned.
There are some very good websites out there that can help you, but here are three of my own favorite money saving tips:
When buying groceries try to buy several months’ supply so that there is always an extra pack of sugar or flour in the cupboard no matter what.
This tip is obviously limited to products with a long shelf life, but it is amazing how much money you can save by just sticking to this.
An essential part of having your finances under control is to have a budget.
This ideally lists all your income and expenses as well as gives you space for an occasional treat.
Of course there are many ways to do this, but personally I prefer to use a spreadsheet where everything is labeled accordingly.
A car is one of the biggest expenses in a household and having one is of course great.
However, many families also have a second car out of convenience. Try to skip this and get a bike instead.
A bike is an extraordinary way to get around in town where you quite frankly very seldom need a car.
In the rare cases where a second car is necessary there is always the possibility of taking a taxi. There is a lot of money to be saved.
There are many kinds investments that you can choose from. In this section I will briefly try to outline a few of those:
For a beginner a good way is to invest in an index tracker.
An index fund is a fund that owns all the stocks in an index, all the time, without the pretense of being smarter than anyone.
An index fund is cheap – you only pay about 0.2 percent of your invested capital in annual fees.
Index funds only have one drawback – they are boring. They will perform as the overall market – no better, no worse.
This behavior is inherent in an index fund, but because index funds are so cheap their cost advantage will only accrue over time.
My suggestion would be to keep your index fund part of the equity proportion (discussed below) at least to 50 percent.
If you just leave your stock picking to chance, you will be out of luck quickly.
That said, if you would like to join the excitement of investing in stocks, you will need to do some research.
One important metric is price (i.e. how much do you pay for the stock) and another one is the return that you will get out of it.
The first one should be as low as possible in relation to the companies’ earnings and the second should obviously be as high as possible.
Another thing to watch is the companies’ financial situation where the company should have a sufficiently amount of assets in relation to liabilities.
To invest in debt is fundamentally different from investing in equity.
The company or the treasury borrows investors’ money in return of interest that they will pay back over a long time.
The most fundamental question an investor asks himself is the proportion of stocks and bonds in his or her portfolio.
My advice would be never to go below 20 percent of either.
That way you make sure that your at least some of your money will be protected against inflation.
Stocks fluctuate in value all the time and there is always the possibility that your investments will go down in value.
Therefore it is important that you know why you bought your securities in the first place.
In the words of famous value investor Benjamin Graham “you are never forced to sell or buy securities just because they have gone up or down in value”.
If you are inclined to sell in a bear market chances are that you would be better off not having your securities quoted in the first place.
This is important in all kinds of markets, but especially important in a bear market.
This all boils down to what I call “sanity checking your investments”.
If the fundamentals of the security change then there is reason for the decline, but often declines just come from unfounded rumors and hearsay.
Therefore never sell a security just because its value has fallen.
This post tries to explain the simplicity of getting rich. In essence it boils down to two simple things: 1./ Make more money than you spend, and 2./ Invest the surplus wisely and see it grow. That’s all you need to think about.
As a beginner, doesn’t it suck not being able to reap the rewards of the stock market?
I know when I started out, I thought that I would make a killing straight away.
But then I started to talk to people who had been trading for a while and they told me that it wasn’t that easy and that I needed experience in order to thrive.
In hindsight it turns out they were right. In order to consistently make money in the stock market you need to know when to trade and when not to. To be able to spot a good opportunity you need to have done it for a while.
It comes down to chart work and knowing the ins and outs of the patterns that present themselves all the time.
So the first thing that you need to learn is technical analysis. If you don’t find any other introductory text on technical analysis you can do that here.
What separates a good trader from the novice is that the good trader almost always win while the novice only sometimes win.
But then you also need to put real money at stake because if you don’t do that you will never learn. A demo account is just that: A demo account.
There is nothing that beats seeing that candlestick moving up or down.
The only way to learn is to lose your hard earned cash and then come back stronger.
Once you’ve decided to put real money on line, you can begin slowly.
But don’t get too excited if you see that things are going your way.
Even if you are unexperienced, you need to expect a few gains.
One of the most important rules of trading – and one that I’ve personally have learnt the hard way – is always to use a stop-loss.
When you consider a move in the market, up or down, there is always the possibility that you will be wrong.
Therefore it is very important to set a stop for each trade where you say “The buck stops here”.
It’s far easier to get back into the game if you have been stopped out than to see yourself lose significant money day after day for weeks in a row.
To earn a living from the stock market is not for the faint of heart. You need to be mentally prepared for the ups and downs and that you may lose a significant portion of your wealth at any time. But in the end it can be a very profitable business if you apply a system where your losses will be limited.