Tuesday, March 24, 2009

What is inflation and how does it affects your portfolio?

One of your most deadly enemy is certainly inflation. While the aim of your portfolio is to grow with time your first aim is to make sure that your portfolio is able to keep up with inflation.

So what is inflation and why is it so deadly?

Inflation can be defined as the increase in the price of goods, services, wages and natural resources. Simply speaking the price of everything that a person may want to buy increases with time as a result his salary will also tend to increase just to be able to buy the same amount of goods.

What are the effects of inflation on investors?

1. It decreases the real value or purchasing power of actual money. If the price of goods increases with time, then a sum of money will buy less and less volume of goods with time. As a result you will have to work hard to increase the value of your investments just to keep the volume of goods that you can buy constant. One of the first aim of any investors in is thus to be able to beat inflation. If you are unable to beat inflation then the real value of your portfolio , measured in the volume of goods that you can buy , will decrease with time.

2. It cause severe disruption to stock markets for investors will tend to buy stocks that give a return greater than the rate of inflation. Any stocks that is unable to beat inflation will be sold even though the company may be of sound health but is just suffering from a temporary setback. It just amplifies the sell off of stocks that is giving low return irrespective of sound fundamentals.

3. Bond that has medium and long term maturity and that has not been indexed to inflation will slowly lose value if inflation is greater than the interest rate on these bonds. People who have invested largely in bonds will thus sees their portfolio decrease in value with time.

4. Some stocks do badly in an inflationary environment. This is because increase in the price of raw materials is more difficult to pass to consumers in a competitive market. As a result this will drive the profit margin down. This will have a two fold effect on these companies. (a) it will make it difficult to give wage increases and (b) if wage increases are given then the dividends given to shareholders will drop causing a drop in the share prices of these companies.

As you can see the effects on investors and companies alike can be quite devastating. Even moderate inflation if compounded over a long time can be quite dangerous.

So what can be done to reduce the effects of inflation?

The best way to fight inflation is to be well invested with the long term in mind.
Although inflation decimate all investment categories over the medium term, the return over the long term tend to be greater than the cumulative effect of inflation. Also inflation do not affect all asset categories to the same extent.

A well diversified portfolio with the following asset class will make your portfolio inflation resistant.

1. Treasury bills and bonds
Although treasury bills and bonds suffer poorly in inflationary periods, they are able to maintain the value of the portfolio in time of stock market crash and deflation. Also even bills and bonds over the medium and long term have returns that exceed inflation.

2. Stocks
Stocks suffers less that treasury bills and bonds they have the highest possible return when considered over the long term. As a result a well diversified stock portfolio with stocks from different industries and different countries will resist well again inflation. Since inflation does not affect every country and industry the same way and at the same time.

3. Gold

Gold is a good inflation hedge. In inflationary times the value of gold rises to keep up with inflation. So it is a good advise to have a certain percentage of your wealth in gold. Beware however that gold only keep its value and offer no return.Hence your investment in gold will not increase in real value but merely keep up its value.

4. Commodities

It is known that the value of commodities increases in time of inflation, although some commodities will not behave this way. So if you are of the adventuring type, you can invest in commodities futures. I would however not advise any one to do so.

5. Real estates

It is well known that land is a good investment and that it behaves like gold and will keep up the value of the portfolio especially in trouble times. I would thus give the same advice as with gold as land offers no return.

Ok guys that is all. As you can see a well diversified portfolio is a good inflation strategy as over the long term its return will be greater that inflation.

Happy investing.

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Saturday, March 21, 2009

What is compounding?

Compounding is one of the most important concept that the new investor must understand. It is fundamental because it is the behind one of the investing strategies that is most used: The buy and hold strategy.

To start lets talk about the maths. If you start with a certain amount P the principal and you invest this money at an interest rate I for a certain amount T then the amount that you will get is given by the formula

amount = P x (1+ i/100)^T

For more details see my post on interest rate here.

For the purpose of this post i have compiled the table below that shows the return of three persons investing in different conditions. All three are buy and hold investors and as you can see the returns are different.

Name Start End Initial amount Interest rate Amount at 65
Anne 20 65 10000 10 728900
Jack 30 65 10000 10 281000
Paul 20 65 10000 9 483200

We can thus deduce that three conditions must be present for you to maximise your investments.

1. Time

The person must invest as early as possible. As you can see from the table Jack and Anne started investing at different age. The 10000 dollars of Anne were invested for 45 years while that of Jack were invested for only 35 years. This difference of 10 years results in the investment of Anne to be almost double that of Jack.

One advantage for Anne, as you can see from the graph above, is that after some time the increase in value will accelerate and at this point you can stop investing or at least you can reduce your monthly contribution. While Jack and Paul have to increase their contribution just to reach the level of Anne.

2. The rate of return

As you can see from the table if two persons invest with a difference of just 1 % in the interest rate then you can have a large difference in the amount of money at 65 years. Both Anne and Paul started investing at 20 years of age but one at 1o % and the other at 9 %. This will show to you the difference of just 1 % difference in the interest rate. That is what will happen if someone invest in a mutual fund that take 1% return or if you buy and sell often and the broker take 1 % commission. With time as you can see you return will be greatly reduced.

3. Reinvest interest and dividend

It may not be obvious from the graph but the compounding work only if the earnings are reinvested every year. So guys do not use those interest and dividends.

I hope that this post will have shown to you the advantages of buy and hold and the merits of compounding.

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Wednesday, March 18, 2009

How and when is a dividend paid?

ave you ever wonder when and how dividends are paid but found the process too complex to understand. I have been there so here is a detailed but simple explanation about how these things are done.

So you have bought some stocks and as a result you now have the right to receive dividends from the companies. A dividend is just a share of the profit that the company will give you. Not all companies pay a dividend but it is better for an investor to invest in a company that pays dividend. Hence the paying of a dividend will be an indication of the company good health and by monitoring the dividend payments you will have an idea about the health of the company.

Dividends can paid either cash or . The company will pay a certain amount of money for every share that an investor is holding on the due date or the company might issue to each investor an additional number of shares. A dividend is usually paid in term of shares only if the company has a temporary problem of cash flow. You should be careful as dividend payment in term of shares is not necessarily a sign of a bad company. A good company that has strong fundamentals may have problems of cash flow in a recession and as a result will not be able to pay cash dividends.

So how and when are dividends paid?

It is the board of directors that take the decision to pay a dividend. There are four important dates and they are as follows :

(i) The declaration date - It is the date on which the company declares that it will pay a dividend

(ii) The ex- dividend date - A stock that is bought on this date and after will not receive the dividend. If you want to sell a stock you can sell on this date and still receive the dividend.

(iii) The date of record - This is the date where the company will check the record and will send the dividend to every person and company on the list. This date is usually one day before the ex-dividend date.

(iv) The date of payment - This date is usually after the date of record. It is the date at which the check is issued to you. You need not worry that it is some time after the date of record. You will definitely receive your check but it might take some time.

I hope that you have understood that well. By the way if you have some questions for me place a comment and tick the receive comment by email and you will receive the answer in a short time.

Good luck guys

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Tuesday, March 17, 2009

5 tips to survive a bear market

In a market like this, there seems to be little hope. The share market is falling daily and people are seeing their wealth portfolio shrinking.

So what should you do? Perhaps selling every stocks and put your money in stocks. That would be a great mistake. For as you already know the return of the stock market outperform the return of any investment instruments. In fact the best advice that i can give you is to sit tight and ride the recession. I know it is a little bit difficult so i have compiled 5 advices that you can follow to make sure you do not go nuts before the recession ends.

1. Do not borrow money to invest

The stock market will surely go up one day. However if you borrow money to invest, chances are that in the mean time you will have to pay the loan. Or if you will pay it at a later time, then pay back time may come and the fantastic return that come with the rise of the stock market may not have started. So you will be forced to liquidate assets on the cheap. As a matter of principle I do not advise my readers to borrow to invest.Even when you will become more knowledgeable in the market.

2. Invest only money that you do not need

As a second principle i do not advise people to invest money that they will need in the next few years. While the stock market will surely rise in the long run it may actually fall in the short term and as a result when you will need the money you will have to sell a lot of depressed assets. It is like shooting yourself in the foot.

3. Stick to your plan

If you have a plan that states how much money you should invest monthly, or what is your allocation then stick to it. On the contrary now is the time to invest more than your plan states not less. Buy assets on the cheap and do not under any circumstances change your allocation or get out of stocks.

4, Do not watch the news

Do not watch the news. Remember these people like it when there is blood on the street. So if you have a nice plan and you are sticking to it then do not react to the news. Remember a lot of these tv people do not have a clue about what they are saying.

5. Rebalance your portfolio

Some shares in your portfolio will lose value more that others. Use extra money that you have to rebalance the portfolio every now and then as stated in your plan. Do not panic and sell stocks that are falling in value but which are sound businesses and who are just being affected by the selling panic.

So guys sit tight and hopefully after this bear market ends you will come out of it a little bit richer.

Good luck.

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Thursday, March 12, 2009

What is a pyramid scheme?

People want to make money quickly and if possible with the least effort. One of the tricks intelligent people have been doing over the years is to established pyramid schemes to take money from these naive people. They make these naive people think that if they invest in a certain schemes they would become rich. A pyramid schemes is thus a fraud whose purpose is to take money from people.

So what is a pyramid schemes?

As the name suggest it is built like a pyramid. It is created by a single person who is at the top of the pyramid and he recruits a few people to invest in the scheme. Each person who invest in the schemes will be told that of he enrolls a few more people in the scheme, then he will increase his return in the long term. Then the chain of people will become longer and longer. In fact as you may have guess the aim of the schemes is to take money from the bottom of the pyramid towards the top. Part of money collected will be used to pay people on the second, third, etc level from the top to make people lower down the pyramid think that the system is working. The system will continue until the system can no longer enroll any more people and money stop flowing in the system. By then people awaiting their return will be suspicious and the person at the top will flee.

People have always been attracted to the idea of making quick money with little effort as a result pyramid schemes have always been successful. It is only when the system has collapsed that people have realized that they have been fooled.

It can be quite easy to recognize a pyramid as most of them simply take money from people at the bottom of the pyramid and then give it to people at a higher level in the pyramid. However some schemes may be hidden behind legitimate business like the Madoff schemes. However these can also be recognised because they offer higher return or they require less effort or work that is generally required in the field. The Madoff schemes were giving 10 % + return even in recessions.

So guys be on the lookout for these schemes and remember always be suspisious of anything that offer higher return in less time and with less effort.

Good luck investing. And remembere true wealth takes time and a lot of hard work to built.

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How to survive in the downturn?

In each downturn in the market the portfolio of each investor is tested and some passed the test with some degree of success while others fail. So what do those portfolio have in return and what step can you take to make sure that your portfolio resist the downturn. If you however failed to hold your portfolio together, the lessons learned in this recession will be for a lifetime.

Step 1. Diversification
Your portfolio should be well diversified with a balanced mix of all types of assets.The different types of assets will ensure that while some may decrease in value, the others may hold their value or even appreciate. In this recession some investments that were initially expensive will now become cheap and as a result you will be able to strengthen your portfolio by diversifying further.

You should have in your portfolio a considerable share of defensive counter-cyclical stocks, gold and precious metals, real estates and bonds. These will ensure that your portfolio do not lose value too much in case of a stock market crash.

In such a downturn, even the safest of investments can go bad. So diversification is even more important.

Step 2: Hedging
Hedging is even more important when you consider investing in a recession. I do not mean the type of hedging by hedge funds. I mean that every risk that an investment can have should be offset by another investment. For example if you buy a bond in a risky company that can go bankrupt, buy a treasury bill that can at least offset the loss.

Step 3. Keep cash
You should have a source of cash that you can use if the need arise. It may be because you have loss your job or that an investment on the cheap become available. In this recession where everybody is selling, assets are being sold very cheaply so if you have money you can buy them. Remember the Rothschild make their fortunes buying assets on the cheap. You can have cash readily available by having bond and cd ladders suitable set up so that cash is available on a regular basis.

Step 4. Time
Should your well balanced portfolio began to fall in value, then may be time is the best solution instead of a sale. remember that with time the stock market go up, and that after the recession a portfolio will regain its prerecession value quickly. So do not panic and start selling , just sit back and wait for the recession to pass.

Step 5. Sell when appropriate
Some investment may be going down and may not recover. So if you feel that a company will go bankrupt, its time to sell that stock or bond and at least recover some money. You can then use that money to buy other investments. Chances are if you buy another stock on the cheap and that stock recover your loss might be small.

Stock market and the economy do go down. The better prepared your portfolio is the better you can manage in this downturn. So sit tight and wait for the recovery. And keep that cash ready to swoop on that cheap house or stock.

Good luck guys.

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Wednesday, March 11, 2009

Efficient market theory

You may have heard this theory a lot of times but what is it really about?

Efficient market theory states that it is impossible to beat the market on the long run because all the information available to investors is present in the price of the stock.

I must say that I tend to agree with this argument but there is a big if. The theory is assuming that human beings are rational and that before making an investment they make all the necessary analysis and as a result the price of the shares and any instruments will be a reflect the available information.

This theory however fails to take into account several things:

1. Investors are affected by greed and fear as a results in boom times prices are above the real price and in bust times they are below the real price.

2. Some sectors outperform the market while some sectors underperform the market. As a result investors that invest in these sectors will tend to outperform the market.

3. Following 2 above it can be suggested that because not every portfolio is diversified equally and subjected to the same risk coefficient. As a result some portfolio may outperform others and the market.

4. Some investors have preferential access to investment instruments like Warren Buffet because of their influence. As a result they also might outperform the market.

As you can see even though the Efficient Market Theory may be true in theory, the market is so volatile and unpredictable as a result it is not impossible for some investors to outperform the markets.

If i may say at last, I would tend to think that more would underperform the market than outperform it. So it is better if those that are just starting would stick to Index funds.

As usual if you disagree with me you can leave a comment below.

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Sunday, March 8, 2009

What is an index fund?

As i have mentioned several time on this blog, investing is the key to increase wealth.
One of the instruments available to the investor is the index fund. Today we will learn what is an index fund and what are the advantages and disadvantages of investing in an index fund.

We first have to look at the two types of strategies that an investor can choose.

1. Active investing

The active investor will trade often and would try to time the market. He would buy low and sell high. He would most likely spend a lot of time doing research. This strategy however is costly because you have to pay a lot of fees, so unless you are good at it you will rarely beat the market. Instead fees will eat in your return and reduce it. More often you will miss the lows and also miss the high.

2. Passive investing

The passive investor trade as little as possible. Time is his ally. He knows that on the long run the stock market rises and that if he buys for the long run and sell rarely his wealth will increase with time. So he make research and once he thinks that he has spotted a company that has value, he buy its shares.

An index fund is a mutual fund that try to mimic the stock market or a particular index. The company will buy shares in all the companies in the stock market or in a typical index. For example an s&p index fund will be composed of shares of all 500 companies in the exact proportion as their market capitalization. The index fund will thus increase and decrease in value just as the s&p. And since we know that the stock market always go up in the long run, then those that buy into index fund are certain that their portfolio will not fall in value or at least if the stock market fall, their portfolio will not perform badly. Such an investor knows that it is futile to try to beat the market. They thus move with it either up or down.

Index funds offers a lot of advantages. Normally when you buy shares you have to pay commissions and fees. So building a portfolio is quite expensive. When you buy into index funds you are buying all your shares in all the companies at one go, so it is really cheaper. One of the greatest costs in investing is the fees that you have to pay every time you buy or sell stocks. With time, if done often, it reduces your return.

So if you are entering the world of investing, index funds are a good choice. Your portfolio would increase in value with time, you would not make mistakes and lose your investments and more importantly no research, you will just sit back and enjoy life while your wealth increase.

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Friday, March 6, 2009

Introduction to diversification

Diversification is by far the most important strategy that an investor must learn. It is similar to the old saying "do not put all your eggs in the same basket". It is so obvious that if someone will tell that to you you would offended.

What is Diversification?
Diversification is when you invest in a range of investment instruments that are different from each other. Diversification is done because each instruments have different risk, volatility and liquidity associated with them. Hence by investing in instruments have have different risk, your portfolio is more resilient to shocks in the economy. If the value in some investments decline, the fall might be balanced by rises in others or at least the value of the other investment might not fall as much and as a result the value of your portfolio will not fall as much.

Lets say that you invested in one stock, then in a recession the value of your portfolio will fall with the stock market. However if you buy two stocks, then one of them might fall less and reduce the fall. Consider further that you have used a third of the money to buy bonds. In a recession the value of the bond will be the same. Hence your portfolio will be further able to resist the fall of the stock market. hence as you can see it is a usual practice to have in your portfolio a mix of bonds, stocks and cash. The cash is used to meet emergency expenses so that you don't have to sell bonds and stocks. It is never a wise move to sell stocks of bonds to meet unexpected expenses. Hence a typical portfolio will have a mixture of bonds, stocks and cash. The more aggressive investors will have a larger percentage of stocks while the safe investor will have a larger percentage of bonds.When creating a portfolio that contains both stocks and bonds, aggressive investors may lean toward a mix of 80% stocks and 20% bonds while conservative investors may prefer a 20% stocks to 80% bonds mix.

You should also keep in mind that stocks come in different flavors. There are blue chip companies, medium and small size companies and start-ups that offers varying degree of risk and return. Investors can buy stocks from different sectors of the economy. Remember that different sectors of the economy are not affected in the same way during recessions. some may even be counter cyclical and rise during a recession. It is thus important to include in your portfolio stocks that are from various sectors and from companies of different sizes.
Bonds are also of various types. Bonds may be from governments, companies and municipalities. These bonds have different risks and hence have different returns. They also have different maturity dates so that if you are building a bond ladder with a bonds of maturity dates then you will have bonds that mature every year. It is therefore a good practice to have different types of bonds that have different returns and different maturity dates.

If however you do not want to go to the expense of buying all sorts of stocks and bonds you could buy a mutual fund. Mutual funds are a selection of bonds and/or stocks have have been bought by a company and you got to buy a share of them. You thus invest in the mutual fund and you get the advantages of buying stocks and bonds. Mutual funds comes in all types of flavors. you can have all stocks, different mix of stocks, all bonds, different types of bonds and different mix of bonds. The choice is all yours. You can also have index funds that buy mostly everything so that you benefit from the general trend. The choice is yours. Mutual funds are ideal for those that are starting in the investment world or don't have time to do research. However for the expert investor mutual funds is not advisable for with time the fees eat the profit.

While stocks and bonds represent the traditional investment instruments, a lot of alternative investments can be used for diversification. Real estate investment trusts, hedge funds, art and other investments provide the opportunity to invest in vehicles that do not necessarily move in tandem with the traditional financial markets. I do not however recommend them for they require a lot of professional knowledge.

A word of caution is required here. While diversification is good for the investor, there is also what is called overdiversification. At this point fees increases to such an extent that it decreases the return. Tracking the inverstments is time consuming. So you should not diversify into too many investment instruments.

Your personal time frame, risk tolerance, investment goals, financial means and level of investment experience will play a large role in choosing your diversification strategy. Start by making a financial plan and choose the appropriate mix.

Good luck.

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Stocks have higher return than bonds

Two of the most common investment instruments are stocks and bonds. On average stocks have yielded greater return compared to stocks. So for a long term investor it makes sense to invest in stocks instead of bonds. However the higher return come at a price. Stocks are more volatile and risky while bonds are more secure and their values change less.

Bonds are debt instruments that are repaid at a fixed interest rate. They are issued by companies, governments, municipalities and so on. You are guaranteed to recover your principal together with some interest. The interest cannot change a lot. Unless you sell the bond before its maturity so that you can get a profit greater that the interest rate you initially bought the bond with. However the profit is only a tiny amount greater than the amount you would have obtained had you hold the bond to maturity.

Stocks are however partial ownership in a company and this give you a right to the profit of the company. Hence you get you return either by dividend which is a part of the profit of the company and partly from increase in the value of the shares. As a result if your company is successful the value of the shares and the dividends will increase with time. Hence on the long run the return of stocks has always been greater than the return of bonds.

However on the downside when investing in stocks you are taking a greater risk since the profit of companies cannot be predicted. The company can be highly profitable at a time and make a loss at other times. With this greater risk come the possibility of greater return. However the long term trend of the economy is up and as a result the total profit of the companies will always be up even though a few companies here and there might go bust. Combine this greater return possibility with a good diversification plan and you will see that on the long run stocks will definitely outperform bonds even if you make a loss in one or two stocks.

Stocks are also better able to keep up their values in inflationary time. The value of stocks can increase with time while the principal +interest of bonds can have some difficulties to keep up with inflation.

Bonds are generally associated with certainty and less risk as a result the return is certain and as a result it would be less than that of stocks since they are riskier and more uncertain. They should therefore have greater return. Thus depending on your strategy, risk tolerance, age and plan you could invest in bond alone, in bonds and stocks or in stock alone.

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How to start investing with a small amount of money?

If you have a small amount of money and want to start investing then there are a few things that you need to know. Do not jump in and start buying.

What do you need to know?

1. Most brokerage firm require that you open an account and deposit a certain sum of money in it. You will have to make some research about what that minimum amount is. Most brokerage firm would not have a very high minimum amount but if you have a very small amount then perhaps you will have to wait until you have the required amount or make some more research until you find that broker that will allow you to open an account. I would advise against using any broker. The brokerage firm will need to have a reputation and be a secure company.

2. After you have open your brokerage account, you will have to choose the type of account. You have two types of accounts.

(a) The discount account. A simple account where you do all the research and then phone the broker and give him the instructions. He would not give you any advise but simply follow your instruction and send you the share certificate later. You will have to pay a fee for each transaction. This fee can vary from firm to firm. So you will have to make some research on that as well. Because with time fees can reduce your overall return.

(b)Full-service account. This account allow the broker to advise you on the stock market. But the fees are high and as a result it would not be possible for you to have a full-service broker.

(c) The online brokerage account. This broker allow you to trade online. However you will be faced with many restrictions and high fees.

So what investment are available to you?

1. Over the counter shares. Some companies allow you to buy shares directly from them over the counter or by mail. But i think that it difficult and time consuming. However in doing this you will not be paying fees to the broker.

2. Government bonds. These can be bought directly from the government and by using the broker. However if you buy it yourself you will not pay any fee.

3. Shares. You can buy shares yourself and built your portfolio. But you will see that if you buy shares each transaction will incur a fee and if you trade ten times then you might pay a lot of money. So the best way to invest if you have a small amount of money is through mutual funds. You will pay a small fee initially but the fees will not be as much as if you were buying the share yourself. Later on when you will have more money and more experience you will be able to buy shares yourself. Have a look at my post on index fund here.

So good luck.

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