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.

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.

Conclusion
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.

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.

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.

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.

Conclusion
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.

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.

Conclusion
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.

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.