What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

Strategies for the successful investor part 7 : Performance obsession

Many investors are obsessed by performance in that they are always on the alerts for tips, hot stocks or emerging sectors of the economy. These investors always want to be on board of the latest bull market. They always want to buy at the lowest price and sell at the highest price.

However what investors need to know is that assets are mostly cyclical and that their ups and down do not takes place at the same time. Hence while one sector of the economy is down another sector will be down. Hence if you invest too heavily in one sector or in one asset then if their is a downturn or a bull market then you will be too exposed to that sector and as a result your portfolio will be adversely affected and you might lose heavily.

The way to go is to be exposed be a wide variety of assets such that when one asset lose value the decrease will be offset by an increase in the value of another asset. Hence if you are exposed to a wide variety of asset classes you will have your eggs in the same basket. In case their is a loss in one type of assets then it will only be a small part of your portfolio.

Hence the way to go is to through heavy indexing of the market. You will need to be exposed to a wide range of index fund and mutual fund. You will invest in bond fund, mutual fund in stocks, etc.

Hence when you will invest in index fund and mutual fund you will not have the need to chase performance. You will be exposed to every sectors of the economy and all this will be done passively. Hence  you will not need to chase performance. Your return will be close to that of the overall market.

Strategies for the successful investor part 5 :Do not trust experts or fund managers

The one thing that most people think is that they can outsmart the market and have a better return than the overall return of the market. What can happen is that a few person can outperform the market for a few years but over the long run they would most likely either underperform the market or come close to it.

On the long run the best you can do is to equate the average return of the market. Thus the only investment that would come close to the market average rerun would be the index fund or a mutual fund that is invested in a broad range of stocks and bonds.

why is it that no one can outperform the market?

1. Most fund make use of researches and fund managers that are highly paid so that their salaries have to be deducted from the return of the fund. This would thus reduce the fund’s overall return.

2. A lot of these actively managed funds rely on selling and buying of shares so that investors in these funds need to pay capital gains tax. These taxes thus reduce the return of the funds.

3. Actively managed funds rely on timing the market. That is selling high and buy low. This is quite difficult to achieve and and as a result the return is less that anticipated.

Hence the index fund or the passively managed mutual fund is the best bet to achieve a return that is as close to possible to the average return of the market. The fees of these funds are low because the funds do not need to pay a lot of researches and fund managers. They also mostly rely on the buy and hold strategy thus reducing the need to try to time the market.

Although funds that try to actively time the market and employs famous fund managers are quite attractive, history tell us that they always underperform the market so keep away from them.

Strategies of the successful investor part 4: Rebalancing

One of the most important aspect of your investing life is rebalancing. As you know a portfolio must be diversified in that the portfolio is composed of a wide variety of asset types such as bonds, stocks, etc. Depending on your investment plan and your risk tolerance the different asset classes will be a certain percentage of the portfolio. And in each asset class their would also be some diversification.

You would probably have stocks that are in different sectors of the economy or bonds that are from different types of issuers such as corporate bonds, municipal bonds or government bonds.

Hence it is important that your portfolio composition be as close as possible to that that your plan states. However the economy is not static. Depending on the state of the economy some stocks might increase in value while others decrease in value. This will cause your exposure to these sectors to change. The percentage of the stocks of some sectors of the economy will increase or decrease in your portfolio.

The change in price might also change your exposure to some asset classes. A bull market might increase the percentage of stocks in your portfolio while reducing the percentage of bonds in your portfolio. If left unchecked the asset allocation of your portfolio will change with time and also the riskiness of your portfolio will change. This might thus reduce your chance of reaching your goals.

Thus you need to rebalance regularly. At least once a year is sufficient. Your aim is to reduce your exposure to certain asset classes that have increased in value while increasing your exposure to those that has decreased in value. You will thus return your asset allocation to that that is stated in your investment plan.

You will thus have to sell securities and buy others. This is the most difficult part for some investors because of the cost involved in selling and buying securities. Also some investors may not like selling performing stocks and buying poor performing stocks. However history tells us that a portfolio left to fluctuate with the market always perform poorly.

So keep rebalancing and your portfolio and you will be on course to riches.  

What is an interest-based security?

 

There are two ways in which securities are issued. They are either issued and interest is earned on the principal, hence the term interest-based securities, or they can be issued at a discount or at a premium, hence the term discount based securities.

In this post I am going to talk about those securities that are interest-based.

When you talk about such securities the investor, you, will invest a certain amount of money called the principal. This is the amount that you would invest at the beginning of the contract and at maturity you will receive this same amount. 

Then the return every year on this amount that is invested is called the interest. The interest earned will be calculated using the interest rate on the investment. The higher the interest rate the higher the interest earned.

Hence generally this principal is invested for a length of time ranging from 7 days to five years. The interest rate of the investment also depend on the length of time for which the principal is invested. Generally the longer the time the higher the interest rate. This is because your money is locked in the investment for a longer length of time. You will thus have to be compensated for the decrease liquidity and the greater risk taken.  

Now there are two ways in which interest will be accrued on the principal. It will be either a simple interest  whereby the interest will be calculated every year on the principal alone. Hence you will obtain the same interest every year.

You can read a post on simple interest here.

The other type of interest is the compound interest  whereby the interest earned every year is calculated on the principal and the interest earned in previous years. You can read a post on compound interest  here.

What is a Banker’s Acceptance?

As we have seen in an earlier post, the Banker’s Acceptance is one of the instruments traded in the money market.

It is simply an instruments that are used by companies to obtain funds. It is generally cheaper than loans or overdraft.

Let us take the examples below to understand how it works.

A company needs money to buy goods for the Christmas season and want to obtain funds from the bank and will pay back the money after Christmas. This company generally needs to pay cash especially if it is buying goods abroad where companies do not want to take the risk to give goods on credit.

The company will approach his bank and will enter into an agreement according to the sequence below.

1. The company approach the bank to enquire about the discount rate on BAs.

2. The BA will have a face value that the company will have to pay after a specific period of time. Likewise any investor that have bought the BA on the secondary market and who will present the BA to the bank at maturity will receive the face value as indicated on the BA.

The BA will also contain the commission that the bank will take from the company. Hence the bank will pay the company the face value minus the commission. If the face value is $ 1 million and the commission of the bank is $ 20000 then the company will receive only $ 980 000. 

3. If the bank accepts this agreement it will endorse it. Hence the name of Banker’s Acceptance. If the bank has accepted the agreement it would have to pay the face value of the BA to the holder of the BA at maturity.

4. The bank will then sell the BA on the secondary market where it will be traded until it reaches maturity.

5. At maturity the company will pay back the face value of the BA to the bank. However even if this does not happen, the bank will have to pay the holder the face value.

However I would still discourage small investors from investing directly in the money market. It is much better to invest in a  money market mutual fund.

What is a commercial paper?

The commercial paper is a form of debt securities that is issued by companies. As we have seen in this post on bonds government and corporations issue bonds that have maturities of greater than one year on the capital market. With regards to maturities shorter than one year the government will issue treasury bills whereas corporations will issue commercial papers. The commercial paper will thus be, like the treasury bill, a money market instrument.

Hence the commercial paper will be issued at a discount by companies and at maturity the holder of the commercial paper will be paid the face value of the commercial paper. The discount rate will depend on the credit rating of the company and present market conditions. Since it is only companies with good credit rating that can issue commercial papers, the discount rate will slightly higher than government for treasury bills.

Companies are constantly in need of funds to settle current liabilities and to buy inventories. This is because there is always a mismatch between income and spending, The companies will thus raise the short term fund needed in the money market because use of banks for such short-term financing is costlier and time consuming.

Just like the treasury bills, commercial papers are quite safe. This is because the short-term maturities at which they are issued means that investors can determine whether the firm has a risk of default on the commercial paper. This is because investors would have known from previous financial statements whether the companies is sound and what is the possibility of it going bankrupt. However as you may know banks with their exposure to risky derivatives or bank runs may go bankrupt even if they were sound a few months or weeks before.However given the slight possibility of going bankrupt the return will be slightly higher than on treasury bills.

You might thus think that commercial papers will be good to invest in. However these commercial papers are issued at high denominations. As a result the retail investors like you cannot invest directly in them. Thus the only way to get exposure to them is through money market mutual funds.But like I have said in a previous post it would be better if you invest in stocks, government and corporate bonds and other higher yielding instruments.

Happy investing.

What are treasury bills?

Treasury bills is one type of instruments that is traded in the money market. 

A treasury bill is typically a bond that is issued by a central bank or by a government that has a maturity of less that one year. The treasury bill is sold without coupon payment. A coupon is a payment that is made every six month. It is paid as a percentage of the nominal price of the bond.Hence the treasury bill is sold at a discount and then the government will pay the face value at maturity.

These treasury bills are issued by governments in order to raise funds from the market. Because these bonds are issued by the government of a country it is therefore considered to be the safest asset and as a result would have the lowest return of all. Because of its safety it is used very often to calculate the bond spread of other bonds. The bond spread is simply the difference in return between the other bond and the return on a three month treasury bill. The greater the bond spread the riskier the bonds.

Treasury bills are also the most liquid and the most traded of all instruments. This is mainly because banks and other non-bank financial companies are required by law to hold them. For banks they may be used as collaterals in repo transactions with the central banks or in the interbank market to obtain funds. Because they are highly liquid these institutions hold them so that they can be readily converted to cash to settle obligations. Otherwise if they have excess funds they invest them in treasury bill in order to get a decent return. Short term insurers also hold a significant amount of treasury bills because they also need to have access to their fund on short notice.

These treasury bills are issued in two ways. They are either issued through auctions or over the counter. Banks and other institutions participate in weekly auctions. They state the price, the discount rate and the maturity that they want and the central banks will allocate the bills starting from the one offering the highest offered price. After they are issued in the primary market they can then be sold in the secondary market where you can buy them. However you can still buy them directly from the central bank.

As an investor you might obtain treasury bills at any institutions that have them in their portfolio and are prepared to sell them or over the counter at the central bank. But I would strongly advise investing in a money market fund if you want to gain exposure to the money market.

However since treasury bills are the safest of all investment it makes no sense investing a lot of money in them. At best you can invest 5 to 10 % in them in case you want to diversify your portfolio and decrease the riskiness of your portfolio. I would myself advise about 10% in a money market mutual fund, 10% in a bond mutual fund and the rest in other instruments such as gold, stocks, and so on.    

What is a penny stock?

As the name suggest a penny stock that is worth pennies or is quite cheap. The definition varies but any stocks that is very cheap compared to price of solid companies may be considered as a penny stock. That compared to stocks like Microsoft that may worth hundreds of dollars. Since a stock’s price is a reflection of the future earnings of the company then in theory a penny stock is the stock of a company whose earning’s prospect is quite tiny to be respectful.

So what is the fuss you may ask. The penny stocks is composed of two types:

1. The first group of stocks is made up of the stocks of companies that that are going out of business. Think of a company of  camera with reels, a magnetic tape company, or a company that makes floppy disks, etc. These companies may once have been mighty, but their products are now obsolete or their business model have failed and as a result they will certainly go out of business unless they reform or restructure. So any stocks of these companies is throwing money out of the window.

2. The second groups consist of tiny companies that have just started up but do not have the recognition of the bankers. So they are craving for you to give them the chance  that they need. Think of Microsoft or apple in the 70s.However you also know that 90% of small businesses will go out of business in the next 2 years. So it is still quite difficult to spot the company that will make it big.

Now that you have understood what penny stock is you can see that it is quite risky to invest in them but if you are able to spot the one then you can multiply you money by a lot.

 

Let us look at the factors that makes these stocks risky.

1. These stocks are generally not listed on an exchange. This may be because to list on an exchange a company have to abide to some strict conditions such as financial reporting guidelines, directors have to abide to some rules, etc. If these companies cannot abide to these rules that are there to protect shareholders or other stakeholders, then it is not a good idea to invest in them. Financial statements will enable you to analyse the company’s performance other several years and see if they are worthy of your money. The companies may be run by convicted directors. Companies run by convicted companies will not be allowed to list on exchanges and if they are not listed on exchanges they will not provide reports and as a result you will not know about the directors. As you can see there are a lot of risks.

2.If you have bought these stocks then someone out there may be thanking all the gods of the earth. You do not get an idiot everyday to buy a stocks that no one want. This is because penny stocks are illiquid that is they are difficult to sell. There are a lot of sellers but a few buyers. The only way people can sell their penny stocks is only if someone is foolish enough to buy it.

3. These stocks are easily manipulated by fraudsters. Since they are illiquid and hard to sell, some people buy them cheaply and then make a hype about the stock so that unsuspecting buyers will but them at a higher price.

As you can see it is quite risky to buy these types of stocks. Although you would make it big if you can buy in the next apple or the next Microsoft it is more likely that you will lose your money. So just like I advise investors to avoid derivatives, I would advise them to avoid penny stocks. Invest in healthy companies. Also if a listed companies is delisted or is about to delisted get out immediately.

Good luck to you all in your investing.

Strategies of the successful investor part 3:Do not follow the herd

If there is one thing that I have learned during this 2008-2009 recession is that following the herd is pointless and a waste of time. Hence while everyone was selling in the stock market and buying in the money market, I have been buying stocks on the cheap. the same thing goes for the bond market.

The reason for this is an old instinct from when humans were still like animals, the crowd effect or the herd effect. This instinct meant that when you see a whole bunch of people running in a certain direction, then it must mean that they are running away from a danger and as a result you must run with them.

So how does this translate in the investing world? If you see a lot of investors buying or selling a particular stocks then it must mean that they are right and as a result you must buy that stock too. The second reason is that as people buy that particular stock its value increases and the gain or return on investment increases. As the gain increases those that have not yet bought the stock would be pressured to buy the stock either by the investors that they work for or by their employers. This is a vicious cycle that few could resist.

Guest what I have done it and you can do it also.  How so you would ask.

First of all the only way you could make money on such bull market is to buy it first when it is cheap and then selling to the herd followers when has risen to a high enough value. I would say that this is difficult to do. If you have seen it the surely a lot of people would have seen it. However if you have been able to see it early and get on the bandwagon just wait until it is high enough and wait for some time and sell it so someone else. Do not wait for the top of the ride because when people realised it is all bullsh_t then they would be selling and you would not be able to get your money back.

Apart from such herd following tactics I have my own way of buying stocks. Research is important and as a result you must educate yourself in economics and some basic accounting. Certainly you can watch TV or read newspapers but only to get information on the economy and on spotting trends in the economy that you can exploit by investing in companies that are in that sector.

When you have learned some basic knowledge you can use that knowledge to research companies. You would analyse their financial statements, their future probability and the market they are in. For example you could see that KodaK and their future in the photo reel market is a dead end as they are entering the digital photography market fast enough.

If you want to go into mutual funds, index funds and Exchange traded fund then you could use your knowledge to research the different companies that are offering them. You would make research on historical return, management, commissions and fees and so on.

Very often you would come across the internet websites that promises to teach you how to invest and as a result you would obtain great return. Most of the time you would have to buy a report or a document that promises to give you tips on how to invest and as a result you will make great return. Most of these are false promises and a complete waste of money. Imagine if you have discovered a stocks that promises great return, would you make it public? Certainly not! you would secretly buy it little by little so as not to arouse suspicion. You would keep it a secret and earn the return alone. That is why you should keep to your plan and not buy all the crap documents that are being sold on the internet.

Sure I read on the internet but only information websites like the BBC, Yahoo money or famous economics like Paul Krugman. These website will give analysis on the economy as a whole and will give you indications on what the economy is going to do.

The last advise that i would give is to make your own research and follow your investment plan. Never never follow the crowd. Stick to your investment plan and to you asset allocation and you would stay on tract to meet your objectives.

strategies of the successful investor part 2 :Time is your best friend

As I have written in an earlier post, time is the best friend of the investor. As we have seen in the first post you will have to draw up a plan. this plan will contain information about for objectives, risk tolerance, risk tolerance and asset allocation.

However the time that you have will impact on these four aspects on you investment life.

I am going to take the examples of a person saving for sending his child to university and for retirement and talk about how the time aspect would affect the achievement of these objectives.  

Suppose that a person who is 20 years old want to retire at the age of 60 years old and also to save money for a child who has just been born. Such a person has 40 years to grow his portfolio for his retirement and 20 to send his child to university. Such a person has time on side.

This person can afford to be risk averse and conservative and invest in a greater amount of safe assets. This person can also invest a smaller amount  of money every month because he has the advantage of compounding. Compounding will ensure that his money will grow with time even with small monthly investment. Such a person would be able to achieve his objectives with no problems.

On the other hand if a person is 35 years old and want to retire at 60 years old and want to send his child to university in 10 years then this person will not have time on his side. This person will have to invest more aggressively and cannot afford to be risk averse and must choose assets with greater riskiness but with greater return. Such a person will not also have the advantage of compounding and as a result will have to invest more every month. This person may have no choice but to delay retirement or the time set to attain the objectives.

The lesson that we can learn today is that if you have time on your side then you are a lucky guy. But if you do not have time on your side then it would be harder.

Strategies of the successful investor Part 1: Set up a plan

This is the first part of a series of post which would be about the strategies of the successful investor. As we have previously discussed the only way to be secured financially is through investing. However there are some very important things the the beginner investor must keep in mind so that his portfolio will grow with time.

A plan is the cornerstone of your investing journey. The plan is simply a document that would guide you and make sure that you do not get off-track.

It contains firstly your objectives.Each person may have different objectives and to state them clearly and the time available is crucial to your plan. You may want to retire in 35 years or to send your child to college.

After having written your objectives you would thus try to determine the amount of money that would be required to achieve these objectives.

After having identified your objectives and the money that would be needed, you would then be able to identify the return that would be required to reach that amount of money. Your portfolio will thus have to have a certain annual return so that you will be able to reach that objectives. If you cannot reach that return then you would be unable to achieve your objectives.

However the return is also related to another term and that is your risk tolerance. This is related to the different component of your portfolio and the return of your portfolio. You have to understand that some investment instruments are risky in that you can lose your money especially if the company go bankrupt but if you can hold on to it and the company stays afloat you would have greater return. The higher the riskiness and the greater the return. Some people have a low tolerance and as a result would want safe assets. However safe assets would result in low return. Hence if you want higher return you would have to invest in riskier assets.

After having chosen the return that you want and the risk that you are prepared to tolerate you would thus be able to choose the investment instruments that you need to invest in to achieve the return that you want. 

What is a money market?

The money market is one of the markets that companies and government used to raise funds. What is special about the money market is that securities with a maturity of less that one year are traded in it.

In general all of the money market are debt instruments issued government, banks and companies. These instrument are very liquid and quite safe. As a result because of this safety they have a relatively low return. You would understand that generally instruments that are quite risky have higher yield and vice versa.

The following are the different money market instruments that you can invest in:

1. Treasury bills
2. Banker’s acceptance 
3. Negotiable certificate of deposits
4. repos and reverse repos
5. Commercial papers
6. Eurodollars

However compared to the stock market whereby individual investors can buy individual stocks, money market instruments are issued in high denominations and as a result it is quite difficult for individual investors to but them. The only way for investors to invest in them is through mutual funds and exchange traded funds. However if you have a lot of money you can buy treasury bills from the reserve bank offices.

These money market instruments are like instruments in the bond market in that they are not traded in a stock exchange like shares but are traded over the counter.

There are various reasons for an investor, a bank or an institution to buy securities in the money market and they are as follows:

1. The securities in the money market are very secure and as a result investors that have some money for a short period that they cannot lose prefer to invest in the money market and get a small return until they need the money. They can when needed sell the securities easily to get their money back since money market securities are highly liquid.
2. Some banks are obliged by law to hold a certain amount of money market securities to use as collateral in repo transaction with the central bank. These banks must also have assets that they can easily convert to cash in case money is needed to satisfy liabilities. Since these money market securities are highly liquid they are easily sold in the secondary market.
3. Some type of financial market institutions like short term insurer need by law to hold a certain amount of highly liquid money market instrument so that they can   meet their liabilities.
4. Some investors are risk averse and as a result they have a low risk tolerance. These investors prefer to forgo the high return associated with stocks and prefer to hold safe money market securities that however have low return.
5. Investors and financial institutions that have excess cash, for example after selling stocks and bonds that are falling in value or are about to default and are waiting to invest in other securities, can invest in money market securities and have a small return instead of holding cash with no return.

There are also many other reasons for investing in the money market and as time go by I would increase and refine the list above. So if any of the reasons is appropriate to you then go ahead.

However keep in mind that in the long run investing in the money market is not advised as the return is low. However there is a type of investing strategies called the permanent portfolio that relies on investing in the money market. I would write on it in another post.

How to buy and sell stocks using a broker?

In my two previous post here and here I wrote about what a broker is and how to go about to have a brokerage account.

If you have a full-service broker chances are that you will not need to know these information as the broker will do every thing for you. However it is wise to learn so that you can become more knowledgeable about investing.

If you are have a discount broker then you need to tell him what you want him to do. To be able to do this properly you need to know certain terms so that he will do what you want. You will then communicate this to him by phone or by any previously agreed means in your agreement or brokerage contract.


Here is how things goes. On the market there are people who want to sell stocks and other securities and those who want to buy.

Let say that three people want to sell stock of company x at the following prices. These are the sell prices or the ask prices.


Person A $50
Person B $51
Person C $52

Now three people want to buy the same stock at the following prices. These are the bid prices.

Person D $48
Person E $47
Person F $46

Note that those that are selling are always offering a higher price than those who are buying. The difference between the two is called the ask-bid spread.

In our example the ask-bid spread is $2. This information means that the buyer will have to raise his bid price by two dollars to be able to buy his security or the seller has to lower his ask price by two dollars to be able to sell his security.

What is important is that the person who is ask the lowest price will be given priority and his stocks will be sold first. The same is for those who want to buy stocks, the person who bid the highest will be given stocks in priority.

However if there is a deadlock and that no stock is changing hands, the the seller can suggest the highest bidding price and his stocks will be sold. Using the example above if person A decreases his ask price to $48 then his stocks will be sold to person D. The opposite is also true. Person D can increase his bid price to $ 5o dollars as a result he will be able to get the stocks that person A is selling.

Now what orders are you going to give the broker?

1. Market Order: The broker will buy the stocks at the best available price. In this case if you are person D you will be giving the broker the instruction to buy shares at $50. This order will be executed immediately.

Limit Order: This will be for the broker to buy only when stocks are available at a given price or to sell only when there are buyers that are prepare to buy stocks at the price that you want.

Stop Order: This would mean that you are giving your instruction to stop buying once stocks are exceeding a level and are being too expensive to buy. This is called a stop-limit. You can also give a broker an instruction to sell your stocks once the value of the stock fall below a certain level. This may be because the stock has been bought at a higher price and that the lower it falls the more loss you are going to make on it. That is why such an order is called a stop-loss.

All or None (AON): This means only to buy stocks if all your order can be fulfilled. Sometime if you want to buy 500 stocks of company x at $50 and that there is a seller of 400 stocks at $50, normally the broker will buy the 400 stocks for you. In the All or none the order will be executed only if there is a seller of 500 stocks.

Day Order: This order will be only for the day. That is because some order can continue until the condition for the order is satisfied.

Good Till Canceled (GTC): This order will remain valid unless it is executed by the broker or cancel by the person.

Fill-Or-Kill: If this order is not executed immediately then it is to be canceled.

This now end the three part series on the broker and the service that they offer.

Do you have any question or you want to talk about you experience on using a broker? Leave a comment below.

How to start investing with a small amount of money?
Fees and commissions and how they affect your portfolio.
How to choose a broker?
What is a stock?
Stocks have higher return than bonds
How to be rich buying stocks!!
Should i sell my stock and hold cash?
Introduction to diversification
How and when dividends are paid?
what is a stock exchange?
How to choose a broker - part 2?

How to choose a broker - part 2?

In the first post that you can read here, I talked about the different types of broker and what type of broker would be appropriate for your situation.

Today I will tell you about how to go about creating a brokerage account.

At this point you have analyzed your situation according to the first post and have decided whether you want a discount broker or a full service broker. You have most probably chosen a broker according to the factors mentioned in part one.

How to set up the account?

When setting a new brokerage account it is important to follow the following steps.

1. The broker should understand clearly what your objectives are. You may simply want him to execute your orders as you will do all the thinking or research. However you may want him to do more than that. You may have some long term objectives such as retirement, your children studies, etc. These objectives should be clear to him as he will devise an investment plan for you that will enable you to attain these objectives.

2. The broker should understand what is the level of risk that you can bear. That is your risk tolerance. Read this post to understand and determine your risk tolerance. The broker should know this so that he can recommend the type of securities that fit the level of risk that you can bear.

3. The broker should know your complete financial situation.He should know your income so that he and you can determine the amount of money that you can invest monthly so that you can reach your objectives. However this may help him determine whether investing is appropriate for you. Remember if you have any debt, investing may be inappropriate for you. Read this post on the subject.

4. The power of the broker. If you are unable to make proper assessment of securities, then it is appropriate to let the broker assess the securities and then take the decisions for you. But this right should be in written form, and any decision should be such that it goes toward reaching your goals. A decision by the broker should never be such that it is against your interest or towards reaching your aim.

5. Every time you buy and a security it must be in the prescribed form that is recommended in the contract. If the contract states that orders to be in writing then only written orders will be accepted to buy or sell securities. Also every time a securities is bought or sold you must have written confirmation of it.

If trading is done electronically then you will not have a certificate but simply a notice. If trading is not electronically then the broker can send you the certificate or keep it at the brokerage firm if that is in your contract or agreement.

6. Make sure that everything that we have talked above is in writing and that you have a copy of the contract. You should keep a copy of this for future reference. Everything that the broker can do should be according to this contract.

Now that you have a broker learn how to buy stocks here.

Do you have any questions on choosing a broker? Do you want to share your experience with us?Please leave a comment.

How to start investing with a small amount of money?
Fees and commissions and how they affect your portfolio.
What is a stock?
How to be rich buying stocks!!
How and when dividends are paid?
what is a stock exchange?

What is a bond ladder?

A bond ladder is an investing strategy that try to maximize and create a regular revenue stream with bonds. Read my post on bonds here. As you know bonds are debt instruments that pay a coupon or interest on a regular basis in fact twice a year if you are buying the regular one. This is particularly important for people who are retired or who depend on a regular income from their investment.

The bond ladder has another advantages. It is like dollar-cost averaging. As you will be buying bonds on a regular basis you will avoid buying at times of too low interest rate. Imagine buying all your bonds in a recession. You will be locking low returns on your fortune for a long time to come.

A bond ladder has the following characteristics:

1. Bonds with different maturity period. This would mean that the different bonds would mature at different times and that in case you have an emergency you would have access to funds. For example you might have bonds that have a maturity period ranging from one year to twenty years. The key is to have a bond that matures in the next year so that you are able to be able to redeem your capital and use it in case you have an emergency or buy another one to replace the recently matured bond.

2. Bonds that matured at different months of the year. The key here is to have bonds that mature at different months of the year and as a result pay coupons or interests at different months of the year. If you are a retired person, then you would have regular income.

How to build a bond ladder?

Now suppose you have 1 million dollars in you retirement account and you want to build a bond ladder. The ladder will have the following characteristics.

1. The number of rungs. This would be the number of lots that you want to divide your $1million. If you divide the money into ten lots then you will have will have 10 rungs. If you divide the money into more lots then you will increase the number of different types of bonds that you can invest in. See this post on diversification. However the more lots you have, the more would be your cost when you will have to reinvest a matured bonds. The less you divide your money into lots, this would decrease your reinvestment cost. However this would increase the chance of losing a large percentage of your portfolio in case one of the bond issuer default on your bond.


2. The length of the ladder. This would be the longest maturity length that you want one of your bond to have. You might want to have your bonds to have twenty years maximum maturity. The longer the length of the ladder the more return you will have because remember you will have to be compensated for the increased uncertainty. However keep in mind that twenty years is a long time and it increases the chance that you will lose your capital because of default. But keep in mind that too short a maturity will means that you will have to do will low return. That is also not good.The conservative investor might choose twenty years while the aggressive investor might choose twenty years.


3. The length between the rung. You have the chance to make the time between two bonds attaining maturity long or short. If it is too short then it means you are dividing your money into too many lots or have only short term bond maturity. Either way it is not good. The best way is to have the time between maturing bonds of about 1 year. Hence if you have emergency you would be able to survive on the coupon payments until you are able to redeem the materials.

4. The bond ladder should be composed various types of bonds ranging from government, state, municipal and corporate bonds. This is to avoid placing all your money in a single type of bonds. Please read here and here on the importance of diversification.
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However, I would strongly discourage against anyone having only a bond ladder. This investment will need to be supplemented with other types of securities to meet true diversification even though you have a bond ladder that is well diversified. You never know what could happen.

Do you have a bond ladder? Please share your experience with us or ask a question by leaving a comment.

How to choose a broker?

The broker is the second most important person in your investing life. The first one is you of course. So what is the broker? He can be described as an intermediate between you and the market. You will use him to buy the different instruments on the market. Even though you can buy some instruments on your own, it is time consuming and you might not have access to a wide range of investment instruments as you would if you have a broker. so for all practical purpose i will advise anyone to invest through a broker.

What are the different type of brokers?

There are mainly three types of brokers:

1. Full-service broker

A full-service brokerage as the name suggest will provide all the services that one can need. The broker will provide you with a wide range of securities, they would provide recommendations and advices on the securities that you can buy. The broker can also tailor-make a portfolio for you that is appropriate for your situation. This type of broker is ideal for if you are new to investing because it will reduce the risk that you can commit a costly mistake. This type of broker is generally costly but it is worthwhile for you until you are able to invest on your own. You will pay the broker a fee for advices and a commission as a percentage of transactions.

2. Discount broker
The discount broker will give you access to investments instruments but will not give you advices or give you information, He will only take your instruction on what to buy and what to sell. Your instructions will be through fax, email or telephone. You will have to use your own experience, researches and knowledge on what instruments to buy and to sell. Normally an investor will start with a full-service broker and the later on move to a discount broker. This type of broker is usually advised for experienced investors. This type of broker take a small commission and as a result is better for those that want to increase return.

However if you want to be a couch potato investor and invest in bond fund, index funds, etc it is better to use a discount broker.

3. Online broker
The advent of the internet has come blurred the distinction between the two types of brokers. Now both traditional discount broker and full-service broker are offering online services to cater for the investors that want do things for themselves and who want to have access to real-time information. However it is increasingly common for discount broker to offer online research reducing further the difference between an online broker and a full-service broker. The online broker is the cheapest of all and as a result it is advisable for someone who can manage his investment by himself and who need access to the latest information.

Factors in choosing a broker

1. Make sure that the broker is a registered broker. It must have a good reputation. You can do this by talking around with friends, colleagues and making your own research. The broker must also have a good reputation in the financial world. Only after this has been done that you can go forward. I choose the brokerage arm of my bank.


2. Your financial goals, If you have goals such as retiring, sending your children to school, etc then it is better to choose someone that can give you advice. He will advise you on the portfolio composition, what instruments to buy and sell and what investment strategies to adopt. Then a full-service broker is advised.


3. Your risk tolerance. If you have a low risk tolerance then you will be scared to make mistakes and lose your investment. Then a discount broker is not for you. It would be better if someone else do all the work and take the important decisions for you. Read this post on risk and risk tolerance.


4. The fees and commissions charged by the broker. Remember on the long run fees and commissions reduce your return, so it is important to choose a broker that offer the lowest rate. Discount broker generally offer the smallest rate.
Read this post on fees and commissions on your portfolio.

The brokerage account:

There are two types of brokerage account

1.The cash account

The cash account is like a regular account. You deposit money in it. when you give the broker an instruction to buy a security, the broker will use the money in the account. You can buy securities worth not more than the amount of money in the account. Note also that the dividends that you receive from companies will be deposited in the account.

2. The margin account

The margin account is like a credit account that the brokerage give you to buy securities. When you buy a security you will have to pay the money back with interest. This type of brokerage account is recommended only for the experienced investor. Those involved in option trading or similar risky transactions. I would strongly advised the average investor to invest using a cash brokerage account.

3. Option account

This type of account is for those who want to trade in options. Remember that option trading is very risky. Please read this article to understand risk. I would recommend this type of trading for the experienced investors only.

Please read the second part of this post here.

How to start investing with a small amount of money?
Fees and commissions and how they affect your portfolio.
What is a stock?
How to be rich buying stocks!!
what is a stock exchange?
What is market capitalisation?

Risk and return

One of the most important concept in investing is the concept of risk and return. The lower the risk the lower the potential for the return and conversely the higher the risk the greater the potential of return. In order to be a successful investor you should be able to assess what is your risk tolerance and what is the level of risk in your portfolio. Finally you should be able to decide what is the level of risk that goes with your risk tolerance.

Riskiness of investment

Investments can classified in term of risk. Some investments are quite safe and as a result the possibility if losing your capital is low. Others are riskier because the possibility of losing your capital increases and as a result the person in need of the capital will have to compensate you for taking the risk and hence you will obtain the higher return. Probably the person that raised the capital is doing an activity that has a chance of failing.

The table below shows the different investment instruments in term of the risk associated with them.

As you see, the different instruments can be classified in three different categories depending on the level of risk associated with them and the potential for return.

Group one investment instruments are relatively safe and as a result there is little possibility of losing your capital. Even though on rare occasions relatively safe companies and banks can go bankrupt and make you lose the money in your bank account or the capital of your bonds.

Group two investment instruments are moderately safe and as such give average return. Their is always the possibility of a company going bust or than a town or a state will default on payment. For example if you hed stocks in Leyman Brothers your share will have no value as of now. Also states like California may default on payment of bonds in the future if the deadlock on budget expenditure is not resolved.

Group three investment instruments are highly risky and speculative. There is a great possibility that you will make great return or great losses. You can have bonds from Iceland for example that are highly speculative and you can lose your capital if you invest in these but if the country can hold until the bond reaches maturity, the interest earned will be high and you will get your capital back.


Risk Tolerance

Before jumping in with your hard-earned money and starting to buy investment instruments you need to determine your risk tolerance. The risk tolerance is simply how much risky investment you can hold in your portfolio and you are comfortable with. After you have determined your risk tolerance you will then be able to determine the type of investment instruments you will be able to buy.


Three factors will affect your risk tolerance.

Time

When you invest, you will need to determine your goals. And the time left to attain these goals. If the time left is long then you can afford to take more risk because should you suffer a loss you will have time to recover the loss. You will invest heavily in stocks, company bonds, real estates, etc. You will be an aggressive investor.

However if the time left is short, then you would want to invest in safe instruments. You will not want to risk losing in your money. May be your son will go to university next year, or you will retire in the next ten years. These people will probably shift out of shares and company stocks and invest in safe instruments such as CDs, government bonds and debentures, blue chip stocks or bonds. You will be a conservative investor.

Acceptance of loss


Some people even though they know that they have a long term investment plan, they are not satisfied to the idea that in the short term their investments can decrease in value but keep on increasing in value over the long run. These people will thus choose to be conservative investors. They will contend themselves with measely and mediocre return.

If you want to know how to allocate your portfolio read this post.

You will probably want to read this post on diversification.

Active trading - The key to beating the market

As everyone who has been reading this blog know I am a fan of buy and hold. You can read about arguments for buy and hold here. However some people argue that they are able to beat the market. This type of investment strategy is called active-trading.

I must be clear here that active trading is not for the novice. In order to invest using active trading you need to have a lot of experience and knowledge in the working of the stock market, So if you are new to investing for now you must stick to buy and hold and at the very most trading once in a while.

What Is Active Trading?

As you know over the long run the market go up even if from time to time in recession it goes down, However the trend is always up. Even if the market can go down in the short run, it will always recover and go up. You can see why some people prefer buy and hold. You invest and because you are sure that in the long run it will go up you just wait and watch your portfolio increase in value.

However some people cannot wait for years and they try to take advantage of the short term fluctuations of the stock market. I must say that to predict what the market will do in the short run is quite difficult but not impossible. For example a trader might feel that the price of oil will go up and as a result hedge it, or another one might feel that the shares of a company will fall in vale and short sell it. The strategies that the active trader uses are numerous. However i must say that whatever the active trader do he is increasing the probability of a gain but he also raises the probability of a loss.


So can anyone become an active trader?

I must say no. You need expensive computers and softwares to start. You also need some knowledge in the analysis of data so that you can make sense of the information available. You need to identify trends in data and identify peaks and bottom in the trends so that you know when to buy and when to sell. You need to have considerable knowledge of the factors that can influence the price of a stock and how they influence the price on a daily basis and predict the price of that stock in the short term.

Furthermore active traders used borrowed money in order to increase profit. For example someone who is sure that the price of a stock will double in the next week, might borrow money in order to maximise his gain. Many active traders have made a fortune doing this. But keep in mind that money borrowed must also be returned and if your bet is proved wrong then you might have to sell everything that you own to pay back the money.

Furthermore frequent trading, means that you have to pay commissions and capital gains tax. When taking the taxes and commissions into consideration the return that you have to make above the normal buy and hold return is considerable.


To summarize i would say that active trading is risky, difficult to do in the long run and not for the average guy. I would say that even if you have some experience, active trading is reserved for a select fews that are very good. So guys I would recommend that, as a beginner, you just keep to the buy and hold, index funds or government bonds.

Here are some post that can help you on index funds and on bonds and stocks.

What is market capitalisation?

There are two terms that define the value of the company.

1. The asset value
2, The market capitalisation

The asset value

The asset value is typically the total commercial value of all the buildings, equipment, furniture, patents , etc of the company. Typically everything that can be sold for a price. The reason that asset price is not used is that investors prefer to use market capitalisation as it is a better estimate of the company's ability to make a profit. A lot of asset is not an indication of the ability to make profit.

The market capitalisation

The market capitalisation can be calculated using a simple formula

Market capitalisation = share price X number of oustanding shares

Companies are classified in six broad categories depending on their market capitalisation.

Mega cap

A mega cap company is one that has a market capitalisation greater that $200 billion dollars. These companies are generally large and profitable such as Exxon. There are few of them. Generally their shares are quite expensive and difficult to obtain. If you have them in your portfolio keep hold of them.

Large cap

A large cap is a large company with a market capitalisation of $ 10 billion to $ 200 billion. Examples are Microsoft and IBM. These companies are relatively safe to invest but just as the mega cap their shares are relatively expensive and difficult to get. If you have them keep them unless a major catastrophe will befell the company.


Mega caps and large caps are also called blue chip companies. They are relatively secure to invest in. If you can get your hands on them in this bear market buy them and keep them. You will hold them for the long term.

Mid cap
A mid cap company has a market capitalisation of between $2 billion to $ 10 billion. However these companies offer greater return to the investor but a few of them will certainly fail. This make them a risky bet for the investor so it is better to limit your exposure to mid cap to not more that 20 %.

Small cap

A small cap company is relatively young and has a market capitalisation of between $ 300 million to $ 2 billion. Such a company offer great opportunity for growth. Imagine that if you invested in microsoft when it was a small cap you would be rich today. However a lot of small cap

Smaller companies are called micro caps and nano caps. They are very risky and if you want to invest in them you have to be very careful and limit your exposure to them to just a few percentage points of your wealth.

One last piece of information is that this information is not valid for every country. It is made for multinational companies. If you want to have your own classification for say Egypt, you will have to take the biggest company by market capitalisation and called it a mega cap and classify the other companies according to their market capitalisation.


Good luck. As usual i would like to give this advise again. As a new investor you should limit your exposure to small caps and mid caps. Only after having gained some experience and being able to analyse companies can you increase your exposure to them.

Happy investing.