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.

Credit card debt - The investor's worst nightmare

A few days ago I wrote a post on whether it is possible to invest and to have debt at the same time. I wrote that someone who is on a credit card debt should preferably pay back the debt first.
You can read the post here.

So I have decided to make a few calculations in order to convince you of the above. Suppose that two persons spend $3000 on a credit card. Bob decides to pay it back by monthly payments of $ 100. while Tom decides to pay it back by monthly payments of $75. Suppose the credit card company charged at an interest rate of 20 % per year.

Below is table on how the two of the paid the balance on the credit card.



So what are the information that we can deduce from the table.

For just 25 dollars more per month Bob reduces the time needed to pay the debt by two years and also reduces his interest payment by half compared to Tom.

What is more shocking is the fact the return of the credit card company is roughly 60 % for Tom and that falls to roughly 30 % for Bob.


In order for any investment to pay off with such interest rate payments you would need to have return on your portfolio that is greater than 20 %. I must say that unless you are a very good investor that is not possible for the average person. Unless you invest in a credit card company.


Having a credit card is a definite drag on the investor. If you are unlucky enough to have a credit card balance. try to pay it in the shortest possible time because as i said it in my earlier post the earlier you start investing the better, and you cannot invest with a credit card balance. It is as simple as that.

Please read my post on how to reduce debt and how to live within your means.

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.

Invest or debt reduction?

One of the questions that i hear most often from people that have debt is whether they should invest. Is it not better to pay the debt first and the start investing?

I beg to differ. I think that,while debt reduction is important, you should also invest. Of course it would have been simpler if you had no debt, but hey do you know a lot of people who are debt free?. The key to resolve this issue is a good investment plan and a monthly budget. First you would have to analyze your debt structure so as to determine your investment strategy.


Types of Debt

1. High-interest debt

If the debts have high interest on it then the return on the investment must be more than the interest that you will pay. It is as simple as that. If you have high interest debts like credit card loans then it is better if you pay the loans fast unless you can have a high yielding portfolio. It is very hard for the average investor to build such a portfolio and risky.

2. Low-interest debt

These debts are only a few percentage above the rate of inflation or the repurchase rate. It is still difficult to invest with these types of debts but it is possible to build a portfolio that can have a return of about 10 % to cover the interest of the debts.

3. Tax deductible debts

This the best debt that you can have. You can usually claim a deduction for the interest paid on these loans. As a result you pay only the capital. With such types of debt you can invest in peace as you do not have to build a risky and high yielding portfolio.


So is it not better to pay all debts and then start investing later? That would be a mistake since a lot of debts are long-term debts. As a result you would never start investing. Further investing require discipline, sticking to a budget and to have a plan. I am certain that with a plan and a budget you will spend your money wisely and pay your debts faster or even avoid taking unnecessary debt.

Just like paying debt take time, investing also take time. In fact the earlier you start investing the better your return. I talked about this in this post about compounding. Compounding is simple.

By sticking to your investment plan you can invest small amounts monthly in stocks, bonds or even better in mutual funds and index funds. Investing is a great way to still discipline your spending and help you to live with better debts.

Please read this post about living within your means and how to reduce your debt.
You can also read this post on investing small amount of money.

What is a stock exchange?

A stock exchange is a company that make it possible for people who want to sell stocks and other investment instruments to be connected to a buyer. We can thus say that it facilitate the selling and buying process of stocks.

It is not possible for a buyer to meet a seller directly. Each investor must have a broker and when you want to sell or buy a stock the broker will place your order in the exchange computer. When you get a seller or a buyer the exchange will tell your broker and finally you will be informed by him. You cannot deal directly with the exchange yourself. Nor can you meet the person that is buying your stock.

Apart from facilitating the buy-sell process the stock exchange offer several advantages.

1. You do not have to go around looking for people to buy shares. Also even though some companies sell stocks over the counter this is a daunting task and this can be done using a stock exchange in minutes.

2. The stock exchange protect the investors in that you are certain to get a share when you buy and to get your money when you sell. You also have consumer protection institutions that can initiate actions if your rights have been infringed.

3. Companies that are listed on the exchange have to abide to some rules. They need to have a certain market capitalisation, they need to follow accounting standards, they need to issue financial reports every quarter among others, their shares have to be above a certain value, etc. As you can see, if you are investing in a company listed on an exchange you are sure that the company is secure.

4. Companies must get shareholders agreement before going ahead with some plans such as raising the number of shares, mergers and acquisitions, etc.

5. Companies listed on a stock exchange must a board of directors that are independent and capable of doing their jobs. At least in theory.


As you can see trading on the stock exchange offer some advantages. Even though when trading you have to pay some fees, i sincerely believe that the advantages far outweigh the disadvantages. In fact if you are buying for the long term the gain on the long term will be far greater than the fee.

So guys be safe and trade on an exchange.

Good investing.

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.

Fees and commissions and how they affect your portfolio.

One of the things that you do not hear often is the impact of fees and commissions on your portfolio. Their is a good reason for this. The financial system has no advantage in whether your portfolio grow and shrink. That is because they derive their incomes from fees and commissions.


When you start investing you need to know that whenever you do a transaction you will need to pay a commission. When you buy or sell a share or any investment instrument you pay a commission. You might not realize it but if you start with a small sum you will soon find that you will have paid a large part of it to the brokerage firm as commissions.

To understand what it meant to your portfolio. Lets assume that you invest 1000 dollars with a fee of 10 dollars per transactions. You buy five types of shares. The fees is now 50 dollars. This is 5% of the investment. So if your portfolio has a rate of return of 5% per year then it meant that you will have to wait more that one year just to break even. So imagine that you start to buy and sell shares very soon your portfolio will start to shrink at a rate of 5 dollars per transaction. As you can see it is not a viable option for the new investment to trade often. That is the reason that I favour the buy and hold strategy, at least in the first few years.

So what to do?

When it come to fees the different instruments are not equal to each other. So here is an analysis of different instruments and how they differ when it come to fees.

1. Bonds, gilts and treasury bills.

These can be available at any central bank or their regional offices. They come with little fees.
However their return is not that mush.

2. Exchange traded funds, mutual funds and index funds.

These are my favorite when it come to reduce fees and commissions. It is ideal for the beginner investor. In fact it reduces the impact of diversification which is a great fee and commission eater. I think that a beginner should stick with these funds until they can understand the market and trade on their own in stocks.

3. Stocks

Stocks is the investment instruments that has the highest fees and commissions. In order to have a good portfolio an investor will have buy into many stocks and that will make the initial commision payable high. So i would advise any new investor to stick to bonds, cds, and funds.

4. CD, Certificate of Deposits

These come with small fees and some banks do not charge any. But Beware most banks do have a penalty when to come to taking your moner before the maturity date.

As you can see the fees and commisssions should be kept in mind if you a new investor. If you are not careful the only person that will benefit is the broker.