The 13 Steps to Investing FoolishlyNext Step: Get Fully Foolish>>
Step 12: Advanced Investing IssuesDerivatives, shorting against the box, ascending trend channels, 50-day moving averages, Bollinger bands&ldots; ohmigosh! Yes, there are a heck of a lot of high-level, complicated topics in investing, which, fortunately for you, are basically nonsense.
Top Five Admissions We'll Never Hear From any Investment Guru on T.V. 5. I have no idea why technical analysis should explain anything. 4. I don't understand the difference between a rating of 'outperform' vs. 'accumulate' either. 3. Of course indexing beats trying to time the market. But that won't make for a very good interview. 2. I'm making most of this stuff up as I go along. 1. Our brokerage makes money the old-fashioned way. We charge outrageous fees You can let out a big sigh of relief, because in this step we won't be covering or going into excruciating detail about many of these "advanced" topics. Instead, we'll highlight a few market complexities, some that are worth running away from (options, day trading) others that provide a useful chuckle (technical analysis), and a couple that you might consider learning more about and perhaps employing (margin and shorting).
Options
They're mysterious, alluring, and full of danger. We're speaking not of spies or supermodels, but of "calls" and "puts." These are options, which we generally steer clear of. We'll soon explain why, but first let's review how they work.
Calls give you the right to buy a certain number of shares of stock at a certain price, by a certain date -- usually within a few months. Puts do the opposite, giving you the right to sell.
Imagine that you're excited about Legal Beagles (ticker: WOOFF), a new company providing legal advice for house pets. Shares are currently trading for about $75 each and you expect big things. After researching the company's financial merits, you might decide to buy some shares. Or -- you could buy options on it.
Let's say you buy a May $80 call option. You now have the right to buy 100 shares of WOOFF for $80 per share until the third week of May. (And you've just paid
$500, or $5 per share, for that right.) If by late May WOOFF has indeed risen and is at $95 per share, your plan has worked well. You'll exercise the option, paying $80 per share instead of $95. If you turn around and sell those shares, you've made a $15 per share profit, right? Not quite. Remember to subtract the $5 option price, and to consider the broker commission and the short-term tax bite.
That might still not seem so bad, but realize that most options expire worthless. The underlying stocks might move in the expected direction, but they won't always do so within the typical option's limited time frame. If WOOFF doesn't advance beyond $80 per share by the third week of May, you're out of luck and have just wasted the $500 you paid for the option. WOOFF might soar to $120 in the first week of June, but that's too late for you. If you'd simply bought stock in this company that you believed in, rather than options, you'd own something valuable and lasting.
So why do people like options? Because of leverage. Instead of spending your money buying a few actual shares of stock, that same money will buy you many more options. Instead of paying $7,500 for 100 shares of WOOFF, you could have paid only $500 for the option to buy 100. Options permit you to "establish a position" in a stock at a much lower cost. Just remember that the position is virtually indefinite if you've bought the stock and very temporary if you buy the option.
Another way that options are used is to protect positions. Let's say you've bought actual shares of WOOFF at $75 per share. If you're afraid that the price might drop suddenly, you could invest in put options that will give you the (again, temporary) right to sell WOOFF at a certain price, no matter what it's trading at. That way, you have some downside protection. Of course, we might wonder why you're hanging onto a stock that you feel so ambivalent about. And we notice that you'll have to keep buying more puts as each one expires. Those purchases add up and eat into whatever profit you expect to make on WOOFF.
Beginning investors shouldn't even think of gambling with options, and Foolish veteran investors would probably want to steer clear as well. With options, you're really just buying time and betting on short-term moves.
Day Trading
We think the best way to accumulate wealth is to buy stock in great businesses and hold on for decades. But this is easier said than done. When the stock market is surging or plunging, or when you learn of one exciting company after another, it can be hard to refrain from actively buying or selling.
The buy-and-hold message is further challenged by the likes of "day traders," who believe they can wring extra profit following the stock market by the hour. You've probably seen segments on day traders on your nightly news. It's become a fad, as more and more people forego regular 9-to-5 jobs and instead spend that time with their eyes glued to computer monitors (and we all know how painful that can be), buying thousands of dollars of stock at a time, holding it for a few hours (or minutes!), and then selling. Sheesh.
People "investing" like this aren't really investing. They're gambling. They're not holding on to pieces of strong companies, accumulating wealth as the companies grow. They're making bets that they can outthink others. They aren't participating in the growth of the American economy -- they're betting that they're better guessers than the next guy.
You might think to yourself, "That's fine. I don't day trade. I week trade or month trade." Well, consider the research of Brad Barber and Terrance Odean, professors at the University of California at Davis business school. They recently hammered another nail into the frequent-trading coffin, demonstrating that individual investors who buy and hold generally outperform those who trade frequently.
Barber and Odean studied the trading of more than 60,000 households with accounts at a major discount brokerage from 1991 through 1996. They learned that the average household had a net annualized geometric mean return of about 15.3%, compared with a market gain of 17.1%. Bummer. Even worse, the fifth of the households that traded most often realized merely a 10% yearly gain.
The professors concluded that these folks were losing to the market because they were trading too much. The average household turned over, or "churned," 80% of its stock portfolio each year. This means that a portfolio valued at $10,000 had $8,000 worth of stocks bought and sold during the year. We're not talking small-potatoes expenses here, as things like commissions and capital gains taxes will take significant bites out of these investments.
The lesson is clear: Investors who think of themselves as committed, long-term owners of businesses are much more likely to generate enviable returns than are the active traders who try to time the market by rapidly moving in and out of stocks.
In Barber and Odean's own words, "[Frequent] trading is hazardous to your wealth."
Technical Analysis
"Beware of technical analysis, my son! The jaws that bite, the claws that catch!" Had Lewis Carroll been an investing aficionado, he might have cautioned investors about technical analysis, instead of the Jabberwock and Jubjub bird. Or, heck, he might have just broken down in a fit of laughter. (Which, from what we've heard about his pharmacological habits, he may have been doing quite a bit on his own time.)
There are two major camps of investing. Technical analysis dwells on charts of stock price movements and trading volume. Fundamental analysis, on the other hand, focuses on the value of companies, studying such things as a firm's business, earnings, and competition. While investors from the fundamental school (Fools!) want to understand a business from the inside out, technicians mostly remain on the outside, observing how the stock behaves in the market.
Technicians have defined many patterns in the charts they study, imbuing them with much significance. There's a head-and-shoulders pattern and a cup-and-handle pattern. The patterns they see do exist, but they don't necessarily mean anything. Imagine someone discovering that on presidential election days, whenever the skies above Fresno were cloudy, Republican candidates won. Like many patterns, this would be a randomly occurring one, a coincidence. For you to bet any of your hard-won savings on this would, we think, be nothing more than gambling.
Investors who use technical analysis focus on the psychology of the market, scrutinizing investor behavior. They try to determine where the big, institutional money is going so they can put their cash in the same places. Imagine Warren Buffett trying to follow this short-attention-span crowd instead of seeking, buying, and holding great companies for the long term. Imagine the taxes and commissions. Yeesh.
It's amazing to think that technicians might study a stock chart, see a particular pattern, determine that the stock is "breaking resistance," and then buy shares. All this would be done without understanding what the company does or what its prospects and circumstances are.
Always focus on the fundamentals, Fool. If you find a company quietly selling more and more prefab igloos, increasing its profit margins and earnings and going unnoticed by Wall Street, consider snapping up shares. Don't worry about what others are doing. The true value of great companies is eventually recognized.
Margin
Buying on margin means you're borrowing money from your brokerage firm and using it to buy stocks. It's attractive because you can turn a profit using money that you don't even have. For that privilege, you're paying interest to the brokerage, just as with any other loan. (Actually, it's a lot easier to open a margin account than to apply for a bank loan.) If the market turns against you, you either sell for a loss -- plus interest costs -- or hold on until the market picks up, paying interest all the while.
Investing with margin isn't an automatic no-no, in our opinion. It should
just be used with extreme moderation and caution. While some people will max out on margin, borrowing 50% of the value of their portfolio, we think that's far too risky, and something that any investor is better off avoiding.
We suggest that if you already have been investing for a few years and decide to use margin, you limit yourself to borrowing no more than 20% of your portfolio's value. If you do so and you have $20,000 in your portfolio, you'll be borrowing $4,000 and putting $24,000 to work for you. That's called leverage. A little of it can be a useful and not-too-risky thing.
Think very carefully before you use margin, though. If you're borrowing on margin and paying 9% interest, you should be pretty sure your stocks will appreciate more than 9%. If your margined securities fall below a certain level, you'll receive a "margin call," requiring an infusion of additional cash.
Only experienced investors should use margin. Indeed, many experienced investors steer clear of it. As of this writing, none of our real-money online portfolios have used margin, and they're all doing just fine.
There is one reason why, even if you're not interested in buying stocks on borrowed money, you still might want to open a margin account...
Shorting
If you've ever swaggered up to a craps table, cleared away the necessary elbowroom, and slapped down a few candy-colored chips on the Pass Line, you were doing what most of the people at a craps table do. You were betting with the crowd.
Adjacent to the Pass Line, however, is a cheaper strip of real estate (usually a vacant lot) known as the "Don't Pass." It's virtually the opposite bet; you win when the Pass Line crowd loses, and lose when it wins. Because you're betting against the roller and most of the rest of the table, betting Don't Pass is considered bad form; the craps jargon for you is "wrong bettor." Many other bettors will actually dislike you for doing it, a feeling that will be reinforced whenever you smile at dice rolls that make them frown. If you read our message boards for very long, you'll notice that short-sellers aren't generally the most beloved of contributors to this forum.
When you short a stock, you are banking on that stock's price going down. You initiate the process of shorting a stock by first borrowing shares from a current shareholder. This may sound difficult, but it isn't; your discount broker does this for you automatically. You then sell these borrowed shares at the current market price. Then you sit and wait, rooting the stock downward. While you wait, you have to pay dividends to the person who actually owns the stock you borrowed (if the stock pays a dividend), and, in some cases, you can also be subject to paying margin interest to the brokerage, just as if you had borrowed money.
When you're ready to cash out of your investment -- whether for profit or for loss -- you close out the position by buying the stock back at the then market price, so that you can return your borrowed shares to the lender -- another thing your broker does for you automatically. That's it.
Shorting can offer a couple of potential benefits for your portfolio. First, shorting stock is a "hedge" -- you're taking compensatory measures to counterbalance a potentially plummeting stock market. Outside of its status as a hedge, however, selling stocks short is also a great way to make money. Indeed, if you short the right stocks, you can make money both ways... long as your small stocks and the general market rise AND short as your shorts wither. It's tremendous fun! In fact, before we turned Foolish enough to short stocks, we didn't know just how much fun we were missing.
Second, and more important, the shorting of stocks is vastly underpracticed by the investment community at large. From a purely Foolish point of view, this makes shorting stock even more compelling. That's because Fools relish a good swim against the tide. When most investors are trying to figure out how many more half-point gains they can squeeze out of their equities, we're looking the other way. We're regarding these same securities from the top down, assessing how far each might fall. The seldom-taken contrary view can be lucrative.
A final note: Once in a blue moon, your broker may be forced to return your shorted shares to the anonymous lender, usually because he wants to sell them. Forced into doing so, you'll have to buy back the shares prematurely -- whether you've made money or not. This happens only with very small companies that have few shares outstanding, and is usually just a minor nuisance. Put the money somewhere else.
When calculating returns, keep in mind that all the normal steps of buying a.nd selling a stock are still present, just reversed. Both transactions still have a cost basis and a sales price. But for stocks sold short, the chronological order has been reversed.
Shorting stock is one approach that separates the sophisticated investor from the novice. Believing that selling shares short is difficult and highly dangerous, some people pay oodles of money to enter "hedge funds," mutual fund partnerships whose managers short stock and go on margin. Having read this far, you already know most of what these "pros" know, and can do it yourself.
Finally, remember that when your "Pass Line" friends find out you're shorting stocks, they may start to regard you as Darth Vader. So wear dark clothes, a low visor, breathe loud, and milk it.
For more on the pros and cons of shorting, check out our Shorting Stocks message board and read our Dueling Fools debate on it. You're almost home free, Fool. Now onto the last step to investing Foolishly.
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