Dollar Cost Average: Stay away from Predicting

Posted by Stock Online Trader in Educational on 03-31-2007

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The truth about making money in the stock market is buy low and sell high. Quite simple eh ! But hold on, how do you really know when the market has hit bottom ? Can an investor really predict the bottom ? As a matter of fact hedge fund managers, mutual fund managers, private investment managers, market gurus, CEOs and analysts can’t predict the bottom, nor can you and me. So how should we approach this problem ? It is actually a tough one. Predicting if the market has reached its bottom it not that simple. However using the Dollar Cost Average investing technique, you could protect yourself in a falling market. Let us learn how.

What is Dollar Cost Average (DCA)
Dollar Cost Average is simply putting a X amount of money each month into an investment such as a stock, index fund or mutual fund. Most banks will even set up a monthly automatic-withdrawals service. Dollar Cost Average is also ideal for the investor who doesn’t have that big lump sum at the start but can invest small amounts on a regular basis. For instance, instead of investing a lump sum in one stock immediately, you might invest $2,000 in that stock at the beginning of every month.

Let us paint a scenerio
Let us say you have $5,000 to invest. Instead of investing the lump sum into a security, you decide to use DCA and spread the investment out by investing $1,000 a month for the next five months. This averages the price over five months, so some months you may buy fewer shares, each at a higher price, and some months you may buy more shares, each at a lower price. If the market is lower this month, you may lose money on the shares you bought last month, but this month you receive more shares, which, in the future, will help offset any losses. With DCA, you are able to take advantage of any low during these five months, guaranteeing you to invest at the very bottom because when it comes, you are simply doing what you do every month. Once the market turns around, which it is likely to do in the long term, you’ll be ahead.

For example:

Month

Investment

Price/Share

No. of Shares

Profit/Loss

Jan

$1000

$10

100

$0

Feb

$1000

$5

200

- $500

Mar

$1000

$8

125

+ $400

Apr

$1000

$10

100

+ $1250

May

$1000

$12.5

80

+ $2562

From the table above it is clear that using DCA, you end up making $2,562 as compared to $1,250, had you invested in lump sum.

Benefits of Dollar Cost Average

  • Reduces average cost per share: When you invest a set amount of your money each month, you buy fewer shares when the market is high and more shares when it’s low. This reduces the average cost per share which eventually will help you gain better overall profits as the market increases over the long term.
  • Reinforces disciplined investing: Dollar cost averaging requires the discipline to invest consistently, regardless of market fluctuations, which reinforces the habit of regularly setting aside money for investing.
  • Market trend: The markets, even though they have bad days or even bad years, tend to go up over time. With dollar cost averaging technique, it is very likely you will go ahead in the longer run.
  • Reduces fear of investing: Fear of investing at a market high can keep most investors waiting on the sidelines. With a dollar cost averaging program, you just follow the plan and invest on a periodic basis, without trying to time the market.
  • No need to predict: You do not have to do any predicting! If you were to try to forecast the bottom, you could miss it altogether and risk putting your entire investment in at a bad time.
Conclusion: Next time you hear of a forecasted bottom, you can be confident that he or she is no more insightful than you no matter who the individual is. No person can predict market behavior. But you can be rest assured that if you use dollar-cost averaging, you are being prudent. Dollar Cost Averaging not only offers protection from market swings but also helps you can take advantage of the ever-elusive market bottom.

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How to Determine Your Returns in the Stock Market

Posted by Stock Online Trader in Educational, Emerging Markets on 03-30-2007

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With all of the volatility in the stock market over the past several years, it can be difficult to determine how to devise an investment strategy to maximize your returns. To help you determine a reasonable rate of return to expect on your stock investments, it might be helpful to review some facts about the stock market.
Historical Returns
Stock market is a one place where you can make alot of money very fast as well as lose money at the same pace. Most of us make money on some stocks and lose on some others. What matters in the end is what returns can you expect on an annual basis. If you look at the history,
  • 1926 – 2004, the average return from the stock market was 10.4%
  • 1955 – 2004, the average return from the stock market was 10.9%
  • 1980 – 2004, the average return from the stock market was 13.5%
  • 1995 – 2004, the average return from the stock market was 12.1%
The stock market’s historical return can change dramatically depending on the period considered. But over a period of time, on average, the return has been in double digits.

Market is cyclical
Stock market sooner or later reverts back to the mean. If the stock market has rallied up for a particular time-frame, it has also dropped later on significantly to even out the early gain. Before the dotcom bubble burst, the stock market had reached new highs. After the bubble burst, the stock market saw a significant downturn, helping to bring the averages back in line.

You can expect double digit returns in both markets, be it bull market or bear market. However to do that successfully you need to know how to time the market, that is, when to go long and when to short.

Past Performance as a Bad Predictor
The expected return rate from the investment is typically calculated by analysing the past returns, since no one can predict future returns. However, it’s important to realize that those returns may not be replicated in the future. U.S. market saw excessive growth as it grew from a struggling nation into a superpower. That same growth rate cannot be expected anymore, especially with BRIC nations (Brazil, Russia, India and China) knocking at the door.

Buying stocks based on past performance will not ensure the same returns. With globalization and cut-throat competition, if the company is not in sync with current consumer needs, it wont survive, and eventually affecting your returns.

Inflation and Taxes
Inflation and Taxes are the 2 most significant items not accounted for in historical returns. From 1926 – 2004, the average inflation was 3.0%. Short-term capital gains are taxed at ordinary income tax rates of up to 35%, while long-term capital gains and dividend income are taxed at 15%.

Historical returns do not include several items that investors must deal with, especially inflation and taxes. Both factors need to considered to determine what returns to expect.

Individual investors returns
In general, return rate of investors tend to be lower than the overall market. A recent study found that investors in the NYSE and AMEX experienced annual returns that were 1.3% lower than market returns from 1926 to 2002, while Nasdaq investors experienced annual returns that were 5.3% lower from 1973 to 2002.

Pattern of actual returns
Even if you get the average rate of return exactly right, your portfolio’s balance will depend on the pattern of actual returns during that period. Some years will experience higher-than-average returns, while other years will have lower or even negative returns. If you experience high returns in the early years, your portfolio’s value will be lower than if those returns occurred in the later years. If you encounter negative returns in the early years, you will have a higher balance than if those negative returns came in the later years.

What does all this mean to an investor?
When designing an investment program, use a conservative estimated rate of return, since it may be difficult to earn the historical returns of the past.

Few of the important strategies to use for higher returns:

  • Invest in business you understand and foresee growth
  • Invest in a tax efficient manner
  • Diversify your investment portfolio
  • Consider international investments
  • Evaluate your portfolio’s performance atleast once a year
Conclusion: Everyone wants to maximise their returns in the stock market. However it is easier said than done. With the knowledge of historical returns, market cycle, past performance, inflation & taxes, individual investor returns and pattern of the returns you can make a reasonable guess at the return rates which is what matters at the end of the day.

Recommended Books:

(Source: Investorguide)


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Bankruptcy: Good, Bad and the Ugly

Posted by Stock Online Trader in Finance Sector, Investment on 03-28-2007

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When a person or a firm is unable to pay their ever-increasing debts, they can file for bankruptcy. Let us say Mr X filed for bankruptcy. This means Mr X’s existing assets will be liquidated and he will be relieved of any liability. The reason why most people file bankruptcy is that their debts have reached a level where they cannot pay them back and only way out of it is a fresh start.

Last year in U.S. more than a million filed for bankruptcy. That number will increase this year due to
  • Bad housing market (which leads to foreclosures & delinquencies)
  • Bear stock market (with housing & subprime lending stocks leading the way)
  • Possibility of a recession (as per Greenspan’s comment)
  • Energy prices (ever increasing oil prices putting extra burden on everyone)
  • Increased inflation (driving up the prices of goods and services)
  • Americans save less money leading to high debt to income ratio
Types of Bankruptcy
  1. Chapter 7: Mr X can file for Chapter 7, which basically means that all his assets will be liquidated except few exempted ones depending on which state he lives (car, clothing, household appliances, life insurance, pension and work related stuff). The liquidated assets will be handed to the creditors. A trustee is appointed, who ensures that any assets of Mr X that are secured are sold and that the proceeds are paid to the specific creditors. Generally the secured creditors (banks) are the first one to get paid. After all secured creditors are paid, the remaing cash is distributed to any outstanding creditors with unsecured loans (bondholders and preferred shareholders).
  2. Chapter 11: If Mr X had his own business, he could file for Chapter 11, which is designed largely for businesses. Under this chapter, a business will be continued to operate while a court approved plan is setup to repay the creditors back. A trustee is appointed just like for Chapter 7, but rather than selling of all the assets to pay back to the creditors, the trustee supervises the assets of Mr X and allows business to continue. Chapter 11 differs from Chapter 7 since in Chapter 11 the debt is not pardoned, but only the terms of the debt is restructured.
  3. Chapter 13: If Mr X still has a regular source of income, he could file for Chapter 13 bankruptcy protection, which allows him to keep certain property while he pays off his debts under the supervision of a court-appointed trustee. The time-frame alloted is generally anywhere between 3 to 5 years. In 2003, U.S. citizens filed for Chapter 13 bankruptcy almost 500,000 times, making it the second-most popular form of bankruptcy behind Chapter 7.
The Good, The Bad and The Ugly About Bankruptcy
There few positives and negatives Mr X need to know before filing for bankruptcy.

The Good

  • Distressed debtors can get rid of their debts, especially with Chapter 7.
  • Bankruptcy may get rid of unsecured debts (A loan not secured by an underlying asset or collateral).
  • Bankruptcy can stop foreclosures for homeowners, repossessions, deducting money from wages, utility service cancellations and activities of debt collectors against the debtor.
  • Chapter 7 and 13 bankruptcies provide exemptions that allow debtors to keep certain assets, though those exemption amounts vary greatly from state to state.
  • If a company is successful in chapter 11, it will typically be expected to continue operating in an efficient manner with its newly structured debt.
  • The law forbids discrimination against those who have filed for bankruptcy, so a debtor cannot be denied a job, public housing or a driver’s license on this basis.
The Bad
  • Some debts (student loans, alimony, child support, fines and penalties) will not be discharged.
  • Chapter 7 relief is available only once in any 8 year period.
  • The rights of secured creditors to their collateral continues even though their debt is discharged.
  • Debtor need to file the claim and pay a fee (adding extra expense). Debtor also need to pay a bankruptcy lawyer, and it can be difficult to find a good one, since some try to maximize their profits by handling cases as quickly as possible instead of giving debtor’s bankruptcy the attention it deserves.
  • If a company is not successful in chapter 11, then it will have to file for chapter 7 and liquidate.
The Ugly
  • Debtor if found guilty of certain types of inappropriate behavior (concealing facts related to financial condition) will not be granted a discharge of debt and could possibly face jail time.
  • File for bankruptcy will remain on your record for up to 10 years. This may make it difficult or impossible to obtain a credit card or a loan.
How Does It Affect Investors
Let us say Mr Y and Mr Z are investors with some stakes in Mr X’s company Danger Inc. Mr Y is a shareholder and Mr Z is a bondholder of Danger Inc. Later on Danger Inc filed for bankruptcy. So what happens to Mr Y and Mr Z’s investments ? There is a very high possibility that Mr Y and Mr Z will end up making a sizable loss over the investment.

Generally nobody invests money in a company facing bankruptcy. Add to that when the company declares bankruptcy, its stocks and bonds usually continue trading at extremely low prices. Mr Y will see a substantial decline in the value of his shares. Mr Y will stop receiving dividends if any. Mr Y will also not have any more say or voting rights in Danger Inc’s restructuring plan. Mr Z would be holding bonds that are considered as junk. Mr Z will probably stop receiving interest and principal payments. Ouch…!!

List of Bankrupt Companies
Few known companies that filed bankruptcy are: WorldCom, Enron, Kmart, Silicon Graphics Inc., US Airways, Recently 4 subprime lending companies that filed bankruptcy are: People’s Choice Home Loan Inc., Mortgage Lenders Network USA Inc., Ownit Mortgage Solutions Inc. and ResMae Mortgage Corp.

Conclusion: A debtor should understand the pros and cons of bankruptcy before filing one. In general, bankruptcy should be used only when there’s no other solution. The 3 important types of bankruptcy are Chapter 7, Chapter 11 & Chapter 13. An investor should stay clear of companies declaring bankruptcy unless they have a solid reason to back their investments. There is more to bankruptcy that has not been covered in this post. I will address those topics in a follow up post. So stay tuned :)

Recommended Books:

Products & Services:

(Source: Investopedia, Wikipedia)


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