Selection of Individual Investments
In order to match your objectives with specific investments, you
need to identify the characteristics of the different investments and
their risks. Funds for immediate needs and emergency purposes
should be liquid, in other words, able to be converted easily into
cash without incurring a loss of principal. Such investments are
money market mutual funds, checking accounts, and savings
accounts. These are readily convertible into cash. By increasing the
time horizon from immediate needs to short-term needs, investors
could increase marginally their rates of return by investing in certificates
of deposit (CDs), Treasury bills, and commercial paper.
However, of these, only Treasury bills are marketable, meaning
that they can be sold on the secondary market before maturity.
Savings accounts, CDs, money market mutual funds, Treasury
bills, and commercial paper provide some taxable income, are liquid,
but do not offer the possibilities of capital gains or losses.
Although investors might not lose any of their principal by investing
in this group of investments, there is a risk that the returns from
these investments may not keep up with inflation.Table 18-3
The financing of intermediate-term objectives that stretch
several years into the future—such as the purchase of a car, a
house, or an appliance or the funding of a child’s education—
requires investments that generate income and the return of principal.
These investments need to produce a greater rate of return
than a savings account or short-term money market securities.
Short- to intermediate-term bonds offer increased rates of return
over money market securities as well as the possibility of capital
gains or losses if the investor needs the money before maturity.
Although investors receive increased rates of return from intermediate-
term securities over money market securities, investors need
to be aware that their principal invested in intermediate-term
bonds is not as liquid as short-term securities.
An investment plan to finance a child’s education in five years
requires a relatively safe investment, which would not include
investing in stocks. Most people would not gamble with the money
earmarked for their children’s education in the event of a declining
stock market when the money would be needed.
Long-term objectives such as saving for retirement or for an
infant’s college education in 18 years require investments that offer
long-term growth prospects as well as greater long-term returns.
Stocks provide larger long-term returns than bonds or money
market securities, but stock prices are more volatile. The level of
risk that can be withstood on stock investments depends on the
individual investor’s circumstances.
Amore conservative long-term portfolio might consist of longterm
bonds, blue-chip stocks, and conservative-growth stocks. The
emphasis of this strategy is to invest in good-quality bonds and
the stocks of established companies that pay dividends and offer
the prospect of steady growth over a long period of time. Securities
offering capital growth are important even for conservative portfolios
in order to provide some cover against any potential erosion
in future purchasing power from inflation.
A growth-oriented part of a portfolio seeks the generation
of long-term capital gains and the monetary growth in value of
the stocks in the portfolio. A more speculative portfolio, where
an investor can absorb greater levels of risk to strive for greater
growth and returns, would include growth stocks, stocks of emerging
companies, foreign stocks, emerging market stocks, convertible
bonds, junk bonds, real estate, options, commodities, and futures.
Bear in mind that including the last three types of investments—
options, commodities, and futures—is not an endorsement that
these securities should play a major role in a portfolio. For a speculative
investor who understands the nuances of these investments,
these securities could account for no more than 5 percent of
the total portfolio. The other assets mentioned offer investors the
opportunity for large gains, but the risks of loss are also greater.
Foreign bonds and stocks also should be considered, but investors
should do their homework first so that they understand the risks
fully. International mutual funds might be more helpful to spread
some of the risk, although in the short term there is always currency
risk when investing in off-shore investments. Over the long
term, however, exchange-rate fluctuations tend to even out and are
not a significant factor.
Investors who are not comfortable buying individual bonds and
stocks could choose mutual funds, exchange-traded funds, or closedend
funds. Investors willing to make their own investment decisions
on individual securities can eliminate the fees and expenses charged
by mutual funds and closed-end funds. When considering the different
types of securities to choose for a portfolio, investors should
weigh the characteristics of the type of investment along with the
risks. (See Table 18–3 for a summary of the strategies to reduce the
different types of risk.)
Summary of Strategies to Manage Risk
||Invest for a long period of time.
||Diversification: invest in companies
with low leverage.
||Active or passive strategy,
depending on the investor’s
rates of interest
||Increase the percentage of the
portfolio allocated to stocks.
||Increasing market rates
||Decrease the percentage of the
portfolio allocated to stocks.
||Invest in good-quality stocks.
||Purchasing power risk
||Requires active portfolio
management; invest in
stocks that (when inflation
increases) will weather the
effects of inflation better,
such as gold stocks, oil, and
As mentioned throughout this book, diversification reduces
risk without decreasing returns. A portfolio should include at least
12 to 15 stocks in order to lessen the risk of loss. In other words,
an investment in one company should not account for more than
10 percent of your portfolio. If that investment declines significantly,
you would be limiting the total amount of your loss to at
most 10 percent of your portfolio. One method of building a portfolio
is to invest equal amounts in different stocks. For example,
if you want to invest in 20 stocks, the amount invested in each
stock would be 5 percent of your total capital. However, you might
identify some of the 20 stocks that have the potential to perform
better with lower risk, and you would want to allocate greater
amounts to those stocks and lesser amounts to stocks that might
not be as attractive.Figure 18-8. Industry Selections
Investors who assume that the stock markets are efficient
strive to build portfolios that are well diversified with risks and
returns that match those of the market. In order to earn returns that
are greater than those of the market, investors would need to invest
in securities with higher risks than the market indexes. Passive
investment strategies of matching market returns involve indexing
and long-term buy-and-hold investing strategies.
Investors who think that they can beat the market averages
are more likely to choose their own stocks and are also likely to
have shorter holding periods for their stocks. Market timers buy
and sell stocks as market trends and economic factors change.
Some industries are more sensitive to the economy than others.
Industries that move in the same direction as the economy are referred
to as cyclical industries. The sales and earnings of these companies
generally are aligned with the economic cycle. The stage in
the business cycle of the economy becomes important to the timing
of the investments in these cyclical companies. For example, you
would not want to invest in the stocks of automobile companies at
the peak of an economic expansion because their stock prices
would be at their upper limits, and they would face a downturn in
earnings when the economy slows down. During a period of economic
expansion, the stock prices of cyclical companies traditionally
increase; during an economic recession, the prices decline.
Cyclical companies are in industries such as automobiles, building
and construction, aluminum, steel, chemicals, and lumber. Because
these stocks are sensitive to changes in economic activity, investors
should time their purchases of cyclical stocks to the early phases of
an expansionary period. Figure 18–8 illustrates the timing of the
different industries in the business cycles of the economy.
Coming out of a recession, financial stocks tend to do well
because of lower interest rates, whereas at the expansionary phase,
stocks of consumer durable goods companies are the ones to buy.
During a recession, consumers delay purchases of automobiles,
large appliances, and houses. Cyclical stocks fluctuate with the
state of the economy and are always hit hard by rising interest
rates. Into an expansionary cycle, capital goods companies benefit
from increased sales in the business sector, which result in an
increase in the demand for raw materials and commodities.
Stable industries include health care stocks, beverage stocks, food
retailers, food companies, consumer services, and household nondurables.
This pattern is typical in most business cycles, but exceptions
always exist. During the recession of 2000–2002, for example, auto
companies saw sales of cars rise significantly because of sales and
marketing incentive programs, such as zero-percent financing and
considerable price discounts. This increase improved auto companies’
sales but did not improve their profits. By timing stock purchases
in these different industries, investors might be able to
improve their returns.
Anticipating changes in interest rates could prompt investors
to reallocate the types of investments in their portfolios. If higher
rates of interest are anticipated, an investor has a number of
different options. Profits may be taken by selling stocks that
have appreciated, or the investor may decide to sell stocks in
the interest-sensitive industries, such as financial stocks, cyclical
sector stocks in the automotive and home-building industries,
and utility stocks. Some investors might buy stocks in the pharmaceutical
and food industries, which tend to weather the effects
of higher market interest rates better than other sectors of the
economy. Other investors might decide to hold their existing stocks
but not invest any new money in the stock market until interest
rates start to level off. True market timers might liquidate their
entire stock positions and wait on the sidelines for more favorable
Purchasing power risk, or inflation, hurts all financial investments
to some degree or another. However, traditionally, returns
on stocks tend to outperform those of bonds and money market
securities during low to moderate rates of inflation. Mining stocks,
such as gold and platinum, and aluminum stocks have been good
hedges against inflation.
Even a passively managed portfolio should be examined at
various intervals with regard to returns on different investments as
well as the changing economic conditions. Not all investments
achieve their anticipated returns, and if they turn out to be poor
performers, they might need to be liquidated.
Investors who do not have the knowledge and skills to manage
their portfolios might turn to professional advisors. Financial
planners and accountants offer advice on the planning and management
of portfolios. For investors who do not wish to be
involved in the management of their assets, there are professional
money managers and trust departments of various institutions.
Their fees are often a stated percentage of the total dollar amount
of the portfolio, which often requires that the portfolio be substantial
in dollar terms.
The key to long-term successful investing is to allocate investments
into bonds, stocks, and money market securities suited to
the investor’s particular objectives and circumstances.
Categories in Trading Mistakes
Lack of Trading Plan
Planning plays a key role in the success or failure of any endeavor
Using too much Leverage
Determining the proper capital requirements for trading is a difficult task
Failure to control Risk
Refusing to employ effective risk control measures can ensure your long-term failure
Lack of Discipline
A lack of discipline can destroy even the most talented and best prepared trader
Useful Advices to Beginning Trader
You can control your success or failure
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