Building a Solid Foundation Investing successfully is more about attitude than about money. Even an imminent inheritance and a good-paying job offer little hope of financial success without a positive, constructive attitude that leads to a rational, systematic investing approach. The solution to avoiding a stressful retirement and enjoying financial freedom starts by examining your attitudes. With a thorough self-assessment under your belt, you can begin learning sound investment fundamentals. Profit by Understanding the Risk and Return Relationship What is something you do really well -- better than most people? Whatever it is, your special skill or knowledge is probably characterized by two critical attributes: It's rewarding. Whether the reward is financial or simply the satisfaction of doing something worthwhile, you profit by it in some way. Developing your special skill or knowledge required some type of sacrifice. Investment reward is called return. Return is the financial benefit of risking your money in the market. It is expressed as "rate of return." Investment sacrifice is called risk. The essence of investment risk is the chance you take that the value of your investment will decline. Investment risk is usually expressed in terms of volatility in the value of the investment. The value of some investments, such as government bonds, does not change much, so the chance of losing money is slight. On the other hand, the value of stocks issued by many Internet companies rapidly rises and falls and may not recover. After analyzing your personality and grasping the concepts behind risk and return, you are ready to tackle the one simple fact that underlies the importance of investment risk and return: they are both positively and linearly related. In order to earn higher returns, you have to assume higher risk. If you are unwilling to accept high risk, your returns will be relatively low. In the long term, all investment securities and portfolios operate this way. The key to successful investing lies in a plan that is not only well thought-out and consistently applied, but one that accounts for and manages risk as well. A risk management plan expresses your personal tolerance for risk in terms of the kinds of investments you should own. Assessing Your Risk Tolerance Your risk tolerance is about personal preferences and goals. The cornerstone of a consistently applied risk management plan lies in an assessment of your own tolerance for risk and volatility. This leads to an investment plan reflecting both your personality and tolerance. A thorough risk tolerance assessment taps two key attributes: cash flow needs and your attitude about short-term fluctuation in the value of your investments. Cash flow is money coming in and then going out for expenses. If you depend on investment income to fund your cash flow, your investments should include safe stocks and bonds paying high dividends and interest. If you depend on employment income to fund your cash flow, you can invest in riskier, low-income stocks and bonds with greater potential to grow in value over the long-term. Your financial obligations and preferences determine cash flow needs. If you are approaching retirement, you may not currently have large cash flow needs. But upon retirement, your income source may shift from salary to earnings on your investments. It is at this moment when knowing yourself becomes extremely important, since you will be able to anticipate your reaction to seeing the value of your portfolio take occasional dives and experience long periods of no growth. By anticipating your reaction, you'll be prepared either to adjust your investment strategies or to sit back and ride out the storm. Matching Reward Expectations with Risk Tolerance If stock prices rise, it means the market believes profits will rise at roughly the same rate. In the long run, the economy cannot grow fast enough to sustain high double-digit profits. Therefore, stock prices could not sustain the high double-digit returns we witnessed in some recent years. A reasonable long-term return expectation hovers between 8 and 10 percent if the investor's risk tolerance permits allocating 60 to 80 percent of the portfolio to stocks and the remainder to fixed income investments. Investors with lower risk tolerance should expect less of a return. It can take both discipline and foresight to put money in low-risk investments. Nevertheless, a mismatch between realistic expectations and risk tolerance is a sure formula for disappointment. A well-conceived risk management plan matching risk tolerance and realistic expectations can prevent disaster while yielding respectable long-term returns. Getting a Good Start With Sound Strategy The Big Picture: How Investments Dovetail With Assets A balance sheet is a cumulative record of finances recorded at a single point in time. It is a three-part compilation of everything you own, everything you owe and everything you have left over. The difference between what you own and what you owe -- known as assets and liabilities, respectively -- is your balance sheet equity, also known as net worth. A balance sheet provides a bird's-eye view of finances in a way that lets you see how all of the pieces make up the whole and whether any adjustments need to be made. Balance sheet equity offers an objective measure of financial freedom. Each addition to assets, without an offsetting addition to liabilities, directly increases net worth. And here lies the ultimate goal of investing: increasing your net worth. The first step toward financial freedom demands sufficient liquid assets to fund short-term liabilities and foreseeable obligations, such as home repair or a car replacement fund. Your balance sheet should include categories devoted to specific future obligations. Once these categories have been funded, you can then devote your attention to increasing your net worth through investments. Asset Allocation Asset allocation is a process of continually dividing your assets into categories to maximize returns and control the risk of lost principal. As we move through this course, you'll see how the concept behind asset allocation can also be applied to investments. Effective asset allocation includes liquid asset categories to fund contingencies such as unexpected car repairs. You should also have funds devoted to foreseeable obligations such as insurance co-pays and deductibles. However, you may not want to allocate all the funds up front for long-term obligations. It's a better idea to pay for these in smaller installments. Your personal judgment is also central to how these funds are actually invested. Liquid investments can be converted to cash at any time without losing any of the money you initially invested. Contingency funds should be in cash or highly liquid investments, such as money in a savings account. If you put contingency funds in stocks, an illiquid form of investment, there's no telling what the fund will be worth if you eventually decide that you need the cash to pay your bills. Likewise, funds devoted to short-term foreseeable obligations should be liquid, though with these funds you have a little more latitude in your decision-making process. If you know beforehand when you will need the money, you can invest in higher-earning certificates of deposit or short-term bonds whose maturities match the timing of your obligations. Diversification: Capitalizing on Diversity The markets offer many kinds of investments that differ in their risk and return characteristics. Before thinking about your many choices, it is important to have a clear idea of the advantages of diversification. By sampling many different types of investments and including a proper mix in your portfolio, you ensure stability and a well-rounded portfolio. Diversification allocates investment assets into categories that respond differently to economic events. This helps preserve your portfolio's value, mainly because some investments rise while others fall. Investors also practice diversification to capitalize on unforeseeable growth and increase their net worth. For example, only a few investors anticipated in 1998 that oil service stocks would triple over the next two years. But, if you had a balanced and diversified portfolio that included many different types of investments, there's a good chance that you too might have capitalized on the growth of oil service stocks. Diversification not only provides protection, but it also offers an opportunity for profit. Fixed Income vs. Equity Investments All investments can be categorized as either fixed income or equity. When discussing investments, equity is not quite the same as balance sheet equity. Equity, as it relates to investments, is something you own, such as stock or rental property. Fixed income is a loan you make to somebody who promises to repay principal and interest. Bonds, the most common form of fixed income investment, promise a specified amount of interest and specified maturity date when the loan is to be repaid. Fixed income and equity respond somewhat differently to economic events. Changes in the interest rate directly influence the value of fixed income investments. While rising interest rates reduce their value, falling interest rates will increase their value. Although interest rate increases do tend to suppress stock values, equities are far more sensitive to anticipated future corporate earnings than anything else. This distinction is important because stock prices change even when interest rates are stable, and the value of fixed income can change even when corporate profits are stable. Within the two general investment categories of fixed income and equity, there are many possibilities for diversification, all of which possess different properties. For example, bonds with long maturities (e.g., 10 to 20 years) are more sensitive to interest rate changes than shorter-term bonds. You may want to select several different types of investment to protect yourself from any unforeseeable benefits or problems. Among equities, stocks issued by utility companies, for example, are less sensitive to economic changes than stocks issued by retail companies. An Overview of Asset Categories Successful diversification depends on your knowledge of your own asset categories and how each category responds to economic events. A useful approach conceptualizes investments along two dimensions: equity and fixed income investments, and international and domestic investments. Your personal preferences and goals drive asset allocation and diversification. If your overall financial plan requires income from your investments, your portfolio should have only a few investments that risk principal and more with fixed income investments. If your plan seeks portfolio growth and you have a long time horizon, use fewer fixed income investments and more equities and international investments. Here is a list of the chief investment categories with a brief summary of their properties: Equity Real estate -- Yields rent payments and capital gains, which are the profits you earn when you sell equity at a price higher than the price you paid for it. Prices vary with changes in rental demand and business outlook. Stocks -- Issued by corporations, confer corporate ownership. Income stocks -- Pay high dividends, which are the payments many corporations pay to owners of stock. These stocks commonly have low price volatility, which means that the market value does not change much from day to day, compared with that of most stocks. Growth stocks -- Pay low, if any, dividends. Prices rise faster than for other stocks, but fall faster on bad news. Examples: technology stocks, small company stocks. Value stocks -- Have prices low in relation to "true" value that are often suppressed because of market attention to other sectors or temporary corporate/industry problems. Examples: Oil service stocks in 1998, some technology stocks. Fixed Income All of these prices vary with changes in the prevailing interest rates. Corporate debt -- Generated when companies sell debt to investors. They are essentially IOUs; they carry stated interest rates and maturity dates. Notes are another form of corporate debt. The difference? Notes are short-term, and bonds are long-term. Values vary with ratings based on a company's ability to repay. Junk bonds -- Usually corporate stock issues that pay high interest rates because of market concern over the company's ability to repay. Government debt -- Issued by federal, state and local governments, usually at lower interest rates and with tax benefits. Examples: Treasury issues, municipal bonds. Money market debt -- Usually issued by corporations. Debt with maturity less than one year, low interest, high safety. Domestic -- Any investment issued by U.S. companies. These prices are influenced by economic growth, the prevailing interest rates and by corporate, industry and regional business prospects. International -- Issued by non-U.S. companies. Prices are influenced by currency valuation, political stability, local and regional economics. Investing in Stocks Rules to Follow Before Considering Individual Stocks While it's tempting to buy stock in the companies we like, the only reason to buy a stock is if it relates and contributes to your risk and return goals. Owning stock is not an emotional investment, and you should only consider it to be a source of income. Remembering this fact will help you to keep your perspective so that you can focus solely on your financial goals. In addition to distancing yourself from the corporation emotionally, below you'll find a few more rules that will prove useful for you: A portfolio of individual stocks should consist of at least nine stocks from a wide array of industries. Stocks should be purchased in 100-share lots (called round lots). At an average price of $35 per share of individual stock, you'll need more than $3,500 before you can start investing. If you're just starting to invest or if you don't have at least $50,000 to invest in individual stocks and bonds, invest in mutual funds (mutual funds will be discussed in detail in Lesson 5). Ignore the hot tips you hear on the street and thoroughly research the companies you're interested in before making any investment decisions. Be careful with the news you find in the paper and on TV. By the time you read the headlines, professional traders have most likely already reaped the benefits, and the stock price will probably reflect the changes already. Apply common sense. If it sounds too good to be true, then it probably is. Start with a detailed investment plan and stick to it. Evaluate your plan at least quarterly. Minimize costs by avoiding excessive turnover of stock. Fundamental vs. Technical Analysis Fundamental analysis seeks a discrepancy between intrinsic and market value -- that is, trying to buy stock that is being sold for less than it is worth. Intrinsic value is the actual value that you believe a stock to have, regardless of what it is being bought and sold for on the market. Individuals who are more comfortable with fundamental strategies use a wide array of economic, industry and corporate information to calculate the corporation's "intrinsic value." If you determine that the intrinsic value of the corporation's stock is more than its market value, it is said that a buy opportunity has presented itself. While fundamental analysis places importance on some of the factors underlying the price of stocks, technical analysis tends to focus on outcome data, such as the stock price itself and stock trading volume. Technical analysts believe that the stock price and other measures such as volume behave in patterns that can then be used to anticipate future price directions. Technical analysis seeks to detect patterns and discrepancies in the way the market functions in order to be able to make educated guesses about certain stocks. Technical analysts hope to "predict" market moves in order to take advantage of them quickly. While neither approach has proved to be superior, if you apply a consistent strategy, you will attain your goal more often than if you had no strategy at all. In other words, a necessary element for investment success is a consistent strategy based on sound principles. Mining Annual Reports and Financial Statements for Information The annual report is a convenient way for the corporation to put its best foot forward. If you want to learn more about a company, this is a very good place to start. But if you've tracked the company for a while and already understand what it does and what it plans to do, you can skip all of the flashy public relations sections and go to the back of the annual report, which is where the financial statements appear. The balance sheet is a snapshot of a company's assets and liabilities. It helps you answer such questions as how much cash the company has available, how much debt it has assumed and how much the corporation's net worth is. The income statement reports revenue, expense and net income for a defined period of time. It provides answers to questions regarding the company's net income and will explain how this will affect the budget. The cash flow statement, in conjunction with the income statement, tells you if the company is making money. Net losses on the income statement aren't necessarily bad. Net cash outflow on the cash flow statement isn't necessarily bad. A combination of the two for an extended period of time, however, spells doom for any company. The analysis of financial statements relies on accounting data. Accounting Data and Ratios: Measuring the Corporate Pulse How can you use the information from the financial statements to help you invest wisely? By comparing numbers to each other by means of ratios. These ratios can help you compare the company with its competitors or with its own performance in prior years. All measures should be compared with five to 10 years of historic data and with industry averages to detect if any trends to the information are present. Profitability After-Tax Net Income and Net Income Per Share (after-tax net income/number of common stock shares outstanding): For corporations with seasonal business -- a predictable ebb and flow in revenues that's tied to changes in climate, holidays and vacations -- be sure to compare the same quarters across the years. Return On Assets (after-tax net operating income/total assets): Operating income is income earned from doing business, not the sale of assets or investment returns. This ratio is directly related to the productivity of assets, and a low ratio suggests that the company's assets have not been well managed. Asset Turnover (revenue/total assets): This ratio is the amount of assets the company needed in order to generate a dollar of sales. Liquidity Debt to Equity (long-term debt/total equity -- current liabilities): This measures whether the corporation can satisfy its obligations to its creditors. Long-term debt shouldn't include accruals or accounts payable
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