Subscribe for free access: 7 Steps to Understanding the Stock Market
≡ Menu

An Honest Story about Losing $5,000 on Hot Stock Tips

The following is a guest post from Sam Broom of The Nude Investor. He talks about the first investment he ever made, and how it ended in disaster. He hopes his story will help you avoid losing money from hot stock tips and poor, speculative positions.

hot stock tips

Hot stock tips – we’ve all been there. Your buddy’s been loading up on the “next big thing” and has been urging you to get on board. You know the the kind – “This stock is about to explode”, “It’s almost a guaranteed winner” and “she’s a sure thing, bro”.

I’ll almost guarantee that anyone with any investing experience has heard familiar phrases from friends or family at some stage. Whether it’s been a hot stock tip, real estate investing advice or your buddy regurgitating some washed up tip from a “gold guru” he’s been following – they all have the same message: get in now before the rocket launches into the metaphorical investment stratosphere.

I know this sounds like an oxymoron, but hot stock tips are the bane of any beginner investor – I would know because I lost $5,000, over 80% of my original investment, following a “hot stock tip” when I first started investing in the stock market.

Before I get to the juicy bank destroying details, I feel it’s important that I provide some background information to my story.

I came from a solidly lower-middle class family with parents who had always worked exceptionally hard, but had never themselves been overly fussed with material things. They instilled in me their belief in a solid work ethic – I’ll never forget my dad’s mantra: “If somethings worth doing, it’s worth doing properly”.

A combination of good genes and that instilled work ethic meant I achieved highly at school and ended up gaining acceptance to a reasonably exclusive college. The majority of my fellow students came from wealthy private high schools and it was here that my eyes were opened to the fact that contrary to popular belief, those that worked the hardest weren’t always the best rewarded (in a financial sense at least).

All my friends’ parents were driving around in fancy cars and taking extravagant overseas holidays, yet it seemed like all they did was wine and dine and manage their investments. Meanwhile my parents were slaving away at the same “nine to five” they’d been at for the past 35 years, scraping together enough to renovate that dingy bathroom or to save for their first overseas trip at the ripe old age of 55. I could see that to get ahead, unless you were one of the lucky ones with a big ol’ trust fund, you had to not only save, but put your money to work earning a return that would compound over time.

[click to continue…]

How the Stock Market Cycles like the 4 Seasons

Like winter, spring, summer and fall… the stock market cycles. Now if you are aware of this phenomenon, you can better prepare your investments to reflect this reality. Being unaware of stock market cycles, on the other hand, can make you panic when things don’t go your way.

stock market cycles

One of the most important concepts about the stock market is this feature of moving in cycles. Like the seasons that fluctuate repeatedly, the stock market moves between periods of extreme optimism and pessimism. This is where the terms bear and bull market originate from.

The interesting thing about strong bear or bull markets is that they aren’t readily apparent until after the fact. While general prosperity or low stock market returns are occurring, most investors are consumed with issues inside the current season, unaware that a new season might be and often is just around the corner.

This is one of the reasons why being a contrarian is so profitable. It’s also a factor in why value investing works so well. Value investing depends on investor sentiment and emotions wildly mis-valuing securities beyond its logical value. The difference of undervaluation becomes the margin of safety that value investors chase.

There’s two ways to look at the stock market. One is a very black and white approach. Either you buy a stock and it makes you money or loses you money. This is a very frustrating mindset to have, because you have no control over the situation. Anything can and does happen in the markets, and you’re just hoping that you come out ahead this time. It’s a short term and limited approach.

The other way is to recognize that the stock market moves like the seasons. Other than bankruptcy, nothing is permanent and things are changing all the time. Instead of trying to directly profit from our trades, you’re trying to hold for the long term and generally buy companies that are undervalued. This allows you to hold through less advantageous times and see opportunities where others don’t.

One glance at any stock chart will show you how much more the stock price fluctuates than the actual value of the business does. The ability to identify this value and capitalize on it is a major part of finding success.

Another major key to success is staying conscious of what season the market is in and making investment decisions based on this. Let’s examine some key characteristics behind the 4 seasons of the stock market.  [click to continue…]

With baseball season now in full swing, it’s time to bring out the hot dogs and nachos for some fun in the sun. Baseball is interesting not only because it can entertain us, but also educate us. I thought it’d be fun to compare the investor’s life to a baseball game. Turns out we see some striking parallels.

It might not be fairly obvious but an investor’s strategy should vary depending on the age. A 25 year old has a much longer time horizon and risk tolerance than a 65 year old retiree. However, the in between years aren’t always so clear.

Take this creative guide and use it to apply to your own life if you see fit. If anything, it can serve as a rough mindset.

This only represents the ideal. In baseball, people don’t go only to see the home team win. They come to the games for the atmosphere, the food, and the good times. Likewise with investing, it doesn’t have to be strictly about following the ideal. You can still reap many rewards even if you are “behind”.

investor's life

1st Inning (Age 0-16): This is the warm-up phase. At this point, the investor is just getting loosened up. Hopefully your parents have set up a 529 for your college fund, but it’s no big deal if they didn’t. Plenty of successful individuals didn’t need their parents to pay for college.

This is the time of life where the investor hopefully learns about the value of money and the power of saving. Life skills and mindset shifts are more important here than actual wealth.

2nd Inning (Age 16-23): The 2nd inning can be quite crucial, as it can set the tone for the rest of the game and your life. This is the time where you’ll hopefully get your first job, get into a good college and graduate with a useful degree.

Again, the investing will come later, but the decisions made during this time will impact how great your chances are for financial success. You can always come back, but it’s easier to jump out with a lead early.

3rd Inning (Age 23-30): Here’s where your college degree will be put to first use, and you’ll land your first “real” job with benefits. This is the perfect time to buy your first stock and start investing.

It can be an unsure time period, where many things are new and confusing. You’ll soon see that experience becomes a great teacher, and by taking action you are improving yourself in a much better fashion than with procrastination and analysis paralysis.

You might not know which investing strategy is best for you, and so this is the best time to try them all. Put little sums of money into different investments. Find stocks that will grow your capital for decades, and learn the importance of holding investments for the long term.

4th Inning (Age 30-35): This is about the time when the investor jumps in as a first time home buyer. In fact, The Atlantic talked about how the average age for the first time home buyer is stretching for Millennials from 31 to 32 – 34.

You’ll want to be growing your net worth at this age, and a house can be a great way to do it. However, you should still be maintaining the dollar cost averaging you should’ve established in the 3rd inning and beware of throwing away too much money to the bank with the wrong kind of mortgage. [click to continue…]

Finding Balance w/ Trailing Stop vs. Buy & Hold

Let’s dive into the reader mail for another great question. This one is about struggles with trailing stops and a question about cash reserves.

trailing stop

Andrew,

First of all – the investment information you share through your web site really resonates with me!  But I struggle with two topics.

1.)  I utilize trailing stop loses alerts to minimize my loses and / or lock in gains. This strategies works well but an investor needs to be disciplined and follow through on selling a stock if the alert is triggered.  What happens if the market quickly switched from being bullish  to being bearish. I could receive alerts for all of my investments. Theoretically I should sell, sell, sell. But this is different from the advice to stay in the roll a coaster and ride out the dip in the market.

2.)  How much cash should be held in a portfolio in order to purchase undervalue stock(s). Does an investor always have a percentage of cash on hand in order to purchase stock or dollar cost average in a stock they already own, if the stock price dips? If the cash is used to purchased a stock, does the investor then need to sell investment(s) in order to replenish the cash reservoirs?

Your thoughts on the topics would be great appreciated!

Thanks for the kind words. It’s true you have to find a balance with the trailing stop. Here’s what I think.

1) I introduced the two approaches I take about when to sell a stock in my Value Trap Indicator ebook. Here’s an excerpt from the in-depth explanation.

“There’s two separate approaches that I condone to solve this selling dilemma. The first is effectively used in my newsletter portfolio, The Sather Research eLetter, and recommended to my newsletter subscribers. The tactic is called a trailing stop, and it is so effective both because of its simplicity and the fact that it takes emotions out of the trade. A trailing stop creates a floor for a stock, and if the stock hits that floor then it becomes an automatic sell (see trailing stop explanation here).

The secondary approach for when to sell is also similar to the trailing stop because it creates strict rules that can’t be broken yet gives a stock more chances to recover. In this instance, I advocate not selling a stock no matter how far it falls, as long as you had conviction with your original analysis and you have an established point of when enough is enough.

This kind of an approach seems to be very popular with value investors, who by their nature tend to be extremely confident and more risk averse because of it. The importance here is that the rules for selling must be set in stone. In my case, I set the following three rules for automatic selling.

Examples of Actual Warning Signs
1. Complete cut of the dividend
2. Substantial increase in the debt to equity ratio
3. A year of negative earnings”

Basically, I use the two different strategies in my different portfolios. It has to match the mindset behind the stock pick. So I have a trailing stop portfolio and a own for “forever” portfolio. With a trailing stop you are still riding the dips as long as you are reinvesting after selling. I reinvest the next month after I sell in the trailing stop portfolio. Also, that portfolio is in a Roth IRA, so I’m not penalized tax wise for selling early.

2) That’s personal preference. For myself, I don’t hold much of a cash reserve except for my emergency fund. I’m always invested. But I do know many value investors keep a cash reserve and try to time the markets. You can be successful either way. I prefer to receive dividends and invest my cash ASAP, because I know I will be consistently investing.

Even if this strategy doesn’t work out short term, i.e. a new market crash and opportunity to buy stocks, I still have peace of mind because I’d prefer to stay invested… over the long term this should benefit me more because I’ll ultimately be slow, steady, and consistent rather than trying to predict the future.

**All Rights Reserved. Investing for Beginners 2015**
**Finding Balance with a Trailing Stop vs. Buy and Hold**

Investment Checklist: 99 Problems to Avoid

So you’ve got 99 problems but don’t want a stock to be one. We can’t stop the stock market from crashing. But we can limit the number of crashing stocks we own. Use this investment checklist to avoid costly value traps and bankrupting stocks.

checklist

1. There are no “hot” stock tips
Well they are out there, but it’s in your best interest not to use them. Great investments create returns over a long period of time, and trying to find the “get rich quick” stock is a fool’s game.
2. Stock analysts aren’t your friend
And most of the time, they are wrong too. You have to look at the self motivation of stock analysts. They are actually paid to be bullish, not if they are wrong. Think about that.
3. Don’t buy OTC penny stocks
The major stock exchanges like the NYSE and NASDAQ are there to protect you. Those major exchanges have strict rules and regulations in place to prevent scams. OTC stocks don’t.
4. IPOs are a scam
Speaking of a scam, an IPO is one if I ever saw it. The IPO’s single purpose is to get the founding owners rich. To invest in a company that hasn’t even released a 10-k yet is blindly insane.
5. You can’t time the market
The market is unpredictable. Even the best investors know this. With a solid strategy in place in a long time period, you can make a lot of money for yourself. Trying to time the market will drive you crazy.
6. New technology is never a good investment
Every decade comes with new technology. And as you can expect, new technology always attracts investors. But the initial excitement wears off, and then you are left with overpriced stocks that are crashing in price. Don’t get involved.
7. Beware the retail industry
It might surprise you to know that the industry with the most bankruptcies in the last 20 years is retail. That’s not to say that there aren’t good opportunities in retail, but you have to be careful.
8. Airline stocks are terrible
Ever since the airlines were deregulated in the 1970s, the industry has gone through a tumultuous time period where hundreds of airline stocks have gone bankrupt. It’s essentially a commodity business with poor profit margins. Stay away.
9. You aren’t a hammer, and stocks aren’t a nail
Once you’ve established a successful strategy or stock market idea, don’t go around trying to apply it to every situation. There’s no magic pill, and so you must always be humble and recognize the faults of any one idea. [click to continue…]

4 Free Tools for Dividend Growth Investing

I’ve written many times about the benefits of dividend growth investing. When you look at a concept like compounding interest, there’s many different ways to achieve the same end goal. However, dividend growth investing gives you the best possible way.

dividend growth investing

For one, dividend payments provide compounding by increasing the number of shares held every year through reinvestment. So, a stock held for a long time will compound the interest received simply because there will be more shares from previous reinvestments.

As long as the company continues to pay the dividend, which most do, then the interest received from dividend payments will increase with an increased number of shares.

In addition to that, dividend growth stocks provide compounding interest through the growth of the dividend payments from year to year.

Not only do most dividend paying companies continue to pay their dividend every year, but many of the high performing dividend payers succeed in increasing their payouts every year, to a point where they reach consecutive years of dividend growth.

Dividend Growth Investing Success

10, 25, and even 50 years of consecutive dividend growth are markers of this achievement in a group candidly called dividend aristocrats. These businesses have been successful in achieving the ultimate goal of a corporation, which is to return money to shareholders.

They’ve also succeeded in doing so throughout many economic recessions, bear markets, and economic and global crises and panics. The dividend aristocrats epitomize the best vehicles for rapid compounding of wealth through a stock market investment.

It’s the dividend aristocrats like Coca Cola, Walmart, and Altria who’ve created the inspirational examples of what a small amount of money can become over a long period of time. I’ve written about this many times before, with simple examples showing how a small sum like $10,000 can compound into millions through the right dividend growth companies.

To be sure, not every stock will become a dividend growth investing success. Some of the weaker businesses face a stagnation, suspension, or outright removal of their dividend when hit with tough times.

That’s to be expected, which is why we must combine such an investing strategy with other prudent principles such as value investing and diversification. It’s completely fine to be wrong sometimes, and we don’t even have to be right most of the time. As the examples have shown, it could take just one superb investment to create decades of high-yield, consecutively growing dividend payments.

As dividend payments grow each year, the share price inevitably follows. This double upwards movement multiplies our returns and creates the exponential growth magic of compounding interest. It’s no doubt a much faster and efficient way to utilize compound interest.

The higher share price makes shares accumulated through reinvestment even more profitable, and will continue to do so as long as dividend payments increase. Hopefully you can see why I get so excited about this.

Now that we’ve prefaced the allure of dividend growth investing, I want to help you actually achieve it. [click to continue…]

Measuring Competitiveness in Maturing Industries

Industries tend to mature in similar ways. We can use this information when analyzing stocks to forecast a probable industry trend. Absent government intervention, we can predictably assume that the laws of economics will be shared across many industries.

industry analysis

If you can’t tell, I’m getting excited about this topic. My vocabulary tends to get stuffy and academic when I’m fleshing out complex topics. I understand this makes it harder to follow.

Just read the following post with the understanding that this is a relatively new phenomenon that I’ll likely pursue in the future. As such, with my own mastery will come an easier ability to simplify and teach. Like with many things in the stock market, the concept is simple but it’s application is quite complex.

There’s a couple of principles I want to share with you that reach across various schools of thought. Some of the most fascinating discoveries in the world have occurred from a proven hypothesis being tested in a new arena. The possible overlap of principles and ideas really creates more interesting thoughts and ideas.

In the world of internet search, there is a rule called the 40-20-10 rule. It’s not so much a rule as it is an observation. On any given Google search, 40% of the visitors will click on the 1st ranked website, 20% will click on the second, and 10% will click on the third.

Whether it’s because of human nature, or the psychology behind the innate desire to belong to a group, this internal choice mechanism seems to apply uniformly.

Marketing experts will tell you that humans prefer choices, but not too many choices. There was a study at Columbia University about two different jam displays, one with 6 choices and one with 24 choices. A whopping 30% of customers who were only exposed to 6 choices ended up buying a product, while only 3% of those presented with 24 choices purchased.

As you can see, the human brain tends to prefer less choices. In a limited choice selection environment such as a Google search, a presentation of 6-10 choices yields a “big three” of winners who follow the 40-20-10 rule.

If you graph the 40-20-10 results, what you’ll see is an exponential curve the decreases along the x-axis. Now, this graph gets interesting because it applies in many other fields of life. It’s also known as the long-tail curve.

long tail curve

Forbes did an article where they described the performance of workers in a business follows a long tail curve. The top 10%-15% of the population are considered hyper performers, while the majority of workers are just average. At the end of the long tail, you have the small number of workers who are performing very poorly.

Turns out this long-tail, or fat tail, methodology has been discovered a long time ago. An Italian economist and civil engineer Vilfredo Pareto created the Paretian (power law) distribution. In contrast to Gaussian’s law, which is the familiar bell curve that is employed to attempt and express mathematical averages. You’ll see this bell curve in economic contexts, predicting average returns among other things. [click to continue…]

What does Diluted EPS mean?

Take a look at any income statement, and you’ll see EPS (or earnings per share) divided into two categories: diluted EPS and basic EPS. Which EPS figure should you rely on, and what does those terms mean? Take a seat, grasshopper, and I’ll show you.

diluted eps

EPS is a standard metric for measuring how profitable a company is. While total net earnings indicate how much profit a company is bringing in, the direct effect on an individual shareholder is less clear. That’s where EPS, and consequently dilution, come in.

Basically, dilution refers to how many shares outstanding a company has. A company might have really high net earnings and a great P/E, P/B, and other such valuations… but if the company is too heavily diluted, then the “spoils” of war are reduced for shareholders. Too much dilution leads to a lower EPS, which in turn translates into a lower dividend payout.

As those who have been reading me for some time know, dividends are an extremely important aspect of my investing philosophy. Share appreciation is nice, but I’d prefer a steadily growing dividend payment that is consistent and reliable.

Remember that the total shares outstanding helps determine a company’s market capitalization, which in turn affects valuations and investing metrics.

The reason that earnings gets converted into EPS is so that investors focusing on the share price calculations can make comparisons. For example, a share price of $80.00 tells us nothing about P/E unless we also know that the EPS is $4.00. Of course, the same P/E calculation can be made with market capitalization divided by net earnings, but in both cases the metrics are multiplied by shares outstanding.

Share price * shares outstanding = market capitalization, and EPS * shares outstanding = net earnings. In effect we are making the same calculations, but notice that you can’t divide market cap by EPS, or share price by net earnings. It’s like trying to divide 6 inches by 4 cm.

My point is that problems with dilution aren’t apparent in other calculations, because the metrics are different, and so it’s something that can be easily overlooked. [click to continue…]

Liquidity Ratios: A Business Approach to Investing Pt. 2

The way to measure a good business is the same as measuring a good investment. As a result, many successful people with a background in business make an easy transition into growing their capital through investing.

In a previous post, I shared how to use profitability ratios utilized in accounting to find superior investments. This post will cover the second part of that, using liquidity ratios to measure the health of any business, which will in turn help you discover the best long term investments.

liquidity ratios

There’s a couple of things to consider when it comes to liquidity ratios. Firstly, liquidity is obviously a good characteristic for any type of business. While it’s chiefly important for financial banks, who depend on liquidity to cover any customer withdrawals and other expenses, it’s also crucial for every business.

Every business has a certain number of expenses that are required for the business to run. Some of them might be day-to-day, while others are longer term or sporadic. Regardless of the exact situation, every business must have a minimum amount of liquidity to keep the business running smoothly.

Understanding this concept will help you understand why liquidity ratios are so important. Take the example of a company who isn’t liquid. While running more liabilities than assets isn’t in any way sustainable, a company could continue to run for many months into the foreseeable future– by issuing more debt or increasing earnings in a short period, or making other tough but necessary decisions. This can go on for quite a while until something unexpected arises.

[click to continue…]

Negative PEG Ratio Implications

The implications for a negative PEG ratio might not be as bad as you think. It all depends on the reason behind the negative PEG ratio, which breaks into 2 possibilities. One spells trouble while the other might not.

negative peg ratio

I’m writing this post as a response to an email I received from a reader. He had seen the post I wrote last week about negative P/E ratio, and simply wondered, “what about negative peg ratio”?

If you haven’t read the post about negative P/E yet, I suggest doing that first. You’ll see that it potentially plays a factor into a negative PEG ratio, and you should understand all the reasons why I strongly warn against a negative P/E.

Before digging into the PEG scenarios we first must know how to calculate PEG ratio. It’s a simple division, dividing the P/E ratio by the earnings growth. Now in most general stock market websites, they use yearly earnings growth to calculate PEG. However, some may use Q/Q growth instead, so it’s important to check the numbers for yourself before trusting any website’s ratio.

PEG = (P/E ratio) / (Growth in Net Earnings)

I covered how to calculate P/E ratio in the previous blog post. The upfront calculation for growth, for those who are still unclear, would be this year’s earnings minus last year’s earnings divided by last year’s earnings. Or, if this year was 2015 and last year was 2014…

Growth in Net Earnings =
(2015 Net Earnings – 2014 Net Earnings) / (2014 Net Earnings)

The PEG ratio works like the P/E ratio, in the sense that a lower value is generally more desired. Whereas a P/E ratio is showing how much you are paying in relation to earnings, the PEG ratio expresses how much you are paying in relation to the growth. You can think of a PEG less than 1 as meaning that you are getting more growth than you are paying for, and a PEG greater than 1 as getting less growth than what you are paying for.

This assumption is loosely accurate and wildly based on Peter Lynch’s growth strategy where he wants a growth rate at least higher than the P/E ratio. A stock priced at 17 times earnings is expected to grow 17% next year, which is how this idea is derived. Of course, the way that things play out in the real world and how conventional wisdom tells you they should play out are rarely the same. But still, this is a mostly accurate calculation that I can endorse.

Looking back at the formula for PEG, we see there are only 2 possibilities. [click to continue…]