Fundamental Concepts Of Share Investing

FUNDAMENTAL CONCEPTS OF SHARE INVESTING1 SOME KEY INVESTING DEFINITIONS AS APPLIED TO SHARE INVESTING2 What is investing?3 The definition for ‘investing’: In finance, the purchase of a financial product or other item of value with an expectation of favorable future returns. In general terms, investment means the use money in the hope of making more money.

What is trading?4 The definition for ‘trading’: Buying and selling securities or commodities on a short-term basis, hoping to make quick profits.

Commentary: The common assumption in share investing is that trading is not really investing. However if you notice the definition of investing, it actually means buying shares hoping for a profit, whether you hold the shares for a long or short time. So if you do trade profitably i.e. buy and sell shares on a short term basis and consistently over time profit, then you are a successful investor regardless of the fact that you trade shares for short term gains. What is short term?5 Definition for ‘short term’: Usually one year or less, often used to refer to bonds or loans. Opposite of long-term.

What is long term?6 Definition for ‘long term’: A long period of time, as for a bond (e.g. 10 or more years) or for a buy and hold investment strategy.

Commentary: Following on from the previous commentary, if you are a successful investor (i.e. over time you profit from buying and selling shares), the time horizon i.e. whether you buy and sell shares over short or long periods of time does not really matter. Another common assumption about share investors is that they are either short term investors (i.e. traders) or long term investors. However, why define investors into such neat categories, when certain shares may be suitable for short term trading whilst other shares may be worth holding over the longer term. One investor could apply both short term trading or long term investing to different shares he/she holds within the portfolio. The key to investing is not to get caught up in whether you are right or wrong about a certain company or any other financial fact or theory, or that you have to stick to one strategy or another but that you actually profit! Another key to investing is that like any other skill, share investing requires practice. However, if you are a beginner or you have been involved in share investing for a while now but have yet to produce consistent profits, use small amounts of money that you can afford to lose (using real money is more effective than paper money because the losses or profits made from real money trades involves real losses or real gains). Keep practicing until you can consistently and predictably (as predictable as possible) make profits and that your profits are not one-offs or random events that is up to chance or luck. However, at times be willing to change strategies if what you are repeatedly doing when you buy and sell shares, is not allowing you to profit. Another mistake people make when buying and selling shares is that they cut their winning trades too early and yet let their losing trades go on forever in the ‘hope’ that the price on those losing trades will come back up. 1

This report has been authored by H. Uchibori. This report is for educational and general informational purposes only. Please take care and responsibility for your investment decisions. This report is current as at 27th of March 2009. 2 There are actually many more investment terms that may be relevant to the share investor but to list them all may take up a whole book. Thus only key terms have been selected to highlight key issues in share investing. 3 http://www.investorwords.com/2599/investment.html 4 http://www.investorwords.com/5030/trading.html 5 http://www.investorwords.com/4563/short_term.html 6 http://www.investorwords.com/2885/long_term.html

E.g. if you buy $10000 worth of shares in company A and also buy $10000 worth of shares in company B, and the price of A shares fall by 10% (now worth $9000) and the price of B shares rise by 30% (now worth $13000) and your comfort level for losses is 10%, then sell all of A shares but if you are not sure whether B share price will keep rising or fall (because it may be overbought), then you could sell $8000 of B shares (i.e. half of original amount plus the $3000 profit) and keep $5000 worth of B shares. If then B share price continues to rise, you keep profiting. However if instead of continuing to rise, B share price falls by 10%, sell the rest of B shares (now worth $4500). In this instance even though the B share price fell, you only lost $500 and the total profit you made would be $1500 (=$3000 profit on B shares less $1000 loss on A shares and $500 loss on B shares). This means that you earned a 7.5% return on your original investment of $20000 (i.e. $1500 profit/$20000 original investment) despite the loss on the rest of B shares! If you do this consistently over time, you are profiting by using risk management strategies like the one outlined above, then these sort of returns when they accumulate over time, are far better than the interest earning on your bank account. Thus it is absolutely vital to successful share investing, that you have some sort of risk management strategy in place for capital preservation. What is the buy and hold strategy?7 Definition for ‘buy and hold’: An investment strategy in which stocks are bought and then held for a long period, regardless of the market's fluctuations.

Furthermore, the buy and hold strategy:


Rests upon the assumption that in the very long term (over the course of, say, 10 or 20 years) stock prices will go up, but the average investor doesn't know what will happen tomorrow.





Historical data from the past 50 years supports this claim.




There may be short term fluctuations, due to business cycles or rising inflation, but in the long term these will be smoothed out and the market as a whole will rise.




Two additional benefits to the buy and hold strategy are that trading commissions can be reduced and taxes can be reduced or deferred by buying and selling less often and holding longer.

The logic behind the idea is that in a capitalist society the economy will keep expanding, so profits will keep growing and both stock prices and stock dividends will increase as a result.

Commentary: I do not wish to denigrate the virtues of the buy and hold strategy that has enriched billionaires such as the legendary Warren Buffett. However, I would like to point out a few things. This strategy assumes that over many decades, stock prices keep going up. However, if you look at the chart below of the Japanese Nikkei Index, at December 2008, stock prices had fallen to the level last seen in December 1982. Thus this means that had you bought Japanese stocks in December 1982 and held them til December 2008, you would have earned 0%. Chart: NIKKEI INDEX

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http://www.investorwords.com/637/buy_and_hold.html

Source: http://www.intmath.com/Exponential-logarithmic-functions/nikkei-09.gif

This also means that you actually made a loss e.g. had you placed the $10000 (yen equivalent) spent on Japanese stocks in a bank account earning on average 3% p.a. over the 26 years, by December 2008, the money in your account would equal $ 21565.91 (that is the power of compounding at work)! However in reality, if over the 26 years, the average inflation rate was say around 3% p.a., your real return would be 0% since the inflation rate would have negated the nominal interest rate (i.e. 3% bank interest rate less 3% inflation rate). Thus the Japanese stock investor would have not only lost the purchasing power of his/her original $10000 due to inflation, but also lost potential returns that could have been earned had he/she invested that money in other asset classes (opportunity cost). Thus the assumption that stock prices go up over decades may not hold and this may prove costly for the investor (and 26 years is a very long time). The buy and hold strategy is all well and good during the boom years when companies make profits and stock prices and dividends go up. However during economic downturns, like the one we are going through now, there is income risk and principal risk for the share investor in that he/she loses some of the principal (real or unrealised) due to fall in share prices and also loses some of the dividends received due to dividend cut backs by listed companies as these companies suffer the effects of the economic downturn. The following is a quote from CNNMoney.com in regards to changes in dividends8: Far fewer companies are raising dividends, while the number of firms cutting is moving sharply higher. During the past six months, only 82 S&P 500 companies raised their dividends, compared with 143 firms in the year-earlier period, according to S&P data. Meanwhile, the number of companies cutting dividends topped 46 during the most recent six-month period, versus 17 in the prior year. And when companies cut dividends, the payouts have lately been slashed by 50% to 80%, said Josh Peters, editor of Morningstar's DividendInvestor newsletter. S&P estimates that dividend payments will fall by 22.6% this year, marking the largest decline since a 36.3% slide in 1938.

Also during severe economic recessions, investors themselves may be going through financial difficulties such as becoming unemployed or not being able to meet mortgage commitments. Thus they may be forced to sell some of their share holdings to meet these expense payments at a time when it is the worse time to do so i.e. when share prices are at their very low. So although during the boom years, their share portfolios would have shown paper (unrealised) gains, during recessions, if they are forced to sell their shares, they would be making a real, realised loss. Thus the buy and hold strategy may imply that investors have to sell off their shares at the worse possible time, to payoff expenses. 8

Kenneth Musante “Counting on Dividends? Not so fast” March 20, 2009 http://money.cnn.com/2009/03/20/markets/dividend_caution/index.htm

So instead of short term fluctuations being smoothed out over the long term, buy and hold investors are actually susceptible and possibly more at risk to business cycles since they only enjoy paper gains during the boom years (when share prices rise), but have to suffer real, realised losses during economic downturns (when shares fall most). This is especially a risk since during economic downturns when share prices fall, they fall very fast. Also another problem regarding having to sell shares during bear markets i.e. during recessions, is that there are liquidity risks to the investor, which means that due to less people willing to buy shares during bear markets, it is harder for the investor to sell his/her shares and that if the investor is able to find a buyer for the shares, the investor may have to lower the price to be able to finalise the sale. Also the liquidity risks of smaller company shares are much higher than those of larger listed companies due to lesser number of potential investors who would be willing to trade these shares. However, holding ‘blue chip’ or shares of large listed companies (by market capitalisation) still does not guarantee that these companies are immune from the effects of an economic downturn, as shown in the chart of Citigroup below:

Citigroup during its glory years, used to be the largest bank in the world by market value, but now is ranked 184th in the world. Its share price reached highs of around 55-56 dollars but fell to as low as $1.02 earlier this year. This means that for someone unfortunate enough to buy Citigroup shares during the peak, they would be sitting on unrealised or realised (if they had to sell) losses of 98% on their original investment9. Many buy and hold investors around the world trusted in these large banks and held a large portion (many investors have put all of their savings and retirement money) of their money in shares of these large banks over a long period of time, just to see the value of their shares dwindle during the current global financial crisis. Another important issue in having to sell shares during a bear market, is that during economic downturns, the negative effects of the real economy affects listed companies’ profitability i.e. these companies make less profits or make losses and subsequently have to layoff workers, cut costs and cut dividends. The larger companies may be able to ‘weather’ the storm, due to still being able to obtain financing and be able to raise capital (investors trust that these companies are able to repay their loans still operate viably during economic downturns), or they may have cash set aside exactly to spend in these difficult times. However, other smaller companies or even large companies (that have lost the trust of investors, see tables below) may find it difficult to obtain financing in the financial markets (since during economic downturns creditors become stingier and are unwilling to make new loans or renew old ones on the possibility of the borrower defaulting on their loans) or be able to raise capital in share markets (as share investors are scared in 9

Christine Harper and Jeff Kearns “Citigroup Falls Below $1 as Investor Faith Erodes” March 5, 2009 http://www.bloomberg.com/apps/news?pid=20601087&sid=aKLJO8S5nFaU&refer=home

buying shares in a bear market since they are worried that shares prices may continue to fall). Thus these companies would face solvency problems and even companies that are profitable may find that they are tainted in the same light as the failed companies. Thus if companies are unable to have money to pay off liabilities when and as they fall due, they may have no choice but to face bankruptcy. Thus buy and hold investors of shares may see some of their shareholdings disappear or have to sell their shares at extremely low prices during economic downturns due to the bankruptcy of companies (even those that were actually profitable and fundamentally sound but still were unable to raise money). The following table show large public companies going bankrupt in the U.S.: 20 Largest Public Company Bankruptcy Filings 1980 - Present 10 Company

Bankruptcy Date

Lehman Brothers Holdings Inc. Washington Mutual, Inc. WorldCom, Inc. Enron Corp. Conseco, Inc. Pacific Gas and Electric Company Texaco, Inc. Financial Corp. of America Refco Inc. IndyMac Bancorp, Inc. Global Crossing, Ltd. Bank of New England Corp. Lyondell Chemical Company Calpine Corporation New Century Financial Corporation UAL Corporation Delta Air Lines, Inc. Adelphia Communications Corp. MCorp Mirant Corporation

09/15/08 09/26/08 07/21/02 12/02/01 12/17/02 04/06/01 04/12/87 09/09/88 10/17/05 07/31/08 01/28/02 01/07/91 01/06/09 12/20/05 04/02/07 12/09/02 09/14/05 06/25/02 03/31/89 07/14/03

Description Investment Bank Savings & Loan Holding Co. Telecommunications Energy Trading, Natural Gas Financial Services Holding Co. Electricity & Natural Gas Petroleum & Petrochemicals Financial Services & Savings and Loans Brokerage Services Bank Holding Company Global Telecommunications Carrier Interstate Bank Holding Company Global Manufacturer of Chemicals Integrated Power Company Real Estate Investment Trust Passenger Air Carrier Passenger Airline Telecommunications Banking & Financial Services Electric Services

Assets $691,063 327,913 103,914 65,503 61,392 36,152 34,940 33,864 33,333 32,734 30,185 29,773 27,392 27,216 26,147 25,197 21,801 21,499 20,228 19,415

* Listed in descending order by Pre-Petition Assets (Assets in $mil)

The following is a quote from AACER regarding a rise in bankruptcies in 200811: Total (bankruptcy) filings for companies rose 50 percent to 64,318, while individual filings rose to 1.03 million, according to data compiled by Automated Access to Court Electronic Records, a service of Jupiter ESources LLC in Oklahoma City. It was the biggest annual total since 2005 when Congress changed laws to make it more difficult for consumers to erase debt in bankruptcy. "It's no surprise that bankruptcy rates are well up, given that economic conditions, both at the corporate and household level, deteriorated significantly last year,'' said Robert Dye, a senior economist at PNC Financial Services Group in Pittsburgh. ``I expect to see an ongoing surge in 2009." Last year, 10,084 companies filed to reorganize or liquidate in Chapter 11, a 62 percent increase from 2007 and more than double those filing in 2006.

Thus all these potential downside risks to the buy and hold strategy, may dwarf any benefits derived from a reduction in trading commissions and taxes. What is market timing?12 Definition for ‘market timing’: Attempting to predict future market directions, usually by examining recent price and volume data or economic data, and investing based on those predictions. Also called timing the market.

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http://www.bankruptcydata.com Bill Rochelle “U.S. Bankruptcies in 2008 Approach 1.1 Million, Most Since 2005” http://aacer.com/index.php?option=com_content&task=view&id=100&Itemid=41 12 http://www.investorwords.com/2993/market_timing.html 11

Commentary: Market timers look at the overall market i.e. by looking at several major share indices and extrapolate future market movement based on the current market conditions, and economic data such as unemployment rate, consumer sentiment, the housing market, interest rates, inflation rate, GDP growth rate, current account deficit and so on. Generally most stocks listed on stock exchanges will tend to follow the movements of the major market indices. And the major market indices usually move in line with each other. That is why it is useful to learn to be able to read and understand the charts of market indices so as to be able to recognise what the overall trend is and what is the greatest probability of the market going up, down or staying flat in the near future (this is where technical analysis becomes useful). By predicting the near term movements of market indices, you could also predict the near term movements of shares of specific companies (as share prices tend to move in tandem with market indices) and buy and sell shares based on these near term predictions. See how the major stock indices all move in alignment with each other in the 2 year chart below on the major market indices in the U.S. i.e. the Nasdaq Composite Index13 (green line), the Dow Jones Industrial Average Index14 (blue line) and the S&P 500 Index15 (red line):

I do not think it is useful to predict too far into the future (e.g. where the market will be in the next 5, 10, 20 years-some analysts even like to predict the exact level of a market index in a few years time), since many unforeseen events could eventuate between the present and future (e.g. wars, crises, emerging markets, emerging new trends and technologies, expiry of patents, etc). Although that does not mean that an investor should not be aware of what is going on in the world in terms of global events, news, financial news, new trends and technologies and so on (since a lot of what goes on in the real world does impact the financial 13

The Nasdaq index is used mainly to track technology stocks. Unlike the Dow Jones Industrial Average (DJIA), the Nasdaq is market value-weighted, so it takes into account the total market capitalization of the companies it tracks and not just their share prices. http://www.investorwords.com/3190/Nasdaq_Composite_Index.html 14 The Dow Jones Industrial Average index is the most widely used indicator of the overall condition of the stock market, a priceweighted average of 30 actively traded blue chip stocks, primarily industrials. The 30 stocks are chosen by the editors of the Wall Street Journal. The Dow is computed using a price-weighted indexing system, rather than the more common market cap-weighted indexing system. Simply put, the editors at WSJ add up the prices of all the stocks and then divide by the number of stocks in the index. (In actuality, the divisor is much higher today in order to account for stock splits that have occurred in the past.) http://www.investorwords.com/1566/Dow_Jones_Industrial_Average.html 15

The S&P 500 index is weighted by market value. This index provides a broad snapshot of the overall U.S. equity market; in fact, over 70% of all U.S. equity is tracked by the S&P 500. The index selects its companies based upon their market size, liquidity, and sector. Most of the companies in the index are solid mid cap or large cap corporations.. Most experts consider the S&P 500 one of the best benchmarks available to judge overall U.S. market performance. http://www.investorwords.com/4378/SP_500.html

markets in some way e.g. wars and political instability in the Middle East affects the crude oil price and droughts in commodity exporting countries affects the price of soft commodities such as wheat and corn and new technologies means greater productivity and lower costs which in turn brings the price of the particular good/product lower). It is also important to be able determine what sort of events create long term trends, and which are ‘noise’ or temporary fads that come and go at random. This is crucial since long term trends can last for many years, even decades, and an investor would be missing out on profits if he/she mistakenly thought to take profits after a short while, when in fact the investor could have made a much larger profit by staying with the duration of the trend. Historically, share markets have tended to either go through years of rising share prices i.e. bull market16 or falling share prices i.e. bear market17 and sometimes trade within a range over several years. However, when you do know the long term trend i.e. you have correctly determined that currently the market is either a bull or bear market, be aware that it is natural even during bear markets to have rallies18 (share prices rising) of 10 to 20% and for bull markets to have corrections19 (share prices falling) of 10 to 20%. Thus you can use this knowledge to buy shares during a bull market correction (since afterwards, the share prices will rise) and you could also (this is a little riskier) buy into shares before a bear market rally and sell the shares when the rally runs out of steam. So how do you determine whether the market is in a bull market or bear market? One way of differentiating between the two markets is that during a bull market, the stock price moves up to continuously establishing higher highs and higher lows. During a bear market, the stock price moves downwards and continuously establishes a pattern of lower lows and lower highs. See in the 10 year Dow Jones index chart below how during the bear market of 2000 to 2003 and the current bear market starting in late 2007- early 2008, the market established lower lows and lower highs and during the bull market from 2003 to 2007, there was a series of higher highs and higher lows:

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A bull market is a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as a result of an economic recovery, an economic boom, or investor psychology. The longest and most famous bull market is the one that began in the early 1990s in which the U.S. equity markets grew at their fastest pace ever. Opposite of bear market. http://www.investorwords.com/616/bull_market.html 17

Bear markets usually occur when the economy is in a recession and unemployment is high, or when inflation is rising quickly. The most famous bear market in U.S. history was the Great Depression of the 1930s. The term "bear" has been used in a financial context since at least the early 18th century. While its origins are unclear, the term may have originated from traders who sold bear skins with the expectations that prices would fall in the future. http://www.investorwords.com/443/bear_market.html

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A rally is a substantial rise in the price of a security, commodity, or overall market, following a decline. http://www.investorwords.com/4026/rally.html 19

A correction is a reversal of the prevailing trend in price movement for a security. The term is most often used to describe a decline after a period of rising prices. A correction is often considered beneficial for the long term health of the market, in that the prices had risen too quickly and the drop put them back to more realistic levels. http://www.investorwords.com/1142/correction.html

So you could use this knowledge by implementing an investment strategy that is suited to a bear market (since we had determined that we are currently in a bear market with the moving average crossover). You could benefit from bear markets i.e. falling share prices, by learning to short sell. Short selling involves the borrowing of shares from a broker and selling it at the current price, only to buy them back at a future datehopefully at a lower price- and return the shares to the broker. However, your potential gains are limited since a share price can only fall to 0 but not below 0, but your potential losses (i.e. if instead of falling as you had expected, the share price rises) are unlimited as the share price can rise without limit. Thus short selling is extremely risky and even professional money managers have made losses when they use this strategy. However, with the advent of ETFs20 (long21 and short) or exchange traded funds which tracks indices but unlike mutual funds are traded i.e. bought and sold on stock exchanges. The fee structure of ETFs are such that transactions and operating costs associated with them are very low. They have become very popular since they have the advantages of low costs, being liquid (traded on stock exchanges) and they take out company specific risks (since they track indices which are comprised of many companies within a market or sector). The fact that there are long and inverse ETFs means that an investor can profit from share price rises and share price falls without the hassles and risks associated with short selling or trading options22. The following are lists of ETFs listed on US stock exchanges23: Top 20 US-based ETFs, by assets under management:











SPDRs "spiders" (AMEX: SPY) iShares MSCI EAFE Index (NYSE: EFA) SPDR Gold Shares (NYSE: GLD) iShares MSCI Emerging Markets Index (NYSE: EEM) iShares S&P 500 Index (NYSE: IVV) PowerShares QQQ "qubes" (NASDAQ: QQQQ) iShares Russell 2000 Index (NYSE: IWM) iShares Russell 1000 Growth Index (NYSE: IWF)

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ETFs always bundle together the securities that are in an index. Investors can do just about anything with an ETF that they can do with a normal stock, such as short selling. ETFs are traded on stock exchanges. On the plus side, ETFs are more tax-efficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF. http://www.investorwords.com/1755/ETF.html

21

In share investing when you take a “long” position on a particular stock, this means that you are buying that stock expecting or hoping that its price would go up and profiting from the difference i.e. between the buy price-which should be lower than the sale price-and the price at which you later sell the shares for. Holding a “short” position in a stock, means that you are expecting or betting on the stock price going down and profiting from the difference i.e. between the price you sell the stock for now-which should be higher than the price at which you sell the stock-and the price you buy the shares back at in the future.. 22 If you would like to learn more about risks associated with options trading read “Option Trading Risks” at http://www.optiontradingpedia.com/option_trading_risks.htm 23 “List of Exchange Traded Funds” (ETFs listed in the US and in other countries) Wikipedia at http://en.wikipedia.org/wiki/List_of_exchange-traded_funds#USA_ETFs















iShares Legman Aggregate Bond (NYSE: AGG) iShares Russell 1000 Value Index (NYSE: IWD) Vanguard Total Stock Market ETF (AMEX: VTI) DIAMONDS Trust, Series 1 (AMEX: DIA) iShares Lehman TIPS Bond (NYSE: TIP) Financial Select Sector SPDR (AMEX: XLF) iShares Lehman 1-3 Year Treasury Bond (NYSE: SHY) iShares iBoxx $ Invest Grade Corp Bond (NYSE: LQD) MidCap SPDRs (AMEX: MDY) iShares FTSE/Xinhua China 25 Index (NYSE: FXI) iShares Russell 1000 Index (NYSE: IWB) iShares MSCI Japan Index (NYSE: EWJ)

Regional ETFs
















iShares MSCI EAFE Index (NYSE: EFA) iShares MSCI Emerging Markets Index (NYSE: EEM) Vanguard Emerging Markets Stock ETF (AMEX: VWO) iShares S&P Latin America 40 Index (NYSE: ILF) iShares MSCI Pacific ex-Japan (NYSE: EPP) Vanguard European Stock ETF (NYSE: VGK) iShares S&P Europe 350 Index (NYSE: IEV) Vanguard FTSE All-World ex-US ETF (AMEX: VEU) Vanguard Pacific Stock ETF (AMEX: VPL) iShares MSCI EMU Index (NYSE: EZU) iShares MSCI EAFE Growth Index (NYSE: EFG) Vanguard Europe Pacific ETF (AMEX: VEA) Claymore/BNY BRIC (AMEX: EEB)

Country ETFs














iShares MSCI Brazil Index (NYSE: EWZ) iShares MSCI Japan Index (NYSE: EWJ) iShares FTSE/Xinhua China 25 Index (NYSE: FXI) iShares MSCI Taiwan Index (NYSE: EWT) iShares MSCI South Korea Index (NYSE: EWY) iShares MSCI Canada Index (NYSE: EWC) iShares MSCI Hong Kong Index (NYSE: EWH) iShares MSCI Singapore Index (NYSE: EWS) Market Vectors Russia ETF (NYSE: RSX) iShares MSCI Australia Index (NYSE: EWA) iShares MSCI Mexico Index (NYSE: EWW)

Sector ETFs

























Financial Select Sector SPDR (AMEX: XLF) Energy Select Sector SPDR (AMEX: XLE) Oil Services HOLDRs (AMEX: OIH) Technology Select Sector SPDR (AMEX: XLK) iShares S&P North Amer Natural Resources (NYSE: IGE) PowerShares Water Resources (AMEX: PHO) Consumer Staples Select Sector SPDR (AMEX: XLP) UltraShort Oil & Gas ProShares (AMEX: DUG) bear Ultra Oil & Gas ProShares(AMEX: DIG) Health Care Select Sector SPDR (AMEX: XLV) UltraShort Financials ProShares (AMEX: SKF) bear Utilities Select Sector SPDR (AMEX: XLU) Market Vectors Agribusiness ETF (AMEX: MOO) Market Vectors Gold Miners ETF (AMEX: GDX) Pharmaceutical HOLDRs (AMEX: PPH) PowerShares WilderHill Clean Energy (AMEX: PBW) Biotech HOLDRs (AMEX: BBH) Industrial Select Sector SPDR (AMEX: XLI) Ultra Financials ProShares (AMEX: UYG) Semiconductor HOLDRs (AMEX: SMH) iShares Dow Jones US Energy (NYSE: IYE) iShares Nasdaq Biotechnology (AMEX: IBB)




iShares Dow Jones US Technology (NYSE: IYW) 24

Short ETFs









ProShares Short Dow 30 (AMEX: DOG) ProShares Short S&P 500 (AMEX: SH) ProShares Short S&P MidCap 400 (AMEX: MYY) ProShares Short S&P SmallCap 600 (AMEX: SBB) ProShares Short Nasdaq 100 (AMEX: PSQ) ProShares Short Russell 2000 (AMEX: RWM) 25

Leveraged








ETFs

ProShares Ultra QQQ (AMEX: QLD) tracks 2x the NASDAQ-100 Index ProShares Ultra Dow30 (AMEX: DDM) tracks 2x the Dow Jones Industrial Average SM ProShares Ultra S&P500 (AMEX: SSO) tracks 2x the S&P 500 Index Large Cap Bull 3x (BGU) tracks 3x the Russell 1000 Small Cap Bull 3x (TNA) tracks 3x the Russell 2000

Leveraged Short ETFs











UltraShort S&P500 ProShares (AMEX: SDS) UltraShort QQQ ProShares (AMEX: QID) UltraShort Financials ProShares (AMEX: SKF) UltraShort Russell2000 ProShares (AMEX: TWM) UltraShort Dow30 ProShares (AMEX: DXD) UltraShort Real Estate ProShares (AMEX: SRS) UltraShort MidCap400 ProShares (AMEX: MZZ) UltraShort Oil & Gas ProShares (AMEX: DUG)

What is fundamental analysis?26 Definition for ‘fundamental analysis27’: A method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data.

Commentary: Although it is good to familiarise yourself with financial ratios and understand what they are and how they are calculated, since there are thousands of stocks listed on U.S. stock exchanges, if you had to calculate financial ratios for many of these stocks, this would be extremely time consuming and exhausting. 24

Short ETFs enable investors to profit from declines in an underlying index without short selling any securities. Investors who think an index will decline could purchase shares of the short ETF that tracks the index, and the shares increase or decrease in value inversely with the index, so if the value of the underlying index goes down, then the value of the short ETF shares goes up, and vice versa. 25 Leverage ETFs are index funds which try to amplify the return from the underlying index using leveraged money. Leverage ETFs keep a constant leverage level, which can be 2:1 (to double the return) or 3:1 (to triple the return). Unlike trading on margin, which involves paying off of interest on burrowed money, leveraged exchange traded funds use derivatives like index options, index futures and equity swaps to increase or reduce market exposure. These funds are leveraged on a daily basis, and so there is no guarantee of amplified annual returns. For example for a fund that doubles the return, if the index return 1% in one day, the fund value raises 2%; and if returns -1% the fund a return -2%. But as the leverage is constantly adjusted (rebalanced) on daily basis to keep the ratio constant (say 2:1), losses produce bigger effects than profits. For example a 1% loss for 4 days and a 4.1% gain on fifth day will produce no net loss/profit in a normal index ETF performance, but a 0.2% loss in original leveraged ETF value. The daily rebalancing of leverage results in extra trading, interest and management costs, which can bite into the profit. This makes leveraged ETFs unsuitable for long-term profiting. It is advisable to analyze the leveraged ETF’s past daily returns with respect to the underlying index before starting to trade the ETF. http://www.nobletrading.com/blogs/2008/09/what-are-leveraged-etfs.html 26 http://www.investorwords.com/2122/fundamental_analysis.html 27 If you would like to know more about financial ratios used in fundamental analysis of stocks there is a very comprehensive tutorial conducted by Richard Loth called “Financial Ratio Tutorial” Investopedia at http://www.investopedia.com/university/ratios/

Some commonly used financial ratios are: 28

Book value Per Share 29

= [Stockholders Equity - Preferred Shares] / Average Outstanding Shares = Cash from Operations / Total Assets

Cash flow to Assets

30

Dividend Payout Ratio

= Yearly Dividend Per Share / Earnings Per Share

31

= [Net Income – Dividends On Preferred Stock] / [Average Outstanding Shares]

32

= [Revenue – Cost of Goods Sold] / Revenue

Earnings Per Share Gross Profit Margin

33

Price to Earnings Ratio 34

= Market Value Per Share / Earnings Per Share = Net Income / Revenue

Profit Margin

35

Return on Assets

36

= [Net Income + Interest Expense] / Total Assets = Net Income / Shareholders Equity

Return on Equity

37

Inventory Turnover

= Cost of Goods Sold / Average or Current Period Inventory

28

If the company’s market value (i.e. share price x number of shares outstanding) is greater than its book value, this may mean the stock is overvalued (or it may indicate investors’ trust in the continued profitability of the company). If the company’s market value is less than its book value, this may mean the stock is undervalued (or that investors are not trusting the company’s management and are staying away from the stock). During bull markets, most stocks would be trading at higher than book value whilst in bear markets, most stocks would be trading at closer to its book value.

29

If this ratio shrinks compared to previous years, this may indicate the company running into cash flow problems.

30

Investors usually punish companies that decrease their dividend payouts by selling the stock and buying other stocks with strong dividend policies. A stable dividend payout ratio indicates that the company’s earnings are growing and thus this is a reflection of a solid dividend policy by the company’s directors. 31 Generally if the company issues more shares, this may dilute the company’s earnings that would be divided over more shares, so the ratio may shrink. Unless the company also grows its earnings by an equal rate that keeps the ratio the same as the previous year, this ratio will decline. An increasing Earnings Per Share ratio is usually a good sign for investors that the company is operating viably and is growing either its revenues, or is managing its costs more efficiently. 32

This ratio indicates the company’s pricing policy and what its true mark up margins are.

33 Usually a high P/E ratio indicates that investors expect the future earnings of this company to grow; the average P/E for companies is between 20 and 25; estimated earnings could be used in the ratio to calculate forward P/E; companies that make a loss or are not yet making money (e.g. the small mining companies or small pharmaceutical firms) will not have P/E ratios; a low P/E ratio does not indicate that the stock is a bargain, it may mean that investors do not have faith in the company’s management and are staying away from the stock. 34 The ratio would not exist for companies losing money. A small profit margin may indicate that either the company’s costs are not efficiently managed or that it is selling high volume of low priced goods and this may be a consequence of pressure from competition. The converse is also true in that a high profit margin may indicate the company is managing its costs efficiently or that it is a price setter and are able to sell their goods at a relatively high price. 35

This ratio is sometimes also called Return on Investment. This ratio shows what the company is generating in terms of net income on the company’s assets/investments. The interest expense is added to negate the costs of funding those assets/investments. A large ROA ratio may indicate that the company is operating efficiently and are making a good use of the money invested in the company. 36 The ROE ratio indicates how much the company is generating in terms of net income on the owner’s investment. If the company issues new shares then the ROE may fall and so net income is diluted across greater number of shares outstanding, unless the company is also able to increase its net income. A high growth or well performing companies would probably have high ROE ratios and the ROE may also grow from year to year, thus it is advisable to look at say the past ten years’ ROE ratios and see if it has been stable or growing from year to year. 37 A low inventory turnover is not good for business since it indicates that goods are not selling as fast as they should be, so the company is not profiting as much as it could be. Low inventory turnover means that goods that stay unsold will age and will become worth less and there are also storage costs involved with goods that sit in the warehouse. A low inventory turnover may also indicate the incompetence of the company’s management as they may not be advertising as effectively as they should be, or they may not have done enough research on customers’ needs (customers may not like the goods the company is selling), or simply that the management is not experienced enough to understand the business, or that there may be delays in the shipment of goods or an inefficient ordering and delivery system may be in place.

38

Debt to Equity Ratio

= Total Liabilities / Shareholders Equity

Yahoo! Finance (http://finance.yahoo.com) has a lot of information for each company including company news, profile, SEC filings, key statistics, competitors and industry, analyst estimates (of earnings growth forecasts etc), analyst upgrades/downgrades, major holders, insider transactions (director buys and sells of company shares), and financial statements such as income statement, balance sheet and cash flow statement. And the good news is all this information (except research reports) is for free. So this is quite a comprehensive set of information regarding a company which should give you a good idea about whether the company is fundamentally sound and strong to invest in. What is technical analysis?39 Definition of ‘technical analysis’: A method of evaluating securities by relying on the assumption that market data, such as charts of price, volume, and open interest, can help predict future (usually short-term) market trends.

Furthermore, with technical analysis:





Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis assumes that market psychology influences trading in a way that enables predicting when a stock will rise or fall. For that reason, many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.

Commentary: Technical analysis involves the use of technical indicators40 which are supposed to indicate where the price of a security is at present and what it would most likely do next i.e. go up, down or trade within a range. So they are supposed to predict short term price movements and do not take into account fundamental analysis. Due to some inherent weaknesses of the buy and hold approach discussed earlier, technical analysis, once an investor learns technical indicators well enough through much practice and patience, offers the investor better chances of cutting their losses early and letting their winning trades run. This is possible by understanding when indicators are showing signs of a stock being overbought (i.e. share price had risen to a level where there is a strong possibility of a reversal) and when indicators show signs of a stock being oversold (i.e. sold to a level where there is a possibility of buyers coming in to buy the stock) so that when you could sell when prices have peaked and buy when stock prices have fallen to a low.

38

If this ratio is greater than one, this means that the company is using more debt than equity to finance its assets, if the ratio is less than one, then the company is using more equity than debt to finance its assets. A high debt to equity ratio would indicate that this company would become riskier as interest rate increases as its debt burden increases. Some analysts state that ideally the companies that are more conservative would have a debt to equity ratio of 30% or less. 39

http://www.investorwords.com/4925/technical_analysis.html Technical indicators are any class of metrics whose value is derived from generic price activity in a stock or asset. Technical indicators look to predict the future price levels, or simply the general price direction, of a security by looking at past patterns. Examples of common technical indicators include Relative Strength Index, Money Flow Index, Stochastics, MACD and Bollinger Bands. 40

Technical indicators, collectively called "technicals", are distinguished by the fact that they do not analyze any part of the fundamental business, like earnings, revenue and profit margins. Technical indicators are used most extensively by active traders in the market, as they are designed primarily for analyzing short-term price movements. To a long-term investor, most technical indicators are of little value, as they do nothing to shed light on the underlying business. The most effective uses of technicals for a long-term investor are to help identify good entry and exit points for the stock by analyzing the long-term trend. “Technical Indicator” Investopedia at http://www.investopedia.com/terms/t/technicalindicator.asp

Although this is easier said then done, it is possible. It is also important to use several indicators to get an overall picture of the strength of the stock price and not just use one indicator, as sometimes it is difficult to understand what the stock price will do based on just one indicator. Some of the more popular technical indicators are: 41

Relative Strength Index or RSI :

RSI = 100 -

100 ______ 1 + RS

RS = Average of x days' up closes / Average of x days' down closes 42

Moving Average Convergence Divergence or MACD : MACD = 12 day EMA – 26 day EMA Trigger or signal line = 9 day EMA of the MACD 43

Stochastic Oscillator :

%K = 100[(C - L14)/(H14 - L14)]

C = the most recent closing price L14 = the low of the 14 previous trading sessions H14 = the highest price traded during the same 14-day period. %D = 3-period moving average of %K 44

Simple Moving Average or SMA :

SMA = ∑ (closing price of stock) / n

42The RSI is calculated with the above formula. The RSI has a range between 0 and 100. When the RSI is above 70, the stock is technically overbought and there is greater likelihood of a price correction. Conversely when the RSI is below 30, technically the stock is oversold and there is a greater likelihood of a price rise. http://www.investopedia.com 42

Crossovers - When the MACD falls below the trigger, this is a bearish, so it may be time to sell. Conversely, when the MACD rises above the trigger, this is bullish, so the stock price may be in an upward momentum and so it may be time to buy. Divergence - When the stock price diverges from the MACD this signals the end of the current trend. Dramatic rise - When the MACD rises dramatically it is a signal that the stock is overbought and will likely adjust to normal levels. Zero line - When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. When the MACD is below zero, this signals downward momentum. As you can see from the chart above, the zero line often acts as an area of support and resistance for the indicator. http://www.investopedia.com 43

In an upward-trending market, stock prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. This is the basis behind the stochastic indicator. Transaction signals occur when the %K crosses through a threeperiod moving average called the "%D. When the %K crosses above %D, this is a bullish signal since it indicates that the stock is oversold and would most likely move up, so this may be the time to buy the stock. When the %K crosses below the %D, this is bearish as it indicates that the stock is overbought and the price would most likely pullback, so this may be the time to sell. Also 80 is considered an overbought level and 20 is considered to be an oversold level. http://www.investopedia.com 44

So the SMA is the average stock price over a certain period of time and equal weighting is applied to each daily price. Usually short-term averages crossing above longer-term averages is a bullish signal marking the beginning of an uptrend, so this may be the time to buy the stock. Conversely, if the short term average crosses below the longer term average, this is a bearish signal that marks the beginning of a downtrend and may be the time to sell the stock. Short-term averages (e.g. 15 or 20 period SMA) act as levels of support when the price experiences a pullback. Support levels become stronger as the number of time periods used to calculate the

n = number of time periods A simple moving average is calculated by adding the closing price of the stock for a number of time periods and then dividing this total by the number of time periods.

As an example see the 6 month chart of McDonalds below:

The blue lines indicate oversold levels where the RSI is close to 20, the MACD is negative and the slow stochastic is below 20. Thus after this point, the stock price of MCD moves up. The move up in price is confirmed by the crossover of the %K over %D in the slow stochastic and also later with the MACD crossing over the trigger or signal line. The pink line indicate an overbought level where the RSI is close to 70, the MACD is positive and the slow stochastic is at above 80. Thus after this point, the stock price of MCD moves down. This move down in price is confirmed by the crossing of the %K beneath the %D in the slow stochastic and with the MACD crossing below the trigger or signal line. There is a comprehensive tutorial on technical indicators at Investopedia titled “Technical Analysis: Introduction” by Casey Murphy, Cory Janssen and Chad Langager at http://www.investopedia.com/terms/t/technicalindicator.asp. There is a common assumption that an investor is either a fundamental analyst or a technical analyst. However why the need to be referred to as one or the other? Why not have as many tools of analysis available to you as possible? To be an all round investor, take in the benefits of: (i) market timers, i.e. understand the state of the overall market and the state of the local and global economies (ii) fundamental analysts i.e. look at the information on each company that you are interested in investing in at Yahoo! Finance or calculate financial SMA increases. http://www.investopedia.com

ratios yourself from company annual reports (which are free) and (iii) technical analysts i.e. if you have found a few stocks you are interested in, which you have checked to be fundamentally sound from (ii) and you understand the current state/condition of the market and the economy from (i), then you can determine from looking at various technical indicators on the charts whether this is the right time for you to buy (long-you expect the price of the stock to rise in the future), or short (you expect the price of the stock to fall in the future), and once the price reaches a certain level, decide whether you wish to hold, buy more or sell some or all of your holdings (for short sellers-consider whether to close the short position) depending on what the technical indicators are showing you now. Remember that the key to successful investing is not whether you hold a certain strategy/concept against others or that you are right on some point of analysis, the point is to make profits consistently over time. So you would like to have as many helpful tools available for you to invest successfully and not worried about being labelled this or that. Be flexible and be open to new ideas/opinions and be willing to change and adopt new strategies as the market or economy changes. What is inflation risk?45 Definition of ‘inflation risk’: The possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Inflation causes money to decrease in value at some rate, and does so whether the money is invested or not.

Commentary: Inflation risk is eliminated if you can successfully profit from share investing over time. As long as your annual return is above the inflation rate for that year, you are eliminating inflation risk46. What is principal risk?47 Definition of ‘principal risk’: The risk of losing the amount invested due to bankruptcy or default. There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost, not just profits.

Commentary: You can minimise the risk of losing money from companies that go bankrupt by only investing in the larger, financially strong, liquid (i.e. easy to trade) companies. This risk is minimised if you diversify amongst different sectors e.g. you could invest in 10 companies which represent leaders from 10 different sectors. Also now with ETFs, you could diversify across sectors and asset classes without being at risk to one particular company going bankrupt (since indexes represent all companies in a sector or market) for very low cost. What is liquidity risk?48 Definition of ‘liquidity risk’: The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as a house).

Commentary: This risk is minimised by investing in larger listed companies and also ETFs. Smaller companies (especially those that are not yet producing income) will at most times be highly illiquid. What is market risk?49

45

http://www.investorwords.com/4292/risk.html

46

E.g. if you initially invested $10000 into stocks at the beginning of the year and after trading several times that year, you sold all your shares for $12000 and the inflation rate for that year was 3%. This means that your real return is 17% for the year (20% return on investment less 3% inflation rate, but does not take into account brokerage fees nor taxes). 47 48

http://www.investorwords.com/4292/risk.html http://www.investorwords.com/4292/risk.html

Definition of ‘market risk’: Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times. Also called systematic risk.

Commentary: In the current global financial crisis, most asset classes have declined in value including commodities, property, stocks, bonds (as some previously ‘investment’ grade bonds have now been classified as ‘junk’ bonds). So in times like these, even diversifying across these asset classes would have produced a negative return. In uncertain times such as the global economic downturn we are experiencing now, investors and corporations have de-leveraged (paid off debt) and sold off their investments in stocks, commodities, property, and junk bonds and have placed their money in traditional ‘safe havens’ such as gold, U.S. treasuries, us investment grade bonds, U.S. dollar and Japanese yen. Thus to be an ‘active’ investor you really need to know what is happening around you and to respect the market. If you hold onto these asset classes that deteriorate in value because other investors are selling them off, it is better to be aware of this situation and to respond quickly (e.g. sell when during a bear market rally when the stock price recovers from their low). It is even better if you can foresee these problems ahead of time and to anticipate what the market will do. However in reality it is difficult to forecast what will happen, but the key is to respond quickly and to have a risk management strategy in place (e.g. using stop losses50) and apply these as stringently as possible to minimise your losses. In order to preserve your money, you could place a big portion in cash and also in the ‘safe havens’ such as gold and spend some money on inverse ETFs (which increase in price as the underlying index falls in price e.g. since the stock market is in a bear market, you could purchase an inverse ETF that is negatively correlated to the underlying market index). However, a note of caution, since Ben Bernanke of the Federal Reserve is going to print 1 trillion U.S. dollars and spend $300 billion to buy US treasuries, this will ultimately mean a decline in the US dollar (since increase in supply drives down the value of the US dollar) and also a rise in US treasury price (since buying huge quantities of US treasuries will increase demand for them and drive up the price of these bonds51), so it may be wise to stay away from buying into US dollars and also Japanese yen (since the rise in Japanese yen has hurt Japanese exporters severely, it may be in the national interest for the Bank of Japan to keep the yen from rising against foreign currencies). Printing $1 trillion may also have inflationary effects on the US economy and thus this should be bullish for gold as gold is known as an ‘inflation’ hedge.

49

http://www.investorwords.com/4292/risk.html A stop loss is an order placed with a broker to sell a stock when it reaches a certain price. This is so as to limit an investor's loss on a stock position. 51 This is a quote from a Reuters article that showed US treasury prices rising as the US Federal Reserve moved to buy US treasuries [article by Richard Leong “TREASURIES-Bonds rise on Fed purchase, supply pause” March 27, 2009 Reuters]: 50

U.S. Treasury debt prices climbed for a second day on Friday as traders raised their bullish bets in hopes of profiting from the Federal Reserve's purchases of government securities. The market's tone also improved on a pause in government debt supply after this week's record-setting $98 billion in coupon securities, analysts and traders said. 'The mantra of 'Buy what the government buys' has infiltrated the market. People are trying to get ahead of the Fed,' said Richard Schlanger, portfolio manager with Pioneer Investments USA in Boston. The Fed bought $7.5 billion in Treasuries maturing in the next two to three years on Friday, matching the amount of intermediate issues in its debut purchases on Wednesday. Long-dated bonds rallied in the wake of Friday's purchase, as traders set up positions in advance of the Fed's buying of long-dated bonds on Monday. Thirty-year Treasuries gained more than a point in price.

Also a rule of thumb is that when inflation is high and economic growth (growth in the GDP-Gross Domestic Product) is high, it is suitable to invest in commodities52; when inflation is low and economic growth is high, it is suitable for investing in stocks and property53; and when inflation is low and economic growth is low, it is suitable to buy bonds.54 We are currently in a period of low inflation and low economic growth, that is why bonds (not junk bonds) have performed better than stocks, property and commodities. What is opportunity risk?55 Definition of ‘opportunity risk’: The risk that a better opportunity may present itself after an irreversible decision has been made. Commentary: By understanding market conditions, the state of the economy and understanding the various asset class cycles, an investor would be better able to choose the investment that is the most suitable for those conditions. If an investor is able to continuously choose and change his/her investments based on changes in external environment, then the investor would be able to minimise opportunity risk as he/she would be investing in the ‘right’ assets at the ‘right’ time. What is income risk?56 Definition of ‘income risk’: The possibility that the income provided by a fund will fluctuate due to changing interest rates. Commentary: Once again by choosing the right investments that is appropriate for the current market, economic conditions, an investor would be able to minimise income risk. What is credit risk?57 Definition of ‘credit risk’: The possibility that a bond issuer will default, by failing to repay principal and interest in a timely manner. Bonds issued by the federal government, for the most part, are immune from default (if the government needs money it can just print more). Bonds issued by corporations are more likely to be defaulted on, since companies often go bankrupt. Municipalities occasionally default as well, although it is much less common. Also called default risk.

Commentary: Some bonds that were previously classed as investment grade have now been reclassed as junk bonds. These are the sort of companies that are at great risk of defaulting on their bonds. However, this credit

52

Since a booming economy requires a lot of raw materials and high inflation drives down the value of paper currency, thus commodities are purchased as it represents tangible value e.g. since all commodities are priced in US dollars, when high inflation drives down the value of the US dollar commodity prices rise to offset the fall in the US dollar. 53

As low inflation means that interest rates are fairly low and stable which is beneficial for businesses and as they profit due to a growing economy, they make profits and thus their stock prices rise. When interest rates are low and stable, this is a bullish environment also for housing as people borrow money at low rates and they have sufficient income to meet loan repayment obligations (as in a booming economy, most people are able to find jobs, and if they have jobs and an income, banks are willing to loan them the money). Previously, the housing market used to lag the stock market, but there may have been a decoupling of these markets since the housing market bubble burst in November 2006 and the stock market entered the current bear market about a year later in the U.S.

54

Low inflation in an environment of low economic growth will mean that the interest rate is fairly low. As bond yields move in inverse direction to the bond price, a low yield or low interest rate will drive up the bond price. Also in times of crisis as we are in now, investors will sell their assets and buy us bonds which are traditionally viewed as a ‘safe haven’, thus this also drives up the price of these bonds. 55 http://www.investorwords.com/4292/risk.html 56 http://www.investorwords.com/4292/risk.html 57 http://www.investorwords.com/4292/risk.html

risk is minimised if an investor purchases US government bonds which are traditionally thought of as ‘safe haven’ assets58. What is unsystematic risk?59 Definition of ‘unsystematic risk’: The risk of price change due to the unique circumstances of a specific security, as opposed to the overall market. This risk can be virtually eliminated from a portfolio through diversification.

Commentary: Now with sector and index ETFs, an investor can eliminate this risk since these ETFs represent all the stocks in a sector or index. What is asset allocation?60 Definition of ‘asset allocation’: The process of dividing investments among different kinds of assets, such as stocks, bonds, real estate, commodities and cash, to optimize the risk/reward tradeoff based on an individual's or institution's specific situation and goals. A key concept in financial planning and money management.

Commentary: Once again as was previously discussed, in the current crisis most asset classes have fallen in value, so equally diversifying across these assets would still have meant that an investor would have lost quite a lot of money. Thus the key is to understand the current market and economic conditions in such a way as to choose the right investment for the current conditions. This way an investor would be able to preserve his/her capital and also be able to have a positive return (even if the return is small). What is diversification?61 Definition of ‘diversification’: A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.

Commentary: Diversification for the sake of diversification will not serve the investor well, since although diversification can reduce downside potential, it can also dilute your positive returns as well. So the key to successful investing is to understand the current state of the markets, economy, asset cycles and choose the various investments that will perform well under those conditions e.g. in the current environment of low inflation and low economic growth, bonds will do well. However, as the US Federal Reserve is going to print trillions of US dollars, this may cause inflation to rise. So if in fact inflation rises, and the stimulus package does have a positive impact on the US economy62, then the environment would have changed to one of high inflation and positive economic growth which would be 58

However, some analysts have cited that with the US government issuing so much new debt, potential investors will require higher yields (as reward for greater risk they are taking on) which should bring down the price of these bonds as yields move in inverse direction to the bond price. 59 http://www.investorwords.com/4292/risk.html 60 http://www.investorwords.com/275/asset_allocation.html 61 http://www.investorwords.com/1504/diversification.html 62 This is a quote from Yahoo! News [Associate Press article by Jeannine Aversa “Bernanke says recession could end in 2009” March 2009]: Still, Bernanke stressed — as he did to Congress last month — that the prospects for the recession ending this year and a recovery taking root next year hinge on a difficult task: getting banks to lend more freely again and getting the financial markets to work more normally. "We've seen some progress in the financial markets, absolutely," Bernanke said. "But until we get that stabilized and working normally, we're not going to see recovery. "But we do have a plan. We're working on it. And, I do think that we will get it stabilized, and we'll see the recession coming to an end probably this year."

suitable for commodities. Thus the point to all this is being constantly alert (the economy and markets never stay still for long, there is always something happening) to new events, news, data, technologies and so on, so as to change your investments as the external environment changes and buy the right investment for those conditions. What is compounding? Definition of ‘compounding63’: the value of an investment increases exponentially over time due to compound interest.

The

equation for compound interest is: P = C(1+ r/n)nt Where: P = future value C = initial deposit r = interest rate n = # of times per year interest is compounded t = number of years invested

This is why we need to learn to become successful at investing and learn to earn positive rates of return each year (however small), consistently over many years. To illustrate the power of compounding see the following table: Return p.a. (%) 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

0.1

20

Value ($) 10000 11000 12100 13310 14641 16105.10 17715.61 19487.17 21435.89 23579.48 25937.42 28531.17 31384.28 34522.71 37974.98 41772.48 45949.73 50544.70 55599.17 61159.09 67,275.00

Return p.a. (%)

Years

0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Value ($) 10000 12000 14400 17280 20736 24883.20 29859.84 35831.81 42998.17 51597.80 61917.36 74300.84 89161.00 106993.21 128391.85 154070.22 184884.26 221861.11 266233.33 319480.00

0.2

20

383,376.00

Return p.a. (%)

Years

0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Value ($) 10000 13000 16900 21970 28561 37129.30 48268.09 62748.52 81573.07 106044.99 137858.49 179216.04 232980.85 302875.11 393737.64 511858.93 665416.61 865041.59 1124554.07 1461920.29

0.3

20

1,900,496.38

In the white table, say an investor consistently earns a net return of 10% per annum from share investing and his/her starting capital is $10,000. After 20 years the initial capital has grown to $67,275. In the blue table, an investor consistently earns a net return of 20% per annum from share investing and again his/her starting capital is $10,000. After 20 years the initial capital has grown to $383,376. In the green table, an investor consistently earns a net return of 30% per annum from share investing and again his/her starting capital is $10,000. After 20 years the initial capital has grown to $1,900,496.38. Although in the real world it is difficult to earn the same exact return year on year, this table is used to illustrate the exponential power of compounding. The key is to try to make a positive return every year that beats inflation (inflation has averaged out to be around 3% p.a.). IN CONCLUDING..

63

http://www.investorwords.com/1013/compound_interest.html

I would presume, that people want to learn to be successful at investing so as to grow their wealth and become financially independent and free. As such, it is important to keep this goal in mind regardless of setbacks. Just like any other skill, success in share investing requires patience, persistence and perseverance. It does not matter if you fail, as long as you learn from your mistakes and only use an amount of money that you can afford to lose (especially in the beginning and in volatile conditions). However, if you constantly do the same thing over and over again and yet expect to get different results each time, this will not happen. Your goal (of financial freedom) stays constant and yet if you have not yet achieved success, your methods to attain your goal may need constant revision, fine tuning or change. Investing is a lifelong learning process. Since the markets and economy never stays constant for long, it is vital that you keep learning new techniques, read new books, read articles, keep up to date on news and events and technologies. By constantly learning, you will be storing as much knowledge and tools of analysis that will be handy at some point in your investing career. So the key is to harness the power of compounding, and doing your bit by being able to achieve a positive return on your investments each year (however small). In this way, your money will keep growing and you are definitely on your way to achieving your goal.