Saturday, January 21, 2012
Fun Things You Can Do (with Stocks)
Fun Things You Can Do (with Stocks)
You can do a number of interesting things with stocks: You can diversify, allocate, compound, split them, and short them. Let’s look at each of these concepts in turn.
Diversification: Avoiding Putting All of Your Eggs in One Basket
I’ve already mentioned the importance of diversification, meaning that instead of betting your entire portfolio on one or two stocks, you spread the risk by investing in a variety of securities, with the number and the specific securities depending on how much risk you want to take and how long you will stick with your investment. (A portfolio is a list of the securities, including stocks, mutual funds, bonds, and cash, that you own.) The idea behind diversification is that even if one investment goes sour, your other investments might soar.
Many people’s portfolios were destroyed during the recent bear market because they invested all of their money in one stock, often that of the company for which they worked. For example, if the only stock you owned was Enron because you worked there, not only did you lose your job when Enron filed for bankruptcy, but you lost your investment as well.
Let’s see how diversification works when you are 100 percent invested in the stock market. First of all, you need a lot of money to properly diversify, more than most people can afford. That’s because you need to own at least 25 to 50 stocks in various industries to be properly diversified (now you understand why mutual funds are such a good idea). Many financial experts suggest that you own a mixture of growth, value, and income stocks, along with a smattering of international stocks. You might also own stocks in both large companies and smaller ones.
It takes considerable skill to determine how you should diversify because so much depends on how much risk you are comfortable with (called risk tolerance), your age, and your investment goals. For example, when the Internet stocks were going up, many people put 100 per-cent of their money into those stocks. Unfortunately, this wasn’t proper diversification. Although putting all their eggs in one basket did make some people rich on paper, most of the people who did this didn’t understand the risks they were taking until it was too late. (Many people thought they were properly diversified until all of their investments went down at once.)
In my opinion, if you insist on investing 100 percent of your money in stocks (and even if you add mutual funds, bonds, and cash to the mix), you should speak to a financial planner or adviser about proper diversification. There are so many possible combinations that diversifying your money can be mind-boggling. On the one hand, you don’t want to play it too safe by being over diversified. On the other hand, you don’t want to expose yourself to too much risk.
Asset Allocation: Deciding How Much Money to Allot to Each Investment
Once you have diversified, you have to decide what percentage of your money you want to allocate (or distribute) to each investment. For example, if you are 30 years away from retirement, you might invest 65 percent in individual stocks and stock mutual funds and 25 percent in bonds, and keep 10 percent in cash. This is asset allocation.
As with diversification, the correct asset allocation depends on your age, your risk tolerance, and when you’ll need the money. In the old days, you were told to subtract your age from 100 to determine the percentage to put into stocks. Unfortunately, it’s a lot more complicated than that. Once again, it is a good idea to seek professional help in determining the ideal asset allocation for you.
In a real-life example, one 80-year-old man I know had 90 percent of his portfolio in only two stocks, Lucent and Cisco Systems. When these stocks plummeted, his two-stock portfolio was ruined. Now he’s worried that he won’t have enough money to survive, and he’s right. The goal for this man is to protect his original investment. On the other hand, I have a 21-year-old friend who is putting much of
her money in stocks and stock mutual funds, and she can afford to do so because her time horizon is so much longer.
Compounding: Creating Earnings on Your Earnings
There is something you can do with stocks that can make you rich, according to the mathematicians who dream up this stuff. The idea behind compounding is the reason that people began to buy and hold stocks in the first place. Compounding works like this: You reinvest any money you make on your savings or investments: interest, dividends, or capital gains. The longer you keep reinvesting your earnings, the more money you’ll make.
For example, if you invest $100 and it grows by 10 percent in one year, at the end of the year you’ll have a total of $110. If you leave the money alone, you’ll have $121 by the end of the next year. The extra $11 is called compound earnings, or the earnings that are earned on earnings. The more your investment is earning, the faster the com-pounding. The advocates of compounding remind you to invest
early if you want to have more money later. Compounding is a neat accounting maneuver that can make you rich if you live long enough to see it work. The idea is that as the stock you own goes up, it compounds in value, bringing you even greater profits. The longer you leave your money in a stock, the more it compounds over time. John Bogle, ex-chairman of the mutual fund company Van-guard, called compounding “the greatest mathematical discovery of all time for the investor seeking maximum reward.”
The only problem with compounding formulas is that they make assumptions that may not occur in real life. Compounding works like a charm as long as your stock goes up in price. The problem with the stock market (and compounding) is that there are no guarantees that your stock will go up in price or that you’ll make 8 percent or more a year in the market.
The Stock Split: Convincing People to Buy Your Stock When a corporation announces a 2-for-1 stock split, this simply means that the price of the stock is cut in half but the number of shares you own is doubled. For example, let’s say you own 100 shares of IBM at $80. If IBM announces a 2-for-1 stock split, the price of IBM would be cut in half, to $40 a share. Now, instead of owning 100 shares of IBM, you’d own 200 shares. From a mathematical perspective, nothing has changed at all. You own twice as many shares, but since the price of the stock is reduced by half, the value of your investment is exactly the same. (You can also have a 3-for-1 or 4-for-1 stock split.)
A stock split is often done for psychological reasons more than anything else. In this example, the price of IBM has dropped from $80 to $40 a share. Investors who are primarily focused on price might consider the $40 price a bargain, something like a half-off sale. In reality, a stock split doesn’t change the corporation’s financial condition at all. Instead, the biggest advantage of a stock split is that it
may lure more investors—those who felt that they couldn’t afford to buy IBM at $80. During the bull market, after a company announced a stock split, the stock price often went up.
Nevertheless, there are practical reasons for a company to split its stock. For example, do you know what would happen if a corporation never split its stock? Think about Berkshire Hathaway, Warren Buffett’s corporation. As I write this book, his stock is trading at $70,000 a share. That is not a typo! Most people couldn’t afford even one share of stock at that price. So from a practical standpoint, stock splits do make sense for corporations. They do nothing to increase the value of the corporation, however. Splitting the stock is purely an accounting (or marketing!) procedure designed to make a stock more enticing to investors.
Some companies with low stock prices have used another type of maneuver, the reverse split, to artificially pump up the price of their stock so that they aren’t delisted from a stock exchange.
For example, if a stock is trading for $1 a share, after a 1-for-5 reverse split, the price will rise to $5 a share. Just as with the regular stock split, fundamentally nothing has changed in the company. If you are a shareholder, the value of your shares remains the same, but you now own fewer shares. (Let’s say you own 100 shares of a $1 stock. After a 1-for-5 reverse split, the stock rises to $5, but the 100 shares you own are reduced to 20 shares. From an accounting standpoint, you still own $100 worth of stock.) The bad news about reverse splits is that most of the time the higher stock price doesn’t last. Before long, the stock may return to $1 a share.
Selling Short: Profiting from a Falling Stock
When you invest in a stock hoping that it will rise in price, you are said to be “long” the stock. Your goal is to buy low and sell high. Your profit is the difference between the price at which you bought the stock and your selling price. On the other hand, if you hope that a stock will go down in price, you are said to be “short” the stock. When you short a stock, you first sell the stock, hoping to buy it back at a lower price. Your profit is the difference between the price at which you sold the stock and the price at which you bought it back. If you’ve never shorted stocks, it sounds strange until you do it a few times.
Imagine making money when a stock goes down in price! For many people, it sounds almost un-American or unethical to profit from a falling stock. In reality, you’re in the market for only one reason: to make money. It doesn’t matter whether you go long or short as long as you make profits. It’s neither un-American nor unethical to short stocks. It’s a sophisticated strategy that allows you to profit even
during dismal economic conditions.
For example, let’s say you are watching Bright Light, and you believe that over the next month it will go down in price. Perhaps there is negative news about the industry, or perhaps you notice that the company has a lot of debt. You account and decide to short 100 shares of Bright Light at the current market price of $20 a share, so you call your brokerage firm or use your online account. When you place the order, the brokerage firm will lend you 100 shares of Bright Light (since you don’t own it). Let’s say Bright Light falls to $18 a share. You now buy back the shares that you borrowed for a point profit.
There are a few rules that you must follow in order to short stocks. First, you must buy when the stock is temporarily rising, which is called an uptick. If a stock is falling quickly and buyers have abandoned it, you may not be allowed to short it. You have to wait for the next uptick, when buyers have taken a position on the stock, a technical rule that prevents short sellers from piling onto a losing stock. Another rule is that you can’t short a stock whose price is less than $5 a share.
Although selling short sounds like an easy strategy, a lot of things can go wrong. First, when you go long a stock, the most you can lose is everything you invested. I know, that’s pretty bad. On the other hand, when you short a stock, you can lose more than you invested, which is why shorting can be risky. Let’s see how this works.
If you sell short 100 shares of Bright Light at $20 a share, you receive $2000. If Bright Light drops to $18 a share, you made 2 points, or a $200 profit. Let’s say you are wrong and Bright Light goes higher. For every point Bright Light goes up, you lose $100. How high can Bright Light rise? The answer is frightening: infinitely! The problem with shorting is that if the stock goes up, not down, your losses are incalculable. I knew a group of guys who shorted Yahoo! in 1997 when it reached $90 a share. They were convinced that Yahoo! was overpriced. Perhaps they were technically correct, but that didn’t stop the stock from soaring to as high as $400 one year later.(It actually went over $1000 in 1999, or a split-adjusted price of $445.) These guys were forced to buy back the shares early, losing over 100 points, because the losses grew so large. A few years later, after the market came to its senses, Yahoo! dropped to less than $20 a share (adjusted for splits), but it was too late for my acquaintances.
Personally, I find it very enlightening to listen to short sellers. Too often, investors delude themselves into thinking that the market will always go higher. Professional short sellers are good at poking holes in the “too-good-to-be-true” proclamations of market bulls. In my opinion, you should listen to both sides of an argument, but in the end you should do what you think makes the most sense.
Other Ways to Classify Stocks
Outstanding Shares
As you remember, corporations issue shares of stock, which are made available to investors through a stock exchange. The total number of shares that a corporation has issued is called its outstanding shares. (I agree it’s not the most exciting name.) In a real-life example, you might ask someone in the corporation, “What is the number of outstanding shares?”
To save yourself time, you could also look up the number of out-standing shares on the Internet—for example, at Yahoo! Finance. Keep in mind that the bigger the corporation, the more outstanding shares there are. Because the stock market goes up and down based on supply and demand, a corporation doesn’t want to issue too many shares unless it is pretty sure that people will scoop them up.
Let’s say that over a 10-year period, Microsoft issues a total of 1 bil-lion shares to the public and to corporate insiders; therefore, the number of outstanding shares for Microsoft is 1 billion shares. (It is up to the board of directors of Microsoft to decide how many shares it wants to issue.) Obviously, the board keeps millions of shares of the stock for the company’s officers and employees. Because they are
company insiders, they got the shares at extremely low prices, perhaps for a few dollars a share. (This is one of the reasons that so many people who worked at Microsoft became millionaires.) In addition, the board of directors also sets aside millions of shares to be used for equipment, computers, and research and development.
The Float
The total number of shares issued by the corporation is called the out-standing shares. Can you guess what the shares are called when we refer only to those owned by outside investors like you and me? Those shares are called the float.
I’ll explain this as simply as possible. Let’s say a corporation has a total of 5 million outstanding shares. Of those 5 million shares, corporate insiders hold 3 million. The question of the day: How many shares have been allocated to outside investors to be actively traded? If you guessed 2 million shares, you’re right. The float is 2 million shares. These are the shares that are traded every day on the stock
exchange by investors and traders.
Why Outstanding Shares and Float Are Important
Although some people don’t care how many shares are outstanding or what the float is, others think this information is extremely important. Why? Keep in mind that the market is all about supply and demand. If you know how many shares are outstanding and what the float is, you can calculate whether there is too little supply and too much demand (the stock will go up in price) or too much supply
and not enough demand (the stock price will go down). Also, it’s a good idea for new investors to become familiar with market vocabulary.
Market Capitalization
Another way to classify stocks is by size. The market capitalization (market cap) of a stock tells you how large the corporation is. (To calculate market cap, you multiply the number of outstanding shares by the current stock price. Therefore, the market cap of a stock varies depending on both the number of outstanding shares and the stock price. For example, a large corporation with 10 billion outstanding shares and a stock price of $50 has a market cap of $500 billion.)
Some people will invest only in large-cap stocks (those of large corporations worth more than $5 billion), which include the stocks of corporations like Coca-Cola, Alcoa, and Johnson & Johnson, because they feel that the stocks of these corporations are safer and the corporations will never go bankrupt. (This isn’t always true, however, since the fifth largest company in the country, Enron Corporation, filed for bankruptcy in 2002.) Other investors are attracted to mid-cap stocks (those of medium-sized corporations worth between $1 and $5 billion), while still others invest in small-cap or microcap stocks (those of small corporations worth between $250 million and $1 billion) because they cost less and their price often moves quickly.
When you compare the stock price to the market cap, you can see how difficult it is for large-cap stocks to double or triple. For example, let’s say you own shares in a $50 large-cap stock of a company with a market cap of $500 billion. In order for the stock price to double, the company would have to increase in value from $500 billion to $1 tril-lion—not impossible, but extremely difficult and time-consuming.
One reason some investors prefer small-cap stocks is that there is a better chance that they will double or triple. On the other hand, the smaller the stock’s markets cap, the higher the risk.
The IPO
Stocks that are being sold to the public for the first time are called initial public offerings, or IPOs. (Wall Street refers to this process as “going public.”) The IPO is an exciting time for the corporation. The biggest advantage of going public for a company is that it allows the company to raise money. It can use this money to expand, to pay off debt, or to pay for research and development of a new product. In addition, if the IPO is successful, it can make company insiders extremely rich. There are two types of IPOs, the start-up (a company that never existed before) and the private company that decides to go public.
The corporation will appoint a major Wall Street stock brokerage firm (identified as the lead underwriter) to manage the IPO process and bring the stock to market. Investment bankers who work for the brokerage
firm will determine how many shares of stock to issue to the public and what price to set.
Before the company goes public, early investors are given a chance to buy the stock at cut-rate prices. For example, corporate insiders could get thousands of shares of the stock for a dollar. Meanwhile, investment bankers will work with the underwriters to try to create investor interest in the corporation. Once the company goes public, research analysts that work for the underwriter may issue buy recommendations on the stock and make positive comments about the corporation.
We all saw the power of the Internet stocks when Netscape went public in April 1995. The lead underwriter, a major New York brokerage firm, calculated that the stock would be worth $28 a share. Minutes after
the stock opened for the day, it rose to $75 a share, a price move that surprised many on Wall Street (although in later years some Internet IPOs rose by even more— for example, in 1998 TheGlobe.com went from $9 to $87 in one day, and in 1999, an IPO called VA Linux jumped 700 percent in one day, opening at $30 and rising to a high of $299). For the next 5 years, any stock that had anything to do with the Internet was given a robust reception by Wall Street. The demand for these Internet stocks was nothing short of phenomenal.
Like all good things, however, the fun ended after a few years. Most of the Internet stocks made a round trip back to their original price, and many went out of business. For example, a few years after its IPO, VA Linux was trading for less than $5, and TheGlobe.com was recently at less than a dollar. In addition, many of those who bought Internet IPOs on the first day lost thousands of dollars because they bought too high.
As an individual investor without inside connections, it is probably best if you avoid buying IPOs. More than likely, you will end up buying at the top and be forced to sell at a loss. Although some traders made small fortunes on IPOs on the way up, the IPO game is difficult to win, unless you are a company insider and buy early shares.
If you do want to participate in an IPO, however, be sure you read the prospectus, a legally binding document filed with the SEC that includes the company’s future plans as well as its cur-rent financial condition.
To cover themselves, startup companies will mention, often in small print, that there are no guarantees the company will succeed and there are tremendous risks. After reading all the risks, you may decide not to
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