When it comes to mutual funds, there is a lot more to success than just finding a good one. Sad investment stories like the following are all too common. I hope my sharing it with you will help you avoid making the same devastating financial mistake one of my former clients made.

This story begins during the height of the investment madness in 2000, just prior to the bear market. I had been managing an IRA account for "Bob" for around six years, with a better than average record of success. So I was surprised when Bob sheepishly called in July, 2000 to let me know he was transferring his IRA account, which had done particularly well during our latest Buy cycle going into the year 2000.

However, his tax preparer, a long time personal friend of Bob’s wife’s, was now also offering investment services, having recently received his Registered Representative’s license.

Fast forward to the end of September. It had become increasingly clear to me that the Bull market had run its course. So, in accordance with the Sell signal from our trend tracking methodology, we sold all of our mutual fund positions on October 13, 2000 and went 100% into money market. (See my article “How we eluded the Bear in 2000” at http://www.successful-investment.com/articles12.htm). From our safe haven we watched the market crash and burn, causing most other investors to sustain double digit losses eventually reaching as high as 50 - 60% of their assets.

In 2002 Bob unexpectedly stopped by my office. As it turned out, things had not gone well at all with his IRA investments. As most advisors would have done, his tax preparer/advisor had quickly moved all of Bob’s assets into a variety of “load funds.”

Of course, being newly licensed he was clueless (as were many licensed advisors) as to market behavior or analysis of any kind. The end result was that Bob’s portfolio lost in excess of 50% over the next 2 years. (Not to gloat, but my clients’ losses in the same period were non-existent.)

Unfortunately, the degree of loss Bob sustained was experienced by many investors who did not follow a disciplined and methodical approach.

What I find particularly distasteful is that Bob’s tax preparer misused his position of trust. He made financial decisions that he was not qualified to make, though his license implied that he did know enough to make them. So now we know what a piece of paper is worth.

This is no different than letting a newly graduated medical student with a fresh MD behind his name perform heart surgery. Or, hiring a new MBA grad to Chief Financial Officer of a Fortune 500 company. Yet the financial services industry allows someone to get a license (after a fairly short course) and to immediately start making incredibly important and far reaching financial decisions for anyone he or she can sell their service to.

This is a worrisome trend in this industry. A CPA friend confirmed that he has been approached many times by firms wanting him to offer investment services.

Why? It’s easy money! Accountants and tax professionals have a great business base. They are in a unique position of trust, because of the information their clients disclose to them. Whether they are employed by a company or they maintain an individual practice, there is probably no other person (other than your spouse) who knows as many intimate details of your financial life as your accountant/tax preparer.

To abuse this trust for personal gain—no matter how noble the motive may appear—is a total conflict of interest and a huge betrayal.

The bear market of 2000 has shown that investing must be a disciplined endeavor. Even most professionals have failed to recognize this. What busy accountant, in the middle of tax season, can put the necessary time and attention to a volatile investment market that may require action at a moment’s notice?

As for Bob, he’s still with his accountant, and in the same investments that brought his portfolio down. He’s hoping for a miracle recovery. As of this writing, the stock market is engaged in something of an upswing and Bob, I’m sure, is getting his hopes up that he will recover some of his losses. However, I shudder to think that this rally may come to an end and the bear market resumes. Where will Bob be then?

At 58 years old Bob is still playing Russian roulette with his retirement. He’s apparently unable to make a decision to move to someone who has the ability to make sense of market trends and the discipline to follow the signals they communicate. This is a decision that will have a profound affect on his financial future—and will determine whether his story has a happy or sad ending.

About The Author

Ulli Niemann is an investment advisor and has been writing about objective, methodical approaches to investing for over 10 years. He eluded the bear market of 2000 and has helped countless of people make better investment decisions. To find out more about his approach and his FREE Newsletter, please visit: www.successful-investment.com; ulli@successful-investment.com

This article describes the model of a natural relationship between trading system performance, trade position size, stop loss settings and profit goals. The model consists of algebraic equations that specify the trade size and stop loss settings needed to meet profit goals over a specified time period for any consistently used trading system for which historical performance data is available.

Most of us think of a trailing stop loss when the term money management is mentioned. William O’Neil in his book, “How to Make Money in Stocks”, used a value from 7 to 8%. Many stock advisories, including Stansberry and Associates, Outstanding Investments and the Oxford Club, typically use a 25% trailing stop loss. Option advisories use still higher values in the 35% range, as is done by Michael Lombardi, and up to as high as 50%, as used by Dr. Stephen Cooper. Trailing stops are typically used along with a maximum percentage of capital per trade to avoid large portfolio draw-downs in the event that a given trade goes badly.

Beyond this precaution, there is little theory to explain how position size and trailing stop losses should be arrived at, leaving the impression that they can be arbitrarily chosen based on one’s risk comfort level. However, this is not the case. Too narrow a stop loss setting can eat into profits by exiting volatile trades too early. Too wide a stop loss setting can eat into trading profits by consuming too much capital. A systematic way is needed to choose an optimum position size and stop loss setting to achieve a precise level of money management.

Intuitively, the higher the success rate in correctly choosing the direction of trade and the higher the average gain per trade, the looser one can afford to set his stop loss. However, when one has a specific earnings goal, this relationship needs to be more precise. Fortunately, the availability of consistent trading system performance data allows the use of an engineering approach. This approach enables us to define a very precise relationship between the average return for a series of trades, the percentage of correct choices in the direction of a trade, the size of each trade, profit goals and the appropriate stop loss settings.

The model introduced here for precision money management is based on average values of historical trading system performance and is only applicable when a trading system is consistently followed. The model should not be applied to unstructured trading across a variety of instruments requiring varying trading techniques. Each trading system or technique generates a unique set of statistics to which this methodology can be applied on an individual basis.

The model is derived based on fractional averages from information readily available to anyone that uses a trading system consistently. A pair of concise algebraic relationships evolves in the process. Finally, examples are provided to show the roles of position size and stop loss settings in meeting profit goals.

FP is defined as the average fractional profit for all historical trades being taken into consideration. FP is equal to the sum of the fractional gains and losses for all trades divided by the total number of trades N,

FP = (sum of fractional gains + sum of fractional loses) / N

In order for this to be valid, each trade must involve very close to the same amount of capital that we will assign an average value C. For example, if there were 3 historical trades resulting in +25%, -15% and +30% gains, the average fractional profit would be (0.25 - 0.15 + 0.30)/3 = 0.133. Of course, a much larger statistically significant number of trades would be used in practice.

Since the sum of fractional gains is equal to the number of gains NG times the average fractional gain FG, and the sum of fractional loses is equal to the number of loses NL times the average fractional loss FL, the definition can be expressed as,

FP = (NG FG + NL FL)/ N

It is understood that NG + NL = N. The value of NG divided by N equals FC, the fraction of trades chosen in the correct direction. NL divided by N equals (1 – FC), the fraction of trades chosen in the wrong direction. So N divided into NG and NL leaves the following form.

FP = FC FG + (1 – FC) FL . . . . . . . . . .(1)

Where,

FP is the average fractional profit for N trades that each uses an average amount of capital C

FC is the fraction of trades chosen in the correct direction

FG is the average fractional gain for NG winning trades

FL is the average fractional loss for NL losing trades

The fractional quantities can each be expressed individually as percentages but they should be expressed as decimal fractions in the equation.

In order to use equation (1), a profit goal must be established over a definite period of time. The profit per trade needed to meet a specific profit goal in a given amount of time depends on the number of promising trades likely to be identified by the trading system over that time period. The number of promising trades that become available within a given time period must be estimated judiciously because the last thing we want to do is force a trade under less than ideal conditions. In other words, we need to remain true to whatever system we are using.

For N trades each valued at an average capital amount C, the average fractional profit can also be defined by the total dollar profit goal DG divided by the dollar sum of all N trades DS,

FP = DG / DS

Since DS is equal to the average capital amount C times the number of trades N, this becomes,

FP = DG / (C N) . . . . . . . . . .(2)

Example 1:

Let us suppose that we have done a sufficient number of trades using our system to determine that the average fractional profit is 10%, the average gain per trade has been 29% and the fraction of times we chose the correct trading direction was 70%. Further let us set a goal to earn $3,000 per month. By our estimate, we figure that we can safely enter an average of 3 trades a week and remain within trading system guidelines. This equates to 3 trades per week times 4.33 weeks per month or an average of 13 trades per month.

Variables: FP = 0.1

N = 13

DG = $3,000

FC = 0.7

FG = 0.29

Solving equation (2) for C gives us the average size of each trade,

C = DG / (FP N) = $3,000 / [(0.1) (13)] = $2307.69 for the average size of each trade

Rearranging equation (1), the average stop loss setting FL must be,

FL = (FP - FC FG) / (1 - FC)

= [0.1 – (0.7) (0.29)] / (1 – 0.7) = - 0.3433 or -34.33%

Example 2:

Using essentially the same situation, we can look at what the effect of certain improvements in trading would have on the profits. Say we habitually exit winning trades too early and could possibly increase the average fractional gain FG from 29% to 36%. From the same relationship used for example 1, the resulting stop loss setting FL could then be widened to,

FL = (FP - FC FG) / (1 - FC)

= [0.1 – (0.7) (0.36)] / (1 – 0.7) = - 0.5066 or -50.66%

Example 3:

Let’s suppose that for a series of potentially high yielding trades we know that an extra wide stop loss setting of -60% is needed and we want to know what the effect will be.

First we might want to look at the effect of a wider stop loss setting on profits with everything else remaining constant. We do this by equating the right sides of equations (1) and (2) and solving for DG,

DG = (C N) [FC FG + (1 – FC) FL] . . . . . . . . . .(3)

= ($2307.69) (13) [(0.7) (0.29) + (1 – 0.7) (-0.6)] = $689.99

Clearly, our original monthly profit goal of $3,000 can not be met without some additional changes, such as an increase in the number of trades from 13 to 57 over the month period. But this is not feasible since it was already estimated that the maximum number of trades identified by the trading system would be only 13 per month.

Example 4:

Next, since the trades in example 3 are believed to be potentially high yielding trades, we might look at the increase in the fractional gain per trade FG needed to justify the wider stop loss setting of -60% and still meet the original profit goal. By rearranging equation (1),

FG = [FP - (1 – FC) FL] / FC

= [0.1 – (1 – 0.7) (-0.6)] / 0.7 = 0.4 or 40%

So the average fractional gain for winning trades FG would need to increase from 29% to 40% to justify a widening of the stop loss from -34.33% to -60%, keeping everything else the same while meeting the monthly profit goal.

The foregoing examples give insight into trading system characteristics that affect position size and stop loss settings. Narrow stop loss settings imply a smaller fraction of trades chosen in the correct direction or a smaller fractional gain for winning trades. Wider settings imply the opposite. Stop loss settings should not be arbitrarily set independently of position size, trading goals and trading system performance. Stop loss levels more or less define future profits for a given set of trading rules, whether the user realizes it or not. While it is laudable that traders are encouraged by their advisors to adopt money management, the recommendation of a specific stop loss value without knowing the profit goal and average position size can be misleading. When a trading system is used consistently, this model enables precise money management.

James Andrews authors a free newsletter at http://www.wisertrader.com where investment math formulas are developed at little or no cost. The site offers option alerts, free stock picks, an online forum, trading templates and advanced automatic trading systems.

© 2005 Permission is granted to reproduce this article, as long as, this paragraph is included intact.

The bear market that showed up at the end of 2000 has every brokerage house-as well as the entire mutual fund industry-scrambling to find creative ways to boost both their image and bottom line. Unfortunately, this is often at the investors’ expense.

Fund managers are ever on the lookout for ways to spin the stats to hide lousy track records and to find ways to obscure fees. To add insult to (financial) injury, investors end up being penalized for selling. So what’s an investor to do? In this case, knowledge is power. Here are some of the ways mutual fund investors are being taken advantage of:

Keep in mind that mutual fund companies have market share in mind, not your best interest. If you think that might not be true, consider the skyrocket growth rate for pure technology funds. But look at them now: they’ve crashed & burned and no buy & holder has come out with a win.

Then there’s the sad story of incompetence in the mutual fund industry. There are hordes of inexperienced financial planners (commissioned salesmen) just waiting to sell you load funds (A and B shares), or to recommend an asset allocation approach with no real plan or strategy that will serve you in a bear market.

Of course, there’s always the option of having a perfectly balanced portfolio designed. Such was the case when a prospective client phoned me in 1999 during the height of the technology boom. He felt left out because everybody was making money in one of history’s great bull markets, but his portfolio was so well balanced that he was neither making nor losing anything. He would have been better off in a money market account.

To me, the term balanced portfolio translates into this: I have no clue what I’m doing, where the major trend is, what I should be buying or whether I should be in the market in the first place. I’m hedging so much that one investment goes up and another goes down.

Balance is one thing and safety is really quite another. And mutual funds do not automatically mean either safety or balance. The key is always information-knowing how to get reliable info and what it means once you have it.

This is not for everyone. If you have money to invest and you don’t have the time or the inclination to do the homework, then your smartest move is to find someone you trust. That would be someone with a track record you can verify, and someone who is not going to make money off your investment every time you buy or sell something.

People like this do exist, and the good news is you only need to do your homework once. That’s when you check them out. From then on, you can relax knowing you’re just not likely to fall prey to any of the rip-offs that are out there.

About The Author

Ulli Niemann is an investment advisor and has been writing about objective, methodical approaches to investing for over 10 years. He eluded the bear market of 2000 and has helped hundreds of people make better investment decisions. To find out more about his approach and his FREE Newsletter, please visit: http://www.successful-investment.com; ulli@successful-investment.com

If you are serious about making and keeping money by trading stocks, then there are three things you need to do, and do well.

Money management

Money management comes first. Without a rock-solid method of managing your trading funds, you trading results will be only be fair at best. Money management is more than just knowing how much money you have tied up in a trade. It’s a method of using the right portion of your trading account on any one trade relative to the perceived risk and reward.

There are a few things to consider to managing a trade successfully:

1. What is your account size?
2. How profitable is your trading system?
3. What is the initial amount at risk on a per share basis?
4. What is the profit potential?

Account size

Your account size determines how long you stay in the trading game. If you are skillful, then you will not require a large account. On the other hand, even if you are a new trader, you can use a small account as long as you control your risk.

Controlling the risk means never using more money then you need on any one trade. A very simple formula for stock market success is to risk less than 3% of your total account value on a single trade.

If you have a $10,000 account, this means you never lose more than $300 per trade. If your account drops to $9,000, then you risk less than $270.

As your account grows, while the total amount at risk increases, you still only risk a maximum of 3% of your account. Say your account is at $12,000, then your maximum amount at risk is $360.

In theory, this ensures that you never go broke! And that is of utmost importance.

Profitable

If your system is profitable, then you will typically win more money then you lose. While some consider the percentage of winners relative to the number of losers, nothing could be further from the truth.

It doesn’t do you any good to have a system that wins on nine out of very ten trades if you give all of your gains back on the one loser. More important is that the winners overwhelm the losers.

A profitable trading system might have a third of the trades result in the maximum loss planned for, a third of the trades either make or lose a little money, and a third of the trades bring in the profits.

Risk

It’s worth repeating, risk no more than 3% of your total account value on any one trade. If you keep this in mind, you are ensured of minimizing losses to your account. At what price you enter a stock and where you place your initial stop price are used to determine how many shares you trade.

Profit

The profit potential of a system is the "edge". If you can estimate how much money you *might* make over time, and if that profit comes from many trades over time, then you probably have a winning system.

A trading system will either have a profit target that determines when to enter AND exit (good) or it will tell you when to enter and keep you in a profitable trade as long as possible without giving back much, or any, gains (better).

Orders

No matter what trading pattern you use to enter a stock, you will make the most money by using the correct orders.

When you wait until a stock has proven it’s intensions - typically by trading above the previous day’s high for a buy, or below the previous day’s low for a sell short - then having an order in place that captures that exact price is crucial.

Let’s say your favorite trading pattern signals a buy for. If you are an end of day trader, then the next morning you watch the opening price for the stock. If the stock opens less then yesterday’s high, you place a stop order to buy above the previous day’s high. Even better is to include a limit price with that buy stop order.

How much above the previous day’s high is your call. As long as it is greater than the previous day’s high, you are making the stock prove that it is going up.

Sure, you give up some of the profit potential. But you are more likely to turn a profit with a stock that is moving in your favor.

Once you are in a position, then you need to protect yourself from loss. If your method of picking stocks is good, then it’s unlikely that the stock will revisit the current prices. Continuing with the buy example, to protect your account from a catostrophic loss, place a good-till-cancel sell stop order below the recent low. If yesterday’s low is lower then the current day’s low, that’s where the sell stop order goes.

And make certain that the order does not include a limit. Stocks can and do gap down. Expecting that you will have a sell order filled at your stop price is a quick way to the poor house.

Trading system

Your choice of what method to enter and exit stocks plays a critical part in your stock market sucess.

A great trading system looks for low risk opportunities to enter a stock. Knowing at exactly what price signal to enter and when to exit - even if it is for a small loss - will keep your account growing. As long as you consistently follow the rules layed out by a well designed trading plan, you can count on steadily growing your trading account.

My favorite trading pattern does a great job of identifying stock likely to move rapidly in your favor.

There is no reason to be trading stocks that are not ready to deliver the biggest gains in the least amount of time.

If you are serious about taking your stock trading to a higher level, then read about this trading pattern.

Regards,

Dave

About The Author

Dave Wooding is NOT a registered investment advisor, nor does he suggest you trade with money you can’t afford to lose. Instead, he offers practical swing trading pattern information at http://www.trading-pattern.com that comes from years of trading experience.

The stock market is very unstable at this time going up and down while interest rates are so low you want to be a borrower and not a lender. Would you like some suggestions on how can you get the most out of low interest rates while being assured your principal will not disappear while you are trying to make some money? Of course, there is always the danger of borrowing the money and then spending it just because it is there.

So, would you also like to know what is the best way to borrow money at today’s low rates without spending it? Buy real estate. Not any real estate but real estate that will hold its value, even if single family houses go down. It is apartment buildings. Because apartment rents are still going up, the value of apartment buildings have the best chance of appreciating while everything else goes down.

Low interest rates mean that you can have a positive cash flow at real estate purchase prices you would have lost your shirt on, even two years ago. Rates are currently 4.5% to 6.5% interest rates when we used to pay 9% for apartment loans just a few years ago. Apartments have become a better investment for two main reasons. First, carrying costs (interest costs) have been going down. Second, income has been going up, substantially. Can things be better than this? YES IT CAN.

I have developed two programs. One is to take people with a small net worth and build an estate or self directed IRA (tax free retirement plan) that is worth up to $800,000 in 15 years and that generates an income of $60,000 per year with both still going up after that.

For those that can put together $100,000 to start I have developed a second program where the numbers come in at $1,300,000 net worth, with a $100,000 annual net profit and in only 10 years. Unbelievable? And, with low risk as well! This comes out to be a 25% annual return with no roller coaster stock market ride. I figured out how to do it and it really works. I have done it before and I know many now retired senior citizens that have done it in the past.

The problem today with most 50+-year-old baby boomers is that they never got started in build a retirement fund. So now, instead of having the normal 30 years to build a retirement fund, they need to be there in 10-15 years. It might take one year of financial hell to come up with some cash. (That means no money for anything except accumulating cash) But after that, it can be a sweet painless ride to wealth. The best part is the possibility of failure is less than 10%, if my steps are followed

First: The money is not touched for 10 years. That is why a trust fund, IRA or a self directed retirement plan is a great place to put this.

Second: I have taken my 30 years of real estate experience to develop exactly which properties will give the biggest appreciation and cash flow and also be the best risks. Interestingly, almost everyone I talk to picks the wrong locations to buy until they hear the whole list of criteria.

Now that I have told you the lazy man’s way to riches, let me tell you the downside. You have to have the correct timing on your purchase. In Dec 2001, everything was in place to do these two programs, in Los Angeles County. Unfortunately, by July 2002, the numbers didn’t work any more. They did still work in Florida, for example, but not in Los Angeles. What happens is that prices go up after the rates go down. The seller sees how good a deal the buyer can get and raises the asking prices. So! Your timing to start these programs is very important. Do not be discouraged, though. If the numbers do not work today, it will work sometime tomorrow. The system is sound, and since we are talking long-term wealth accumulation, a little patience can go a long way.

About The Author

Willard Michlin is an Investor, California Real Estate Broker, Accountant, Financial Distress Consultant, Well known Public speaker and Administrative/Business Consultant. He can be contacted at his Ventura, California office by calling 805-529-9854 or by e-mail at kismetrei@earthlink.net. See other article by Willard at http://www.kismetgroup.com; kismetrei@earthlink.net

If you are fed up with early redemption charges and ever increasing mutual fund management fees on top of bad-performing fund managers, read on. There is a quiet revolution going on in the no-load mutual fund industry and you, the individual investor, may benefit from it greatly.

I am referring to Exchange Traded Funds (ETFs), which have been around for years, but have grown tremendously since their inception. There are currently over 100 choices with around $10 billion in assets.

In a nutshell, an ETF is a specific kind of no-load mutual fund that you might consider to be a basket of stocks. ETFs are diversified like mutual funds, only they trade like stocks. They are cheap to trade (as low as $8.00) and don’t hit you with any short-term redemption fees. And they offer investing opportunities across the board.

ETFs track every index under the sun including the S&P 500, the Nasdaq 100, The Russell 2000 and many others. Available through any discount broker, they basically fall into one of three categories: broad-based U.S. indexes, sectors and international.

The have esoteric names such as iShares, StreetTracks, HOLDRs and SPYDRs. The difference is in the index they are tracking and the company marketing them. You will see big name companies offering them, like the American Stock Exchange, Barclay’s Global Investors, Vanguard, and State Street Global Investors.

In my newsletter I track the currently most appropriate ETFs for you to consider. For more detailed information you can visit these web sites:

In addition to inexpensive trades and no short-term redemption fees, how else can ETFs save you money vs. no load mutual funds? One way is on their annual management fees. That fee for ETFs is in the area of 0.45% vs. 1.5% on average for no load mutual funds. The fees charged by discount broker are so low they almost can be disregarded, usually less than 0.1% of the transaction.

For example, I have used ETFs for some managed account clients during my last Buy cycle, which started on 4/29/03, and paid $27 for a $28,000 order — and that wasn’t even with the cheapest discount broker.

So, if these ETFs are so great, why hasn’t your broker or financial planner recommended them to you? Simple! Brokers, and those advisors working on commissions, don’t make money on ETFs; no commissions up front or hidden on the back end. It’s simply not in their interest to promote them.

With all the positives for the investor, there is one disadvantage, which may not be applicable to you unless you are a hot shot no load mutual fund picker. It is that in any given economic environment really super performing mutual funds can outperform the indexes, but an ETF can never outperform the index it’s tied to. You would need to look at your own investment record to know whether this is a downside for you.

Here’s a real life example from my advisory practice. My trend tracking indicator signaled a Buy on 4/29/03. Based on my momentum indicators I chose 5 no load mutual funds and 4 ETFs. Over the following 3 months my ETFs gained anywhere from +10.02% to +22.36%, while my no load mutual funds gained from +9.15% to +36.35%. If you’re fortunate enough to make a superior selection you will outperform an ETF. Of course, that presumes you picked a very successful fund as compared to only a moderately successful ETF.

A word of caution! Just because ETFs are cheap and easy to buy doesn’t mean they will guarantee you a profit. You can lose money with them just as easily as you do with no-load mutual funds. You still need to make sure you have a disciplined methodology in place to help you get into and out of the market. If you don’t, you’re gambling no matter what you invest in.

Having gotten the disclaimer out of the way, hopefully these insights into ETFs will broaden your perspective on ways you can prosper in your investments.

© Ulli G. Niemann

About The Author

Ulli Niemann is an investment advisor and has been writing about objective, methodical approaches to investing for over 10 years. He eluded the bear market of 2000 and has helped countless people make better investment decisions. To find out more about his approach and his FREE Newsletter, please visit: www.successful-investment.com; ulli@successful-investment.com

What is leverage?

Here is a definition of leverage from an online dictionary "leverage - The use of credit or borrowed funds to improve one’s speculative capacity and increase the rate of return from an investment, as in buying securities on margin."

Essentially, the core idea of leverage is that investors can use less money to control bigger amount of investment so that investors can make more money when the price movement is in investors’ favor. In fact, the investment involved in leverage does not have to be stocks, it can be bonds, or real estate, or any other investment vehicles. It does not have be margin or debt either. Options (put or calls), warrants are special kind of leverage where small amount of dollar can control much bigger amount of common stocks.

Leverage is common tool available for individual investors. Whenever we open a brokerage account at pretty much any broker, such as E*trade, TD Waterhouse, etc, we can enable margin or option feature pretty easily. Because options usually are not favorable leverage tool for value investors, I generally do not recommend options for investment purposes. This article will focus mainly on margin to illustrate the concept and usage of leverage in stock investment.

Leverage - how it works?

Margin is open-ended debt that investors borrow money forever as long as the margin requirements are met. Right now at this low interest rate environment, brokerages typically charge about 5% - 7% interest rate on margin debt.

Here is an example how an investor can make more money by using margin. Suppose John had $10,000 deposited into a new brokerage margin account 5 years ago. Margin interest rate was 5% for past 5 years. John has invested into only one stock XYZ with 20% yearly smooth performance( there was rarely such stock existing, just a hypothetical one) for past 5 years.

Case 1

If John did not use any margin and fully invested that cash into stock XYZ, the past 5 years performance was 20% per year or 149% total performance for 5 years as in Table 1.

Table 1 Full investment into XYZ, no margin. year Account Equity Value

start $10,000

year1 $12,000

year2 $14,400

year3 $17,280

year4 $20,736

year5 $24,883

Case 2 If John invested $20,000 into XYZ in his account and borrowed $10,000 money on margin 5 years ago, every year John had to pay 5% interest or $500 margin interest, but the investment performance was 30% per year or 273% total performance for 5 years as in Table 2. That is significantly higher performance than Table 1 case.

Table 2 Borrowed $10,000 on margin. 5% margin interest

year Account Equity Value

start $10,000

year1 $13,500

year2 $17,800

year3 $23,060

year4 $29,472

year5 $37,266

Leverage - are there any trap?

By looking at table 1 and table 2 cases, should we all rush into margin tomorrow? Not yet. There is serious flaw in above 2 cases.

In real life, you can rarely find a stock performed like above example XYZ! In fact, investors should never expect a stock can rise smoothly over relatively long time frame.

Here is a typical stock XYZ would have done for 5 years. The 5 years performance was still 20% per year in average, but not smoothly. In the beginning of second year, due to a short term negative event, XYZ lost 60% of price suddenly and recovered all losses and gained 20% that year at year end.

Now let’s redo that math for above cases.

Case 1 If John did not use any margin, the 5 year performance was no difference. John did not sell during the second year 60% loss and he still made 20% for that year.

revised Table 1 Full investment into XYZ, no margin.

year Account Equity Value

start $10,000

year1 $12,000

year2 $14,400

year3 $17,280

year4 $20,736

year5 $24,883

Case 2 If John invested $20,000 into XYZ and borrowed $10,000 money on margin 5 years ago into that portfolio, The beginning of second year John had $24,000 in XYZ with roughly $10,500 margin on it. Because XYZ lost 60% suddenly during that year, which triggered margin call, John’s broker liquidated John’s account and John lost everything on year2! John’s account was wiped out

revised Table 2 Borrowed $10,000 on margin. 5% margin interest

Account Equity Value

start $10,000

year1 $13,500

year2 $0

year3 $0

year4 $0

year5 $0

Let’s think about above revised tables. XYZ stock was not really bad stock, it performed well with 20% return over past 5 years. However, by misusing margin, John actually lost everything and got wiped out!

Don’t use leverage, don’t use margin if you do not fully understand it!

Rule No. 1 - Forget about reward, focus on safety

The No.1 reason investors want to use leverage is to make more money, not to lose money. Wipe out is especially bad.

Over past decades of stock investment, I made lots of mistakes before, speculation and losses at earlier years, misjudgment of stock analysis, etc. But one thing I never encountered that I never got wiped out because I have always been aware of the danger of margin and danger of leverage lure.

I have seen online BBS discussions that somehow wipe out is beneficial to investor and a great investor must go through multiple wipe outs. Maybe one wipe out was not that bad for an individual so that he/she can learn a lesson in earlier years. Something must be wrong if the investor went through multiple wipe outs. He/she was not learning from past failures.

The risk of margin comes from the volatility of stocks and diversification degree of portfolio. To avoid risk of margin leverage, investors can study past chart of stock price, and diversify portfolio into different stocks or different industries. While a value investor does not have to care that much about short term stock price movement, a value investor must take extraordinary caution on analyzing the volatility of a stock if he/she is using leverage in stock investment.

While past stock price volatility and portfolio diversification are all relevant, there is more to consider on leverage. Here comes Rule No.2 below.

Rule No. 2 - the riskier the investment, the less the leverage

The key thing to avoid wipe out in leveraged investment is to use leverage based on risk of investment. The more risk of portfolio, the less leverage or less margin can be used.

The risk can not just be past volatility, a value investor must do home work of business analysis of company profits or earnings to assess the risk of investment.

Real estate is relative safe so that homeowners or real estate investors can use 4-1 to 10-1 leverage to buy a house on mortgage.

Banks use up to 100-1 leverage and most local banks in USA are pretty safe. Bank business is essentially like a leveraged investment. Banks borrow money from retail depositors and lend out money with mortgage or business loans. We can consider mortgages or business loans are "investment vehicle" of banks. The interest difference between checking account (0%-1%), or CD (2%-3%) and mortgage or business loans (5% to 8% or more) is what banks are making. Because interest rate up or down volatility is not as big as that of stocks, 100-1 leverage is not really as scary as it may appear in many cases.

Value investing is just a "special" kind of business just like bank business or real estate investing. Value investors can evaluate leverage usage just like a bank or real estate investor. There is nothing truly wrong with leverage if investors can properly use it. The value investor master Benjamin Graham said clearly in his book Intelligent Investor, that it is perfectly OK to use margin to profit from some bond arbitrage opportunities while it is actually very unwise to load full bunch of hyped up penny stocks in a cash account!

Rule No 3 - Look for minimum 2-1 margin interest coverage

In typical security analysis, an interest coverage of 4-1 or 2-1 minimum ratio is usually standard criteria to assess the risk of bond investment. If a company’s pretax or pre-interest earning is $4 per share, and its debt interest is $1 per share, it meets the 4-1 interest coverage ($4 divided by $1) and therefore the company’s bond is considered as safe investment.

The same concept can be applied to leveraged value investment. This is particularly true for certain bond-like investment like REIT or high dividend stocks. If the investment reward is less than 2-1 ratio, don’t even consider to use any leverage.

Case study on FB Here is case study of my past 2001 stock pick Friedman, Ramsey Asset (Ticker FB, now merged into FBR). In 2001, FB was trading right at its book value with 18% dividend yield, and it was REIT stock. Its business model was leveraged mortgage investment by borrowing short term loans with 3% and investing into long term Fannie Mae or Freddie Mac mortgage with interest of 5%. FB utilized 10-1 leverage on this 2% interest rate spread and made nearly 20% return to support this 18% dividend yield.

FB business risk is mainly from interest rate risk. Because the mortgage was guaranteed by a quasi-government company Fannie Mae or Freddie Mak, there was little credit risk involved in FB business model. In fact, compared to banks’ sometimes 100-1 leverage ratio, FB business leverage was pretty low and reasonable. After an internet bubble, I predicted that interest rate would be quite stable if not lower. The stock volatility was not issue as well. If FB stock price dropped below book value too much, FB company and its affiliate FBR would simply buy up its common shares instead of investing into mortgages.

Considering 18% dividend yield vs 5% brokerage margin interest, there was nearly 4-1 ratio of margin interest coverage if I use margin to buy FB stock, which was exactly what I did in 2001. During 2001, 2002 and 2003, FB was very solid stock delivering 18% dividend yield. After the merger with FBR, FB+FBR almost doubled from where they were couple of years ago.

Of course, FB investment was just one position of my diversified portfolio together with NEN and other stocks. But the rule of 2-1 minimum margin interest coverage can be applied to other positions as well.

Certainly with portfolio full of safe stocks like FB, or NEN or other similar value stocks, using a small amount of margin made sense to enhance performance back in 2001 even though the market was horrible then. If the stock was a tech stock like CSCO or YHOO, margin would have been disastrous and sure way to wipe out an account.

Currently with 7% dividend yield and rising interest rate outlook, FBR is no longer as safe and profitable investment as FB was in 2001. FBR no longer qualifies my margin interest coverage requirement today.

OK, that’s all for today, remember Don’t use leverage until you fully understand it!

Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut. Visit http://www.BlastInvest.com for FREE "how-to" investing assistance, web services and more.

A recent cartoon in my daily newspaper showed two guys sitting in a bar. One is saying to the other: “I did learn something from my broker…how to diversify my investment losses.”

While this struck me as funny, there is certainly an element of truth to it judging by the number of tragic e-mails and phone calls I have received over the past couple of years.

This was brought home even more so by a reader who responded with strong disagreement to one of my articles. I advocate a methodical, disciplined approach to investing in no-load mutual funds. It keeps me invested during up markets and on the sidelines during down markets. It was exactly this approach that got me and my clients out of the market in October, 2000 and put us back in to take advantage of the April, 2003 upswing.

Judging from the reader’s e-mail it appears that he works for a major bank and is adamant about Buy & Hold and Dollar Cost Averaging. Maybe it’s the approach he has chosen and he doesn’t like hearing that the emperor is wearing no clothes. Nothing personal, honestly, but I find it incomprehensible that anyone, after the bear market and the financial disasters most people experienced, can even consider such theories. The results are just too black & white.

Here are his three main points:

1. "There is no real feasible way to know whether the market is going to be up or down and when exactly to invest.
2. "The only logical way for an investor to make money is through the buy and hold approach. This method is used by Warren Buffett and he has consistently beaten the best with an average annual return of 29%.
3. "Dollar cost average helps to hedge against the ups and downs of the market; moreover, one should have been buying up stocks during the last 3 years, though I do agree with your cashing out at in 2000. I do not wish to insult you, but that seems to me more luck than intuition."

It appears that the only thing that I can agree with him on is, as he says, there is no reasonable way to "know" whether the market is going to be up or down. However, this statement also underscores that he is not familiar with trend tracking methodologies and the idea that one does not need to "know" or "predict" in order to make profitable investment decisions.

I’ve put together the composite for my trend tracking index in the 80s and it has consistently served me and my clients well by getting us into and out of the markets in a timely manner.

The reader cites Warren Buffett’s success. Sure, he is legendary, but remember that he made most of his fortune during one of the greatest bull markets. He is probably now considered beyond good and evil. But what about the numerous stories in the press over the past 3 years of the heavy losses he sustained in Coca Cola and other stocks, by stubbornly holding on to this positions. When you have enough money invested in a wide range of holdings, you become almost bullet proof. Do you fit in that category?

Furthermore, Buffet has resources available that the investing public simply does not have. Saying that he is successful only because of his buy and hold approach, and everyone following this technique will be too, is an oversimplification and does not factor in all the issues.

How many non-millionaires have enough spare capital to keep buying and holding and buying some more while stocks plummet? How long can they wait for the upswing when their cost-averaged holdings will start to show a profit? Do the math! Yes, the market will eventually turn up. But will it recover enough fast enough to reverse your losses in time to do you any real good? If you’re 20, then maybe. If you’re 60, who knows?

I have received countless e-mails and phone calls from individuals who have been led astray by brokers, financial planners and others using buy-and-hold and dollar cost averaging. Stories abound of retirees having to go back to work just because someone told them that "the market can’t go any lower" or "let’s dollar cost average."

As for his last point, when I gave the signal to cash out on October 13, 2000, it had nothing to do with either luck or intuition. I had no clue how good of a call that would be; I simply let my indicators be my guide. They pointed to a sell, we considered, and then followed through based on our experience. We held true to our philosophy and kept our emotions, speculations, fears or greed out of the equation. This disciplined approach is what I advocate.

This year it has led us to buy back into the market on 4/29/03. And my detailed analysis and evaluation of a range of funds led us to select some of the best; my top fund being up some 50%.

So, not to be cynical, but to me dollar cost averaging is just a way to spread the pain over a longer period of time and to cloud the obvious with the hope the market will turn around tomorrow. After all, it can’t go any lower. Can it?

About The Author

Ulli Niemann is an investment advisor and has been writing about objective, methodical approaches to investing for over 10 years. He eluded the bear market of 2000 and has helped countless people make better investment decisions. To find out more about his approach and his FREE Newsletter, please visit: http://www.successful-investment.com; ulli@successful-investment.com

I cringe every time I hear a novice investor tell me that they only purchase low priced stocks because they offer higher potential gains. A common phase I hear is “I like to buy $1 and $2 stocks because they can double easily and I will make a 100% profit”.

My reaction is to always let these people know that “stocks are priced low for a reason, just as stocks priced high are there for a reason”.

Like anything in life, quality is never offered at a discount. When I am in the market for a car, I don’t expect to purchase a Mercedes for the price of a Pinto. No pun directed towards Pinto car owners as I am just providing an example.

Stocks are valued at their current market value or perceived value under the current situations. A $1.00 stock is trading at this level because it is only worth this much in investor’s eyes. A stock priced at $50 or $100 is trading at these levels because of a quality that the lower priced stock does not have. Institutions, such as mutual funds, will not purchase a stock at $1 based on strict internal rules and fund guidelines. Stocks move based on vast amounts of support from institutions that have the buying power to propel prices 100%, 200% or more in less than 12 months.

A quick study of stock market history will prove that the majority of stocks priced at $2 or less will be de-listed or bankrupt before they ever give an investor a triple digit return. High quality stocks are typically representative of high quality companies that usually have innovative products or services that are increasing revenues and earnings thus peaking institutional interest. I have seen more stocks double or triple from the $20-$50 range than any other price level during the past five years.

A stock going up 25% in one month’s time is the same whether it is from $5 to $6.25 or $60 to $75. It happens every year. The novice investor is usually hesitant to buy a stock that is priced at $50 or more as it looks too expensive to the untrained eye. What’s expensive to an uneducated investor may be a bargain to an educated investor.

Always buy the stock that presents the highest probability of success based on both fundamental and technical analysis. The price should never matter nor should the lot size. A 25% gain will always be the same whether you buy a $2 stock with 5000 shares or a $100 stock with 100 shares.

I agree that the chances for a quick 25% gain on a $5 stock seems greater than a 25% gain for a $100 stock but it’s also much greater for a 25% slide on the $5 stock than it is for $100 stock. Your downside protection is limited with a low priced stock as it can move quickly and present you with an illiquid position that a higher quality stock may not present.

Here is a very basic example:

If you buy a $2 stock and it gains $1 in two months, you now have a 50% gain. But, if the stock falls $1 in two weeks, you now have a huge 50% loss in your portfolio, a number that usually devastates most traders.

If you buy a $60 stock and it gains $30 in two months, you will have a 50% gain. Now, if the stock starts to fall rapidly and is now down $10 in a few days, you still have a chance to sell the stock within 10% of your purchase price and prevent further loss and devastation to your portfolio. You, the investor will most likely be able to spot negative action or red flags and get out quickly enough without the sudden 50% drop that the lower priced stock could blindside you with.

Don’t buy a stock based on low prices or a quantity of shares. Always buy a stock based on quality looking towards the fundamentals and technicals and the price and volume action. Study our archives and look at the number of stocks that have gone on to tremendous gains from the $20, $30 and $40+ levels.

Chris Perruna - http://www.marketstockwatch.com

Chris is the founder and CEO of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don’t stop at just showing you our daily and weekly screens, we teach you how to make you own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.

With the internet such a huge part of our daily lives, many investors have access to a wide range of instant investment information.

Whether you’re into stocks, bonds, mutual funds, futures or options, there are tons of electronic investment newsletters offering to turn your small stake into a giant fortune. All you need to do is subscribe and watch your portfolio soar.

Yeah, right!

As a practicing investment advisor specializing in no load mutual funds, I have received my share of e-mails from disillusioned subscribers wanting to know how to better evaluate newsletter services.

While there are no absolutes, I can give you a few pointers that might help you make a better decision:

1. Stay away from the most obvious hype. Ads promising to turn your $10,000 into $1 million in 2 years by buying this incredible stock or hot commodity are not promoting investing — they are selling gambling. Follow the "If it sounds too good to be true, it usually is" rule.

2. Most mutual fund newsletters won’t make those outlandish claims, but some of them are still pushing the truth as far as they can. So try to get a free issue or two to examine. If you can’t get a sample, check if they have a trial period? How about a money back guarantee? If not, pay with your credit card. These days you’re pretty well protected by this payment method even if the newsletter doesn’t offer a satisfaction guarantee.

3. Consider the editor as well as the disclaimer notes. Is he or she only publishing a newsletter? Or is he also an investment advisor with a practice?

Why would that last point matter? I may be biased, but I believe that you get far better advice from a writer who also is in the trenches every day investing their own as well as their clients’ portfolios. They would have far better insights as to what works and what doesn’t than someone who has the theory down but no practical experience.

4. Look at the investment recommendations. Are they suggesting you buy into a certain orientation such as mid cap, small cap or large value? Or are they picking specific investments based on a variety of technical indicators?

In my no-load mutual fund practice I use specific recommendations, even for my free newsletter subscribers. They are first based on my trend tracking indicator giving us the green light and secondarily on the selection of mutual funds based on momentum analysis.

The more specific the recommendations, the better, because that allows you to follow along either just on paper (which you should do at first) or with your actual portfolio.

5. Are they recommending when to sell a mutual fund either because of gains or to limit your losses? This to me is the most important issue. If there is no plan in place for getting out, how will you ever know when to sell? This has been the greatest downfall of most publishers (and investors!) since the bear market of 2000 — not selling even if market conditions dictate it would be in your best interest to do so.

The advice of most newsletter services can make you money in bull markets. However, with the continuation of the bear market still a distinct possibility; be sure to look at any newsletter’s investment advice record since 2000.

For many people investing is an emotional issue. The pendulum swings between fear of loss and greed for greater returns. If a complete methodology for buying and selling is offered in a newsletter, such as one I advocate, be sure that it fits your emotional make up.

There is no sense in following an investment approach, which may have merits, if it means sleepless nights for you. You won’t stick with it for the long term — and long-term investing is essential for making your portfolio grow and prosper.

So, the bottom line is to look for a newsletter that:

Following these guidelines may not make you rich, but it will help you avoid some bad advice.

About The Author

Ulli Niemann is an investment advisor and has written about methodical approaches to investing for over 10 years. He avoided the bear market of 2000 and has helped countless people make better investment decisions. Subscribe to his free newsletter: www.successful-investment.com

ulli@successful-investment.com