FIRE ALL FINANCIAL ADVISORS:

PATHS to INDEPENDENT INVESTING

Stock Investments in the Internet Age

By Kishore Jethanandani

Takeaways

The average success rate of pros is 49% which is about average you would

get by tossing a coin.

The key to successful stock-picking is checking facts against the majority

opinion

The reason why people don't make money from stocks lies in psychology:

group think.

In recent months, investors have realized to their dismay that professional

investors have been amiss in anticipating the downturn in financial markets. It is

time to ask whether an individual investor could do just as well and not have to

pay the exorbitant fees that financial "experts" demand. The Internet is a huge

resource for information, discussion and advice. While mastering the knowledge

available on the Internet may initially seem overwhelming, the more seasoned

investors will tell you that it gets enjoyable, if not addictive, once you begin to

master it. Here is a short guide to resources individual investors could use for

stocks.

Basics with stock-picking

Stock-picking, to be successful, requires five important decisions to be made for

the overall wealth of the individual to increase and these are

Return: A positive rate of return at least equal to the average rate of return

earned by the combination of stocks that represent the market index.

Minimal Risk: A positive return from a stock in one period could be followed by a

negative return in subsequent periods of time. This type of risk can be minimized

if another stock is added which is likely to earn positive returns when others earn

negative returns. Investors need to choose a combination of stocks or a portfolio

to maximize their wealth.

Stock-selection methods: What are the characteristics of stocks that perform best

and how do you choose them? Is a strategy for holding stocks for a short period of

time better than keeping them for long periods of time?

Tax minimization: The final rate of return depends on the taxes paid on capital

gains. How can the tax liability be minimized?

Investment Advisors: Are investors likely to earn higher rates of return if they use

the services of advisors enough to justify the fees paid to them? Is it more cost

effective to come to decisions about investment on your own?

More information on issues in investing can be found at

http://www.pathtoinvesting.org/

Why is this critical for you? The choices that a person makes in stock selection

have a very significant impact on a person's life in terms of time commitment,

peace of mind, comforts in life and risk of fraud. Here are some of the ways in

which it could influence your life

Conservative and aggressive investing: Conservatively invested stocks earn an

average rate of return of 8-10% per annum over a lifetime while the average for

aggressive investing is 21%. Returns from conservative investing are much more

certain, take very little learning and time commitment while the opposite is true

for aggressive investing.

Peace of mind: Conservative investing brings much greater peace of mind;

investors have to make very few decisions because they choose to hold stocks

over the long run and change them only when a company is likely to decline for

good. Aggressive investing is for those who enjoy making bets and are motivated

by the prospect of high levels of wealth; these investors enjoy reading about

businesses and economic trends.

Fraud: At its worst, bad judgment and excessive greed in stock selection can mean

ruin as you become victim to aggressive salespeople who pump up worthless

penny stocks. The movie Boiler Room, based on a true story, shows the

shenanigans that go in such schemes. To keep track of the latest frauds in stocks,

see http://www.stockpatrol.com/

Choosing stocks that fit your risk tolerance levels is important otherwise you

could be losing sleep and making bad judgments. Those who choose an aggressive

investment style should ask themselves whether they can weather steep drops in

stock prices like the meltdown in October 1987. On the other had, conservative

investors should ask themselves whether they will be satisfied with a relatively

lower level of consumption. You could estimate your level of risk tolerance at

http://www.rce.rutgers.edu/money/riskquiz/

What are your options?

Types of stocks: In terms of risk and return, stocks can be divided into three

broad categories of securities and these are

Growth stocks: these are securities of fast growing companies often in the

technology industry. Such stocks potentially earn the highest returns when their

profit growth accelerates. The stocks of such companies are also more likely to

disappoint if their growth falters. You can find growth stocks at

http://www.stocktables.com/

Value stocks: these are stocks of well established companies and earn moderate

return with a much lower risk. To select good value stocks, see

www.magicformulainvesting.com/.

High Dividend stocks: these are stocks of slow growing but profitable companies

which reinvest very little of their cash surplus and distribute a higher share of

their profits to investors. These stocks have the lowest risk. You can select

dividend stocks at www.dogsofthedow.com

Portfolio Diversification:

Investors looking to diversify their portfolios and lower their risk have to look for

a combination of stocks whose returns move in opposite directions. In current

conditions, they have two major options:

Invest in combination of small stocks and large stocks: While small stocks are

generally profitable in the early stages of the business cycle such as in the period

2002-2005, larger companies do well in the later stages of the business cycle as is

the case now.

Invest in domestic and international stocks: the prospects of foreign economies

and American economy often move in opposite directions. You can lower your

risk by buying a combination of domestic and overseas stocks.

Method of picking stocks:

There are two major methods of investing; the lazy way and the more active one.

Conservative investors believe that stock prices move randomly so that the highs

and lows in price movements cancel out. The only realistic choice is to earn an

average return. Such investors hold proven companies for very long periods of

time and buy and sell only when there is a compelling reason to do so. Aggressive

investors look for opportunities when they can buy cheap and sell at a high price

to maximize their return. They can do this over infrequently or often. These

investors typically buy in the early stages of the business cycle and sell towards

the end of it.

Taxes and Returns

The rate of taxation is higher, equal to the rate of tax on income, for short-term

gains while it is lower on long-term gains. In addition, short-term investors have

pay more in trading fees when they buy and sell frequently. Taxes on long-term

gains have dropped to 15% (for lower-income tax payers it is lower at 5%). For

dividend income, the tax is lower at 15% instead of the regular income tax.

Taxes can also be saved when stock investments are part of retirement plans

rather than brokerage accounts. According to estimates by Burton Malkiel, the

value of a retirement fund will be $1.7 million if the marginal tax rate is 28% and

average rate of return 8% with yearly investments of $4000 for 45 years. On the

other hand, the equivalent amount will be $600,000 if the money is invested in a

brokerage account. After paying taxes on withdrawals, you are left with $1.2

million.

Gurus and Advisors

Investors often presume that they need to consult an expert to understand the

complexities of investment before they make their decisions. The reality is that

the performance record of an average advisor is poor; one estimate shows that

they got their forecasts right only 49% of the time. For more detailed information

about advisors, see www.cxoadvisory.com/gurus/

What should you do?

Investors can choose to depend on reliable advisors to make their decisions about

investments or they can do it themselves. Those who want to leave stock-picking

to advisors, the ratings at Invertu will help to find a reliable investment advisor.

Alternatively, they can decide to take responsibility for their own investments. For

them, the Internet offers a huge variety of resources for finding information and

opportunities for brainstorming that are powerful aids for decision-making.

Value stocks and dividend stocks: Growth stocks are expected to earn the highest

rates of return since their profits increase at the fastest rate. A good example of a

growth stock is Google which is growing rapidly because it introduced new

concepts in online advertising. However, such stocks are also exposed to much

greater risk. Google, for example, is facing competition from Yahoo! Microsoft

and Wikipedia and it could lose its dominance to them. Whenever the market

perceives Google's profits are going to slowdown, its prices drop sharply. On the

other hand, its price will rise rapidly if growth exceeds expectations.

Value investing looks for well established companies in mature industries selling

at relatively low prices. Indicators such as high book value-to-market value, high

earnings growth relative to price and high cash inflows point to value that has not

been priced in. In other words, this kind of investing looks for bargains. A good

example of this would be Gillette.

Finally, the least risky stock investment strategy is to pick high dividend yield

earning stocks. These are companies that are in low growth sectors like coal

which accumulate high levels of cash because they reinvest only a small

proportion of their profits. The downside is that these companies could go out of

business as they are replaced by other industries.

Portfolio Diversification:

Small stocks and large company stocks: One important consideration of

diversification between stocks is the choice between small and large company

stocks. In general, small company stocks earn higher returns at a higher risk level

while large company returns are more moderate and their risk is low. In addition,

stock returns of small companies tend to be higher in the early stages of the

business cycle when interest rates are low and credit supply more abundant. On

the other hand, large companies perform better in the mature stages of the

business cycle when markets are more volatile and they have more cash reserves

to cope with slower growth in credit supply. Data on the performance of large

companies can be found at

http://www.forbes.com/2004/12/22/05platinumland.htmllarg and small

companies at http://www.forbes.com/lists/2006/23/biz_06200best_The-200-

Best-Small-Companies_land.html

Another important consideration is the choice between domestic and

international stocks. Very often, the returns from overseas stocks are higher

when they are low in the USA. American investors have invested large amounts of

money in international markets in early 2000s while the domestic market was

sluggish. Conversely, international markets were performing poorly in the late

1990s while the American stocks were booming. Some international stocks trade

on American stock exchanges as American Depository Receipts. Other ways to

buy Exchange Traded Funds that are a combination of stocks that form an index in

a foreign country.

Method of picking stocks:

Just how do you make money in stock-markets? What are the characteristics of

stocks that perform well? At what price do you buy and sell a stock? What is a

reasonable profit from a stock? How does an investor ensure that he or she does

not lose money in stocks?

There are really two serious methods in stock-picking and these can be described

as the "the lazy way to making average profits" and the other says "it takes hard

work and experience to make higher than average profits". We have excluded the

numerous "get-rich-quick" theories which we don't consider to be serious.

The best exponent of the first theory is Burton G Malkiel who has written the

much acclaimed book "A Random Walk down Wall Street: the time-tested

strategy for successful investing". The premise of the book is based on the idea

that markets are efficient and they take into account the profit prospects, the

risks, the sentiment and the news to determine the price of a stock. Actual prices

of stocks hover around the average value of the stock and fluctuate randomly;

there is no point in making predictions to try to earn more than the market rate of

return. By the logic of this method, you choose your level of risk tolerance and

target rate of return and pick stocks that you hold on over a long period of time.

The best stocks to pick are those that form the index; they will earn as much as

the market rate of return which is the most reasonable level of expectation.

There is another method of stock-picking which times the market. This method

seeks to buy stocks at the lowest price and sell it at the highest price possible.

This type of method is practiced in a variety of ways but the most successful

implementation has been done by people like Warren Buffet, Peter Lynch and Ken

Fisher. This style of management recognizes that market timing is hard to get

right and takes a great deal of experience. On an average, an investor has to be

right at least 70% of the time; the successful investors of this kind also earn twice

as much the average market rate of return. Typically, such investors do not try to

time every turn in the market; they look at the ups and downs in the business

cycle. They will buy in the early stages of the business cycle and sell when it is

expected to go down. Such investors buy for the long-run and pick stocks when

there is strong evidence to show that they are under-priced and have a high

chance of performing well in the long-run. A serious step-by-step guide helps you

to find your way.

There are two other methods of predicting and timing the market and these are

called technical and fundamental analysis. Technical analysis looks at short-term

trends as uncovered by charts. This type of analysis tries to find patterns which

point to the highs and lows in the market; there are far too many of these

methods to explain all of them here. A commonly used method is the

identification of the support and resistance level in price movements. While a

support level is a relatively firm bottom in the prices of stocks, the resistance level

is a relatively firm high in their prices. Prices will fluctuate around the resistance

or support level before they break away from them. When prices fall below the

support level, they are likely to go down and vice versa. More information on

technical analysis can be found at

http://www.equis.com/customer/resources/TAAZ/Default.aspx?

Another method of identification of suitable stock is fundamental analysis. This

method looks at the intrinsic value of a stock based on its future growth rates.

The higher the future growth rates, the higher the value of the stock. Since the

earnings in the future are of a lower value than the money invested today, the

expected cash inflows in the future are discounted at a rate that is equal to the

risk-free rate of return plus the compensation required for taking the risk. If the

actual price of the stock is less than its intrinsic value, it is worth buying. The

internet provides tools to screen stocks for their fundamental and technical worth

with the MSN Stock Scouter with convenient snapshots.

Taxes and Returns

In general, taxes on short-term are higher than those on long-term gains.

Currently, the rate for short-term gains is the same as that on ordinary income

and on long-term gains it has dropped to 15% (for lower-income tax payers it is

lower at 5%). For dividend income, the tax is lower at 15% instead of the regular

income tax.

When investors put all their money in retirement plans, they save all of these

taxes. They pay taxes on withdrawals for IRA accounts but not for Roth IRA

(however, they don't get tax benefits when they invest their money for Roth IRA).

The cumulative benefit of investing in retirement funds is considerable. According

to estimates by Burton Malkiel, the value of a retirement fund will be $1.7 million

if the marginal tax rate is 28% and average rate of return 8% with yearly

investments of $4000 for 45 years. On the other hand, the equivalent amount will

be $600,000. After paying taxes on withdrawals, you are left with $1.2 million.

Gurus and Advisors

Many investors would rather they did not have to understand the apparently

arcane world of investment and leave the job to investment advisors. The reality

is that the performance record of well-trained finance professionals is at best

good but variable, mostly mediocre and at its worst it is downright dishonest. Dr.

Malkiel in his book "Random Walk" has hundreds of pages of information,

commentary and satire tearing down the pretensions of analysts. Those who still

want to use analyst ratings, more information can be found at

http://www.newratings.com/

There is compelling data to show that well known gurus don't do any better than

a throw of a dice. The average success rate of pros is 49% which is about average

you would get by tossing a coin. The conclusions were based on 3000 forecasts

made by gurus over two years and these were compared with the outcomes. The

detailed data for the entire sample and individual gurus can be found at

http://www.cxoadvisory.com/gurus/

WHAT SHOULD YOU DO?

Stock-picking is clearly not an exact science; it is really analogous to finding a

partner in life. In both cases, you are stepping into the unknown. When you have

no idea and are inexperienced, the chances of getting suckered are high.

Extending the analogy of partners, young women looking for partners on

MySpace get duped by charming men who sometimes turn out to be conmen.

Similarly, inexperienced investors can get carried away by stories of people who

get rich by buying stocks and are caught off-guard when the market crashes. Over

time, you get the sense that there is a method that succeeds but you can't be

entirely sure it will work. Just like we learn to look for signs of a desirable partner

and decide to date quickly when we see them, we learn to recognize the

characteristics of good stocks and pick them quickly before we lose the

opportunity.

Many of us want to use advisors to avoid the burden of understanding the many

factors that influence the movement of stocks. One strategy to cope with this is to

buy brand name companies, selling at relatively low prices such as Corning, Pfizer,

and hold on to them for the long-run. Advisors are like counselors who can help

you to think but they can't provide the final answers.

The best of gurus like Buffet, Peter Lynch and Ken Fisher are in the habit of

repeating their belief that their methods can be emulated by anybody who has

steady nerves and common sense. Peter Lynch used to give spending money to

his daughters when he visiting retail stores. He would observe what they were

most inclined to buy. Their favorite purchases provided him with ideas about

investments.

The best way to begin is to first honestly assess what level of risk you can bear.

This is important because it is important to keep ones cool and look at facts when

the markets are in turmoil. In early 2007, the markets crashed as a result of

erratic movements in the Chinese stock-markets. People tended to believe Alan

Greenspan who made his characteristic ambiguous statement "recession is

probable and has a one in three chance of happening". Cooler heads looked at the

spreads between corporate bonds and treasuries and saw no change there. The

premiums earned on risky bonds are a very good indicator of how market actually

perceives risk. If you don't think you can take the suspense, its best to choose

proven companies and remain happy with moderate returns.

Those who decide they are ready for risks have plenty of resources to help them

make a decision. Many stocks with good value lie under-priced for long periods of

time and information about them is available in the public domain.

The business press is full of lists of fastest growing companies, the most admired

companies, the best places to work in based on large sized samples. Forbes, for

example, issues an annual list of fastest growing technology companies. The stock

performance of the fastest growing companies is better than the Nasdaq index.

For a review of the stock performance of the fastest growing companies, see

http://www.forbes.com/strategies/2006/01/26/lifecell-celgene-winnerslosers-

cz_pm_0127sf.html.

However, fast growth does not necessarily ensure that the company is going to be

able to sustain its performance. Biotech companies, for example, grow fast but

they often run into situations where their drugs or devices do damage to patients

and have to be recalled. The companies that are more likely to perform

consistently are those that have strong managements, well rewarded and trained

employees and ethical methods.

The Fortune Magazine has been producing annually a list of companies that are

most admired in the USA. These companies are selected based on the judgments

of 10,000 executives, business leaders and security analysts. One study compared

the stock performance of the portfolio of the most admired companies with the

S&P index. It was found that the Fortune list returned an average of 17.7%

compared to 13% for the S&P 500 index. All the companies in the Fortune

magazine list are stable companies so the difference in the rates is not explained

by any risk premium. For the details of the analysis, see

http://www.economics.pomona.edu/GarySmith/FortuneAdmired.pdf

The key to successful stock-picking is checking facts against the majority opinion

and you will find information that others have missed. Of the list of "gurus" we

had discussed earlier, Ken Fisher is the most successful because he trusts his own

analysis. He discusses how he checks out commonly held views and comes up

with an idea that is uniquely his. For more, see http://www.financial-

planning.com/pubs/fp/20061101025.html

Stock-picking involves two simple decisions which are the same for buying any

product or service. One, does the stock have value or does the company have the

ability to perform better than its competitors in the same industry? A related

question is whether the company is part of an industry which does better than

other sectors in the economy. Two, is the price of the stock equal to its intrinsic

value or the discounted value of its expected future earnings? It's a no-brainer

that anybody should buy stocks with high value and low prices and we will find

out this is the least implemented practice.

One source for screening for sectors and well performing companies is

http://www.equitytrader.com/structure/default.php. Click Yields to get a

selection of companies that yield high income. You can also look for sector with a

substantial difference between the potential and actual performance for finding

high growth companies. We had cited sources earlier which will help you to

identify companies that are underpriced and growing fast. While fundamental

analysis is a poor guide to future growth, it is not hard to find data to confirm

whether the target company has higher than average growth rate. To judge

whether the performance is going to be sustained, look at the news about what

the company is doing to launch new products and find new markets.

Companies have to not only grow fast but they have to be also perceived to be

growing fast. Here is where technical analysis proves useful even though this

method is also imperfect. While technical analysis is not useful in forecasting the

future, it does help to track where market perceptions are moving. Any unusual

increase in volumes or a breakaway from trend indicates that the traders are

changing their view of the company. You can confirm this by listening carefully to

the news. Also, data on insider trading is a solid measure of the assessment of

company executives about the prospects of their company. This information is

readily available at http://finance.yahoo.com/q/it?s=msft.

The reason why people don't make money lies in psychology: group think. Most

of us look our shoulders and see what stocks others are picking and lemming like

follow them. Recall the Internet bubble when everybody bought money losing

stocks and literally sank in the sea of loss. Most managers in mutual fund

companies don't want to take decisions their colleagues will not like and choose

to pick underperforming stocks everybody approves of rather than go for the

winning ones which their peers don't like.

The Internet provides all the resources an independent investor needs to make

good decisions. It also has discussion sites where you can brainstorm ideas. Why

pay financial advisors to make your picks. If you lose, you will learn enough from

the loss to eventually profit from a success.

More resources

http://www.pathtoinvesting.org/

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