113 KiB
The Motley Fool
00 What Does It Take To Invest Like a Fool?
You may not yet realize it, but right now you're staring at a ticket to financial independence. That's right, this brief primer might make a big difference in your life, enabling you to retire in your 50s (or 40s, even), send your grandchildren to college, buy that summer place on Lake Whatchamacallit, or fly around the world in a zeppelin emblazoned with your high school nickname. (Hey, "Hot Lips" – can you hear the violins playing as you float over a herd of wildebeest charging across Ngorongoro Crater?)
You've probably heard of The Motley Fool. But you may not yet know what we're all about and what we can offer you. Let's take care of that first.
Fool co-founders David Gardner, Tom Gardner, and Erik Rydholm came up with a mission and cranked out the first issue of The Motley Fool printed newsletter in July 1993. The Fool debuted online a year later, on August 4, 1994. Their mission was, has been, and will always be to help you to invest for yourself and gain control of your personal finances. We want to help you make smart decisions about your money.
We strive to educate, amuse, and enrich – all at the same time. We know that most people have never been taught much about finance or investing, and that a glance through The Wall Street Journal or a mutual fund prospectus can be rather intimidating or confusing sometimes. That's how they like it. But you know better (or at least you're going to in just a moment). Learning about financial topics doesn't require a Ph.D., and making good financial decisions doesn't require high-priced helpers.
Tending to your finances isn't as mysterious and complex as you've been led to believe. The professional Wise men on Wall Street, however, would like you to keep thinking it's too difficult for you to do yourself. That way you'll entrust your hard-earned dollars to them, so that they can generate fat commissions for themselves.
Sure, there are some good brokers out there worth the money they charge. But know that most financial advisors aren't paid by how well they manage your investments, but by how often they get you to trade in and out of stocks. Their main job isn't money management. It's sales. And what do you get in return? Sub-par performance and lower returns.
Give us a little time and we'll show you how you can beat Wall Street at its own game. You read that right. Your portfolio shouldn't have much trouble trouncing 75%-90% of professionally managed mutual funds over time.
And now for a hot stock tip….
Just kidding! We don't believe in hot stock tips gleaned from others.
We think the person who most has your financial best interests at heart is you. That's right, you're the one who should be making the decisions affecting your monetary future. And you don't need an MBA or a pair of suspenders or a pricey summer home in the Hamptons. You don't even need a stranger's hot stock tip. (FYI: Most of those were cold long before they got to you.) Believe it or not, some fifth-grade math and a dash of horse sense is pretty much all you need to get better returns than most professional money managers.
Once you have a little knowledge under your belt, we suspect you'll find that managing your own money can actually be fun – you might even want to delve into the world of picking stocks for yourself. The
Motley Fool has tools to help you along the way: books <http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=81>, research <http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91>, online seminars <http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=94>, discussion boards <http://boards.fool.com/>, Fool's School <http://www.fool.com/school.htm>, TMF Money Advisor <http://www.fool.com/landing/ma/landing.htm>, and even jester caps <http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=ALL501>.
(What – you weren't planning to get your finances in ship-shape without a velveteen jester cap, were you?)
Start with this modest primer. In it we lay out a systematic approach to investing that should benefit novice and seasoned investors alike.
We first focus on getting your financial house in order, then move into a discussion of various investment options, and later address more advanced investing topics.
No material presented here should frighten or intimidate you (unless you happen to be frightened by semicolons or puns involving llamas).
You don't need any fancy credentials in order to understand anything in here, but that doesn't mean you should jump immediately into the stock market with all your dollars. Ease into investing. Take it one step at a time.
For example, you might want to first move your mutual fund money into an S&P 500 index fund (we'll explain why shortly) and then take a breather while you read and learn more. You may never move beyond that point, but you still would have made a dynamite financial decision.
Don't take any action until you're comfortable with what you're doing, though.
Without further ado, let's part the curtains and unveil the Foolish approach to investing.
Creak, creak, creak.
(The sound of curtains being drawn open.)
(Oohs and ahhs from the audience.)
(Someone in row 17 coughs.)
(Someone in row 12 shushes the lady in row 15 unwrapping her butterscotch.)
01 What is Foolishness?
Date: 10/7/2003
Keywords: Motley Fool
Let's start out with what you may be most confused about right now. If you're a newcomer, you might be wondering just what the heck all this "Fool" stuff is, and why you should spend any time here. You were looking for investment or personal finance information (right?), and now you're suddenly staring a court jester directly in the eye.
Who are these guys?
What is this?
To make a long story short, The Motley Fool name comes directly from the beginning of Act II, scene vii
<http://www.classicreader.com/read.php/sid.5/bookid.151/sec.11/> of
Shakespeare's As You Like It. In the days when Shakespeare was writing about kings, Fools were the happy fellows who were paid to entertain the king and queen with self-effacing humor that instructed as it amused. Fools were, in fact, the only members of their societies who could tell the truth to the king or queen without having their heads rather unpleasantly removed from their shoulders.
In Fooldom, you the reader are the king, and it's our job to tell you the truth about investing and show you how you can manage your own money better than the pros on Wall Street. The mission of The Motley Fool was, is, and will always be to educate, to amuse, and to enrich. We're here to help you help yourself with all aspects of personal finance and investing. We don't manage anyone's money but our own, and we're not investment advisors. Again, our interest is solely in educating, amusing, and enriching. (We do have an interest in winning awards for producing the best financial information in the whole dang world, but that's pretty much a pride thing; there sure isn't any prize money that comes with those awards.)
When you're plying your trade in the investment world, you normally wouldn't want to be caught dead being called a "Fool," right? We think quite the opposite, of course. We look around at the supposed Wisdom in the world today, the Conventional Wisdom, and wish to put an end to it, to reform it. In fact we're on a mission here – a mission from Shakespeare.
So what is some of the conventional wisdom so contrary to the Foolish point of view? We'll preview just a few slivers of it now – suffice it to say that the subsequent 12 steps contain a touch more, and the rest of this website (as well as our other products and services <http://www.foolmart.com> also available to you) goes into Foolishness in much greater detail.
Conventional wisdom #1: You should let "experts" who manage mutual funds manage your money for you.
Foolish response: Yikes! Did you know that some three-quarters of all managed mutual funds underperform the stock market's average return?
In other words, most people are paying Wise "professionals" to make them less money – and these professionals are paid very, very well in the process! Mutual fund managers will try to persuade you that they have some special insight or crystal ball. Unfortunately, their impressive-sounding jargon is hogwash when compared to the actual performance of the market averages. If you're ever going to be invested in mutual funds, you needn't look beyond an index fund, which tracks the market's returns at a very low cost. (For more information, check out our Mutual Fund Center <http://www.fool.com/school/mutualfunds/mfsem/mf.htm>.)
Conventional wisdom #2: Financial gurus do a good job of predicting the direction of the stock market.
Foolish response: Nope. No one has ever demonstrated the ability to predict the stock market's future consistently and accurately. We are amazed and amused by all the people who still try to do it, and all the journalists who daily (or hourly!) quote them on the matter.
Remain focused on the business performance of the stocks you own, and don't sweat where anyone's telling you the market's going. We've had 10 recessions since World War II, and we've emerged from every single one of 'em!
Conventional wisdom #3: Trust the Wall Street brokerage firms. They're here to help you navigate the labyrinthine world of investing.
Foolish response: Well, they spend hundreds of millions a year on TV commercials insisting that they can help us, but… ummm… don't count on it. First off, it's not in Wall Street's best interests to teach <http://www.fool.com/school.htm> you. As long as you're in the dark about investing, you'll have to give your money over to Wall Street to manage it for you. That way, Wall Street professionals can charge you (often via hidden fees) to manage your money. The entire industry is built on your not figuring out how to manage your money.
And, happily, that's exactly what your fellow Fools are here to help you do.
Further, most brokers are well trained in the subtle art of salesmanship and are paid based on how often you trade, not how well you do. (Click here <http://www.fool.com/features/1998/sp981209eyesonwise003.htm> for some of the bloodcurdling details.) That business model has created a massive conflict of interest, because the best way to invest is to buy great companies and hope to never have to sell them. This makes brokers sad. Not your problem.
Don't get us wrong – there are some noble financial pros out there (and we'll show you how to find them a bit later). But the Wise have prevailed in the money world for far too long. Now it's finally time that some Fools showed up and leveled the playing field. By "Fools," of course, we don't just mean ourselves – we also mean the millions of Foolish readers who come in here every month looking to answer one another's Foolish questions on our discussion boards <http://boards.fool.com/>. (Give our acclaimed discussion board community a visit – we offer a painless free trial, with no credit card info required, and you may find lots of invaluable info and perhaps even a few new friends there.)
So let us forthwith make a caveat: If you have found a financial advisor or a mutual fund manager who has managed to beat the market averages for extended periods of time (five-plus years), net of fees and taxes, stick with 'em. Believe it or not, we Fools are not in the business of demonizing people, and there are noble, competent pros out there. If you find one, do not be ashamed to stick with him or her.
But keep watching, and asking. A good advisor should not mind questions.
But whether you work with an advisor <http://www.fool.com/fa/finadvice.htm> or go it alone, ask yourself these questions: What would it be like to know that you made the very best decision with every dollar you spent or saved? Can you imagine looking forward to balancing your budget or checking up on the returns in your brokerage account?
Imagine no longer. What follows is a guide to help you make all the right decisions – confidently – about your money. Knowledge is power. Foolishness is knowledge.
All that we humbly ask is that you use whatever you may learn here for the benefit of good rather than evil, and that if you chance upon some other Fool's question that you can help out with, that you give a thought to doing so.
We believe that when you take control of your financial life, you're taking control of your destiny, and that you'll be rewarded for doing so. By the time you're done with our 13 Steps, you'll be well on your way to a lifetime of successful investing and extreme Foolishness.
But before we get into all that investing stuff, first a word about your credit card sponsor….
02 Settle Your Personal Finances
Date: 10/7/2003
Keywords: Motley Fool
You have a few bucks set aside, you've just canceled your subscription to WiseMoney, you've stopped watching the "Cable News Wisdom Channel," and you're thinking of starting to get a little bit Foolish with your dough. Maybe you've registered
<http://www.fool.com/community/register/register.asp> at The Motley
Fool website. In fact, you've even peeked ahead a few steps to read
about choosing a broker <http://www.fool.com/dbc/dbc2.htm> to make
your first purchase of stock…
Hey! Whoa there!
Not so fast, buddy – what's your rush? We know you're on the
information superhighway and all, but believe us, when it comes to
investing money you've worked hard to earn, you want to obey all the
speed limits. Your personal finances need to be in squeaky-clean order
before you ever think of placing that exciting first stock trade. As
you'll find Fools imploring again and again, do not ever rush. This
second step is here to tell you to settle your personal finances.
Erase credit card debt
First stop… how thick is your billfold these days? Is it full of
cash or credit cards? One of the critical keys to investing is only to
use money that is free of other obligations. Thus, if you are carrying
a revolving balance on your credit cards, it ain't free! (Neither are
you, unfortunately.) Here's why: Many credit cards have an annual
interest rate of 16%-21%.
Let's say you have $5,000 to invest, but you also have $5,000 in
credit card debt with an average annual interest rate of 18%. If you
invest the $5,000 instead of using it to pay off the credit card, you
will have to get an 18% return on your investment after taxes (or
about 24% before taxes) just to break even.
Credit card debt remains the single best answer we know to the
question "Why can't I ever seem to get ahead?" As of this writing,
there are more than a billion credit cards in circulation in the
United States – that's almost four cards for every American man,
woman, and child. And nearly 70% of all credit card holders in the
U.S. today carry a revolving card balance each month (i.e., they're
just paying the minimum amount due
<http://www.fool.com/ccc/debt/debt01.htm >).
On a card with an annual interest rate of 18%, making minimum payments
(2% of the balance or $10, whichever is greater) on just a $1,000
balance is going to take you a little over 19 years to pay off. During
which time you will pay close to $1,900 in interest on that $1,000!
It's enough to want to get into the credit card issuing business,
isn't it? When you're ready, you can think about investing in a
company that does.
As you now chart your path to becoming a more Foolish investor, we
simply will not let you pass on to Step 3 until you stop letting the
credit card companies feed on you. Find out the details on how to pay
down your debt
<http://www.fool.com/seminars/sp/index.htm?sid=0001&lid=000&pid=0000>,
or discuss <http://boards.fool.com/messages.asp?id=1040004000000000>
(free trial required) your credit card questions with other Fools.
Whatever it takes, pay off that plastic.
A plan for regular saving
Next stop… how well are you regularly paying yourself? In other
words, are you routinely setting aside an adequate established
percentage of your paycheck every payday? Or do you only set aside
money when there is something left over? Or worse, are you finding
there is nothing left to pay yourself with?
If you answered yes to either of the last two questions, you're simply
not ready to pass "Go" yet. It's time to examine why you aren't paying
– or can't pay – yourself. A Fool does not go investing with her
lunch money, or next month's rent, or with money that should go toward
paying off a credit card. As stated above, only invest money that is
free of other obligations.
Fools try to save around 10% of their annual incomes. For some, it'll
be closer to 5%. Others might manage to put away 15%… for instance,
those whose paychecks come in tractor trailers like the folks in the
National Basketball Association. The important thing is to live below
your means <http://boards.fool.com/messages.asp?id=1040018000000000>
and establish a regular rhythm of savings
<http://www.fool.com/savings/savings.htm?ref=13steps>.
A plan for life's hiccups
We'd be remiss if we glossed over the importance of having an
emergency stash of cash at the ready for life's inevitable bumps. The
law of life dictates that when the hot-water heater goes "BLAM," the
chances of your teenager accidently driving into the garage door are
quadrupled. A cushion of short-term savings – three or six months'
worth of living expenses – can keep you from having to rely on
high-interest plastic, or worse, ending up in bankruptcy court.
We've devoted an entire area <http://www.fool.com/savings/savings.htm>
on our site to helping you figure out how much
<http://www.fool.com/savings/shortterm/02.htm> of a cash cushion you
need, and the most suitable place
<http://www.fool.com/savings/shortterm/03.htm> to keep it. (Hint: It's
not in your mattress.) We treat short-term savings – your emergency
fund and any money that you might need to get your hands on in the
next five years or sooner – very differently from long-term
investments.
When your cash cushion is funded, it's time to move on to your
long-term savings. If you already are routinely saving, are you
exploiting all the possibilities you have to make that money grow
tax-deferred – i.e., through an IRA
<http://www.fool.com/money/allaboutiras/allaboutiras.htm>, or SEP, or
Keogh, or 401(k), or 403(b) <http://www.fool.com/money/401k/401k.htm>
plan? Money in tax-deferred retirement plans
<http://www.fool.com/retirement/retirement.htm> can grow exponentially
compared to money in a regular investment account because you don't
pay taxes on the money deposited or the earnings until you begin to
withdraw it.
Further, a number of employers now offer to match your 401(k) plan
savings with additional monies kicked in to benefit you (read: free
money!). Make certain you are plowing as much of your savings as
possible into these highly Foolish vehicles. Remember: Pay yourself
first, and you'll thank yourself later.
Learn more about the rest of your personal finances
Before you leap headlong into that dramatic first investment, you
should at least give some additional thought to other aspects of your
financial life, such as any investing for your kids
<http://www.fool.com/money/investingforkids/investingforkids.htm>,
getting insurance <http://www.fool.com/insurance/insurance.htm>,
buying a home <http://www.fool.com/house/house.htm>, saving for
college <http://www.fool.com/csc/csc.htm>, building an emergency fund
<http://www.fool.com/savings/savings.htm>, and buying your wheels
<http://www.fool.com/car/buyingacar.htm>. We cover it all in our
Personal Finances <http://www.fool.com/pf.htm> area.
Feeling social? Come on over to the various Managing Your Finances
<http://boards.fool.com/boards.asp?id=1040001000000000> discussion
boards and meet thousands of other readers who are there to share
their experiences and answer one another's questions. Also, check out
The Motley Fool Money Guide
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF031_02&REF=EDPF13>,
which answers 500 common questions about saving, spending, and
investing.
Get Foolish help sorting it all out
Life has this way of squeezing important, big-dollar decisions into
small time frames – from getting off to a solid start early in your
investing career to handling complex financial messes at critical
moments. In times like these, it may be best to call in an honest and
good financial pro.
What?! Isn't that counter to what Foolishness stands for?
Aha, that choice itself – whether to call in the professional-support
troops – reflects your management decision. We Motley Fools have
always maintained that you are the very best person to manage your
money. Like any successful executive, though, there are times when you
must seek out the best help you can get. A good financial pro may earn
his fee many times over by helping you through sticky situations like:
\B7 The death of a parent
\B7 Marriage
\B7 Divorce
\B7 Complex financial products
\B7 Buying and selling a house
\B7 Saving for college
\B7 Estate planning
\B7 Retirement
\B7 Handling employee stock options
\B7 \B7 We've grown weary of the charlatans who sell
investment products based on commission. It is in this spirit that we
developed a Foolish service where subscribers can get independent,
expert, affordable, and instructive financial advice on an as-needed
basis. Because we couldn't think of a suitably clever name
(nominations are accepted), we call the service TMF Money Advisor
<http://www.fool.com/landing/ma/decide.htm?source=imasitlnk600198 >.
TMF Money Advisor takes the best of what we do – education – and
pairs it with the services of a long-standing firm of independent
financial planners. The whole package includes our best online
seminars and crash courses, access to a sophisticated online financial
planning tool, and the one-on-one services of a team of financial
advisors.
As you develop your financial plan – or when you encounter a
particularly complicated or rushed money decision – just pick up the
phone and speak with one of the Ayco Answerline financial advisors.
Yup. It's that easy. These guys (and gals) won't try to sell you
expensive insurance products or recommend certain stocks to pad their
commission – because they don't earn any commissions. That's the
beauty of independent, flat-fee advice.
(Thus ends our TMF Money Advisor shameless plug. Sorry, we can't help
ourselves. We think the service is the bee's knees.)
It all boils down to this: When it comes to your money, get all the
help you need from whatever source works best for you. Of course, it's
important to know your team members and their allegiances and to weigh
all advice accordingly. So we encourage you to become an educated
consumer.
With that thought fresh in our minds, let's move along and make you a
Foolishly educated consumer.
03 Set Expectations & Track Your Results
Date: 10/7/2003
Keywords: Motley Fool
Most people in the U.S. know what place their local sports teams are
in. We know what film won the last Academy Award. We know what
Teletubbies and and Barney are (though we may wish we didn't). We know
the latest about Jennifer Lopez, and we know that Michael Jackson
lives in the aptly named "Neverland." We live in a society that pays a
lot of attention to some pretty weird stuff, but one thing we don't
seem to pay much attention to is how our investments are doing
compared to the market's averages. Why is that?
Because nobody ever taught us how, and because no one who is selling
investment advice has had it in their best interest to show us how to
account for our investment performance. If you think most money
managers, mutual fund managers, and brokers want you to know how your
investments are doing in relationship to the market, we've got a
"limited edition" Tinky Winky doll we'd like to sell you for, oh, a
couple of thousand bucks.
Professional investors just don't want you to pay much attention to
how they're doing. It gives them a lot of room for error. Fools
propose that unless you're going to take the time to measure your
results, you shouldn't put investment dollars into anything but an
index fund – a mutual fund that tracks the market, step for step.
Don't buy stocks, bonds, gold bullion, heating oil futures, or
(especially) managed mutual funds. If you can afford to put money away
for five years, but don't have the time to keep tabs on how you're
doing, buy an index fund and leave it at that. To help you with just
what an index is, we've developed an Index Center
<http://www.fool.com/school/indices/introduction.htm> that explains
and compares the various indexes and shows how each is doing,
year-to-date.
We suspect, though, that many of you have more than an hour a year to
devote to this, are interested, and wouldn't mind aiming to be better
than average if it were possible. You should know that accounting for
your savings <http://www.fool.com/savings/savings.htm?ref=13steps>,
just like a business would, doesn't take much. Nor is it beyond your
abilities to beat the stock market over time. One of today's great
travesties is that most people don't consider their personal finances
a business and don't think the market can be deciphered, let alone
beaten.
That's because not enough people have gotten Foolish yet.
Let's start with some basic expectations… and again, this is for the
money that you can afford to put away for five years (ideally more).
Would it surprise you to hear that some three-quarters of the equity
(i.e. stock) mutual funds that are thrown at us from brokerage houses,
banks, and insurance agencies perform worse than average each year?
At first, it's shocking to think that the achievements of paid
professionals are so significantly shy of mediocre. But on second
consideration, those numbers shouldn't come as any surprise at all.
Managed mutual funds charge their investors average annual fees of
1.5%, partly to "fund" their active and national marketing plans.
That's 1.5% of the total assets in your account, not just the
"earnings" (if there are any). And most fund managers have enough to
do – golf, tennis, cocktail parties, and foxhunting immediately come
to mind – without having to spend time pondering growth stocks,
ever-changing allocation models, and their consistent, predictable,
and enduring market underperformance.
If that sounds harsh, it's meant to be. Bad and overpriced mutual
funds deserve much poking, and since they don't provide much in the
way of results, they should at least be recognized for their vast
capacity to amuse. But we're here to do much more than that, we hope.
Finding problems in the financial "services" industry isn't much of a
challenge. It's tacking on useful solutions that makes things
difficult.
Here's our solution to baseline accountability: Any money that you
have to invest for five years or longer should not underperform the
market over that five-year period. If it does, you've blundered,
because you can get average market performance out of an index fund
without doing any research and without taking on significant risk. The
Motley Fool's free portfolio tracking system
<http://portfolios.fool.com/custom/fool-com/portfolio/view.asp> lets
you enter all of your investments and check their returns against the
S&P 500, the major market index.
Remember – a 10% return one year might seem great, but if the overall
market advanced by 13%, then you (or your managed mutual fund)
actually underperformed. Conversely, you might be bummed to have lost
an annual average of 4% over the past two years – but if the overall
market lost an annual average of 7%, then you've not done so poorly.
Don't look at your portfolio's returns in a vacuum. (Or a Dustbuster.)
Stick close to those expectations, prepare and aim to beat them, and
know why you have or haven't. Set up your own My Fool
<http://my.fool.com/> page, which can include your portfolio, links to
your favorite Fool features, Fool free email subscriptions, and
discussion boards. Browse through FoolMart <http://www.foolmart.com>,
which offers our top-notch stock research newsletters
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91>,
How-to Guides, online seminars
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=49>,
books <http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=82>
and more. Laugh at the business pages of our national newspapers and
magazines, which devote plenty of room to "professional" predictions
but don't typically allow even a day each year for reviews of
bottom-line performance – including the deduction of all trading
costs.
But we've gotten ahead of ourselves. Here we've been yapping away
about index funds without even explaining what they are. So, without
further ado…
04 Start with an Index Fund
Date: 10/7/2003
Keywords: Motley Fool
Let's stop for a second for a brief review:
1st Step <http://www.fool.com/school/13steps/stepone.htm>: You have a
general idea of what it means to be a Foolish investor.
2nd Step <http://www.fool.com/school/13steps/steptwo.htm>: You've
gotten your personal finances in order – paying down all credit card
debt and establishing an emergency fund.
3rd Step <http://www.fool.com/school/13steps/stepthree.htm>: You've
set reasonable expectations, and you're going to track your
investments against the market.
What you have done thus far is prepare yourself emotionally,
financially, and intellectually to be an investor. By so doing, you
are already significantly ahead of the majority of all people
participating in the stock market.
But how can that be, you ask? Simple. A huge number of investors, be
they young, old, new to the market, or old hands, have never bothered
to give themselves or their financial status a checkup before jumping
into investing. Some others did so, but then entrusted their money to
professional management: mutual funds and expensive brokers. Chances
are that these decisions will hinder their future financial standing.
But you, on the other hand, are ready to jump in. So jump!
What, you're still here? You say you don't know where to put your
money? Good. Very good. You pass the test. You shouldn't expect to
have all the answers yet.
In this step, we are going to look at what, for many, is the beginning
point for investing, and for many the end point. A significant number
of individual investors have chosen to invest their money in index
funds, and will never have to think about investing again. They just
send in their checks, and they participate in the future growth of the
domestic and worldwide economy.
Let us emphasize this point. If you are comfortable investing in index
funds and go no further, we applaud you. Our society seems to
celebrate folks who take risks. Well, taking a financial risk that you
are in no way prepared to take is nothing to be celebrated. Buying
into an index fund and getting on with parts of your life you enjoy
more ought to be celebrated.
Index funds remain the lowest-cost, lowest-maintenance form of
investing for an individual. Indexing is free from punitive management
fees, and it is free from the concern that even shareholders of the
most dynamic, stable, individual companies have about their
investments from time to time.
There are as many reasons to invest in index funds as there are
investors. Some investors lack the time, interest, or confidence in
their own ability to pick and track individual stocks. This in no way
makes these people inferior investors. If anything, that
self-awareness makes them superior, more Foolish investors, compared
to many who are out there chasing the next "big thing." (A hint: 99%
of the chasers are still chasing and will continue to chase.)
Index fund investing allows people to take part in the expansion of
the economy – to participate in the stock market – in a low-effort,
lower-risk way. Those who get to this point and determine that their
best choice is to index are to be saluted.
Indexing also serves as a backstop for people who do choose to invest
in individual companies. One particularly Foolish method is the Index
Plus a Few <http://www.fool.com/news/foth/2002/foth020827.htm>
strategy, in which the investor places the majority of his or her
portfolio into an index fund, and then carefully selects a couple of
stocks to augment overall performance.
We'll now discuss the myriad index products that exist, beginning with
the granddaddy of them all.
The S&P 500 index fund
From 1926 to 2002, the S&P 500, an index of 500 of the largest and
most profitable companies in the U.S., has risen an average of 10.2%
annually (with dividends reinvested).
That means that, if you invested $10,000 into the S&P 500 some 76
years ago, today your account would be worth more than $22 million.
Sounds great, huh? But, most people who have invested in equity
(remember, "equity" means "stock") mutual funds haven't pocketed that
market average (or anything close to it) – unless they have invested
in an index fund.
According to Princeton University's Burton Malkiel, the average
actively managed mutual fund has returned 1.8% per year less than the
S&P 500. Interestingly, this 1.8% is not much higher than the average
expense ratio (read: annual fee) of these actively managed funds. That
1.8% per year may not seem like a great deal, but it is, over time.
That aforementioned $22 million would be worth less than $6 million
given a return just 1.8% lower per year. Yowza.
Further, this does not account for the fact that actively managed
funds generally have higher "turnover" (the amount traded in or out by
the manager in a given year), the capital gains taxes of which are
passed on to the fund's shareholders on an annual basis. The lower the
turnover, the lower the annual tax bill. Index funds generally have
turnover of less than 5% per annum. According to the Investment
Company Institute, the turnover for actively managed funds is more
than 40%.
If you are picking a mutual fund for your tax-deferred 401(k) or
403(b) plans, or for an IRA, and if there is an index fund available
in your list of choices, the Foolish thing to do would be to make it
your only choice. If one is not available, never fear! We can help you
make the best choices with our Pick the Best Mutual Funds How-to Guide
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF2602_01>.
Learn to love Spiders
The most well-known index fund is the Vanguard S&P 500 index fund. But
there are many other choices for people who wish to purchase
index-tracking products on a real-time basis. Standard and Poor's
Depositary Receipts, or "SPDRs" (pronounced "Spiders"), are the most
well-known. These kinds of products are known as Exchange-Traded Funds
(ETFs). Spiders are purchased through a broker
<http://www.fool.com/dbc/dbc2.htm> (we'll learn all about this in Step
Six), just as if they were stocks. Spiders trade under the ticker
symbol SPY. Don't believe us? Go to the top of this page and type SPY
into the search box. You will get a current quote on how much Spiders
are trading for, per share.
Indexing beyond the S&P 500
Are index funds just for the S&P 500? Oh, no. If you can name a
measurement of the market or a sector of the market, then somebody has
probably slapped an index fund on top of it. Some indices include: the
Russell 2000 (an index of 2,000 smaller-company stocks), the Wilshire
5000 (the entire stock market – in reality there are about 9,000
publicly traded companies, but the "Wilshire 8,934" just wouldn't
sound too good), and the Dow Jones Industrial Average (the 30 stocks
that make up the Dow). These are a few of the big ones that are
featured in our Index Center
<http://www.fool.com/school/indices/introduction.htm>.
The list of different indices that have mutual funds tracking them is
getting longer all the time. You can purchase these through fund
companies that offer index funds, or you can buy them as ETFs. Want to
buy the companies in the Nasdaq 100? They trade under the symbol QQQ.
How about something that tracks the major index for Malaysia? It
trades under EWM.
We like all of these products. Except for one thing…
The spiraling number of index-based funds and products has added
complication to an area of investing that used to be simple. "Index
fund," until not that long ago, meant the Vanguard S&P 500 product
almost by default. We still believe that this individual fund, and its
cousin, the Spider, are the best long-term products for index
investors. But, to add some international exposure or some additional
technology exposure, there are other options. The best place to get a
current list of ETFs is the American Stock Exchange website
Watch carefully what some companies are selling as "index funds."
Putting your money into a broad-market index fund should deliver great
results to the long-term shareholder, because index funds keep costs
so low. The Vanguard 500 index fund has annual costs of roughly 0.18%.
Full-price brokerage Morgan Stanley, on the other hand, runs an S&P
500 index fund (buying the exact same stocks as Vanguard's fund) with
annual costs of 1.5% – nearly eight times as much!
A Fool reminds you that the only reason to move beyond the Vanguard
500 index fund, or another low-cost index fund, is if you believe you
can beat its performance after all of your investment costs have been
deducted: research reports, fax newsletters, financial newspapers,
business magazines, etc. If you can't beat the index, you'd better
just join it… and keep adding savings to it each year. In the
decades ahead, you (and your heirs) will be happy you did.
Some index funds will allow you to establish a regular account for an
initial investment of as little as $500 if you set up an automatic
investment plan, adding $50 a month thereafter. If you're looking to
get started investing with an even lower amount, make sure to read
Step Five: All About Drip Accounts
<http://www.fool.com/school/13steps/13steps05.htm>.
And finally, a word to the worried: If the few steps you've read so
far are already making your head spin, and you're fretting about how
you'll ever get your financial ducks in a row, stop fretting. By all
means keep reading, and don't expect to master all this at once. But
perhaps also consider checking out our TMF Money Advisor
<http://www.fool.com/landing/ma/decide.htm?source=imasitlnk600198 >
service, which offers you independent and inexpensive financial
planning advice from professionals.
05 All About Dripp Accounts
Date: 10/7/2003
Keywords: Motley Fool
If you've read this far, you may be raring to invest in individual
stocks you've picked yourself. However, you might be worried about one
thing: whether you have enough money to start. This is a common
concern, and, sadly, we suspect that it's one of the main reasons why
many people never get around to investing in stocks. They figure that
it's just for the rich, or at least for those with more money.
But we're here to set the record straight. You don't need very much
money on hand to get started investing. If you have even $20 or $30
per month to invest in stocks, you can do so. You don't need to first
accumulate $3,000 or anything like that. Starting with $200 can be
more than enough.
There are many ways to plunk your dollars into stocks. The most common
way is to buy all the shares of a company that you want to buy at one
time. If you'd like to own 100 shares of Coca-Cola (NYSE: KO)
<http://quote.fool.com/uberdata.asp?symbols=KO> and it's selling for
$45 per share, you cough up $4,500 and buy the shares, paying your
broker what should be a modest commission of roughly $20 or less.
Alternatively, you could enroll in Coke's "dividend reinvestment
program" (often called a "Drip") and spend as little as $10 monthly on
Coke shares, essentially buying fractions of shares at a time –
without paying any brokerage commissions.
"Drip" isn't a very appealing name, but it does get the point across.
You're reinvesting the dividends you receive into additional shares or
fractions of shares of stock, but you're also "dripping" additional
money into your holdings – every month, ideally. Drip… drip…
drip…. That adds up over time.
Dividend reinvestment plans and direct stock purchase plans
These two special types of programs permit investors to bypass brokers
(and broker commissions!) and buy stock directly from companies. The
plans have been growing in popularity in recent years, with more than
1,000 major corporations now offering them.
With dividend reinvestment plans, the company usually requires that
you already own at least one share of its stock before you enroll.
Furthermore, the share must be in your name. This means that if you're
not already a shareholder, you'll have to buy at least one share
through a broker or a Drip service.
If you use a broker <http://www.fool.com/dbc/dbc2.htm>, you'll need to
pay a commission on any initial purchase (more about choosing a broker
is in Step 6). In addition, you'll have to specify that you want the
share(s) registered in your name, not "street name." Brokerages
routinely register shares in street name, meaning that when you buy
stock through them, it's registered in their name. This is normally
not a problem. It means that they hold the certificates for you and
that makes it easier for you to sell quickly, without having to mail
in certificates. If you do own some shares of the stock, but they're
held in street name, you can pay a few dollars to have one or more of
them transferred to your name.
Once you own a share or more in your own name, you can open a Drip
account with the company and buy additional shares directly through
the company (or its agent).
Direct stock purchase plans (DSPs) operate in much the same way,
except they don't require you to own at least one share before
enrolling. That's right – you can buy your very first share through
the program.
These Drips and DSPs vary a little from one to another. Some charge
you a few pennies per share when you buy, most others (the ones we
like best) charge nothing. Some permit automatic regular purchases,
taking money directly from your bank account.
While many of these plans are great bargains, others might not be
worth it, depending on your circumstances and their fees and policies.
You need to examine the particulars of each plan you're interested in
before deciding to enroll.
Advantages
Clearly, these programs are a blessing for those who don't have big
bundles of money to invest at a time.
They're also wonderful in that they will reinvest any dividends sent
your way. This can be a really big deal. Many investors don't
appreciate the power of reinvested dividends. Let's look at an
example.
If you'd held shares of Coca-Cola for the 18 years between 1981
through 1998, they would have appreciated a total of 4,718%. That's an
annualized gain of 24% per year. (Who said enormous global companies
are slow growers?) But wait, there's more! Here's the "secret formula"
for investing in Coke: If you'd reinvested all the dividends paid to
you into more shares of Coke, your total gain would have been 56%
higher, at 7,364%. Annualized, that's 27% per year.
A $5,000 investment in Coke in 1981 would have grown to about $240,000
without reinvested dividends. With dividends reinvested, it would have
become roughly $373,000. Impressive, eh?
Another advantage to these plans is that they permit you to slowly
build up positions in stocks over a long period of time. This might
not seem like such a big deal, but imagine that you really want to
invest in Wal-Mart (NYSE: WMT)
<http://quote.fool.com/uberdata.asp?symbols=WMT>, but it seems very
overpriced right now. If you're a typical investor, not using Drips or
DSPs, you'll probably wait on the sidelines for the stock price to
fall a bit. If it never falls, you're out of luck.
But if you go with one of these programs and choose to invest small
amounts of money in Wal-Mart each month or every few months, you
establish a position in the company immediately and keep adding to it.
If the stock price falls, your regularly invested amount will buy you
more shares. (And you might even opt to send in more money than usual,
to buy more shares.) If it keeps rising, the shares you already bought
keep rising in value.
Another way to use Drips and DSPs is to buy all the shares of a
company that you want at one time through them. For example, imagine
that you want 100 shares of Citigroup (NYSE: C)
<http://quote.fool.com/uberdata.asp?symbols= C> and it's trading
around $50 per share. You might spend $5,000 and buy the shares
through a regular brokerage <http://www.fool.com/dbc/dbc2.htm>, or you
might do so via a Drip or DSP. With the Drip or DSP, you can sign up
for dividend reinvestment and enjoy boosted returns over many years.
(Note that some brokerages now offer dividend reinvestment. See if
yours does, if you're interested.)
Disadvantages
Every silver lining has a cloud, and these plans are no exception. A
major drawback to them is the paperwork involved. If you invest small
sums regularly in a handful of companies, you'll be receiving
statements from each plan every time you invest. You'll need to keep
everything very organized and record all your transactions for tax
purposes. Taxes can get a little hairy when dealing with Drips and
DSPs if you haven't kept good records. Fortunately, there is good
software on the market that can ease some of the record-keeping
hassles.
Another disadvantage, although it's not a major one for most Fools,
relates to timing. Let's say you're convinced of the value of a stock
and are eager to buy. Using a broker, you simply make a phone call or
execute the trade online. Within minutes, you own some shares. But
with dividend reinvestment plans, you usually have to send in a form
and a check. This will take some time.
Also, many plans make all their purchases and sales only once a month,
delaying things further. So you might not get into the stock exactly
when you want, and you might end up paying a little more than you
wanted for it (though sometimes you'll end up paying less). Similarly,
when you want to sell a stock, it's not going to happen immediately.
It might take a few weeks. For someone who's regularly sending in
checks, perhaps every month, these delays don't matter. But be aware
of them.
More information
There's plenty more to learn about dividend reinvestment plans and
direct stock purchase plans. Start with our Fool's School section on
Drips <http://www.fool.com/school/drips.htm>, which explains direct
investing from A to Z.
The Fool's Drip expert Jeff Fischer demystifies the world of direct
investing in his book, Investing Without a Silver Spoon
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF017>,
which provides everything you need to know about getting started. The
book also gives details and contact information for more than 1,000
investment plans and a look at the industries and companies to
strongly consider for direct investing.
A mother lode of information can also be found at Netstockdirect.com
<http://www.netstockdirect.com/>. This site lists details on just
about every one of some 1,600 Drip and DSP programs. At Netstock you
can download plan enrollment information, and you can also begin to
invest directly online in 300 companies (and growing). Now that's
convenient!
The National Association of Investors Corp. (NAIC
<http://www.better-investing.org/>), the country's authority on
investment clubs, offers a Drip enrollment service, the "The Low Cost
Investment Plan." For just $7 plus the price of one share of stock in
any of the participating companies, you'll be enrolled and can then
add to your shares regularly at little or no additional charge. You do
need to be an NAIC member, however, and the annual fee is $39.
The Moneypaper website <http://www.moneypaper.com/> lists information
on more than 1,100 companies that offer Drips. The site also offers
the Temper of the Times enrollment service, which will purchase
initial shares and enroll investors in Drips for a nominal fee.
Direct Stock Purchase Plan Clearinghouse
<http://www.dripinvestor.com/clearinghouse/home.asp> is a free service
that allows investors to order up to five prospectuses from companies
that offer DSPs. (This is for direct stock purchase companies only,
not Drip-only companies.)
One last resource to consider is our stock research newsletter, Motley
Fool Income Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>,
which focuses on investments that provide income, such as stocks with
hefty dividend yields. Many of these could serve as prime candidates
for Drip investing.
Now, on to our next stop on this Foolish journey… Step 6
<13steps06.htm>
06 Open a Brokerage Account
Date: 10/7/2003
Keywords: Motley Fool
Full-service brokers
"Full-service broker" is the name given to those expensively dressed
souls who work for Merrill Lynch (NYSE: MER)
<http://quote.fool.com/uberdata.asp?symbols=MER>, Citigroup's (NYSE:
- <http://quote.fool.com/uberdata.asp?symbols=C> Smith Barney, Morgan
Stanley (NYSE: MWD) <http://quote.fool.com/uberdata.asp?symbols=MWD>,
etc. The phrase "full-service" indicates that they are there to attend
to all the needs of their account holders. That includes generating
investment ideas for you, giving you stock quotes whenever you request
them, managing your account (in many cases), providing investment
research materials, helping you with tax information – the works.
(But don't bother asking them to wash your car. We tried. It didn't
work.)
In return for these full services, the broker will charge you very
high rates to trade stocks in your account. Whereas discount brokers
(we'll get to them in a second) typically charge between $5 and $30
for an online trade, you'll generally pay around $150 for the average
trade done through the typical full-service broker. Furthermore,
full-service firms often charge annual "maintenance" fees through
which they grant themselves a generous slice of your assets, say about
$150 a year or more. In other words, they provide an expensive
"service." (Perhaps we should call them "full-price" brokers.)
OK, two problems here. (Actually, dozens of problems, but we'll keep
it to a brief two for now.)
The first is that most brokers (or, more snootily, "Financial
Consultants") who give advice are just glorified salesmen, shopping
around their brokerage house's stock picks or pricey mutual funds.
While there are some knowledgeable brokers who do a knockout job for
their clients, many aren't actually very good investors – they often
lack impressive or even average performance histories.
The second problem is that full-service brokers usually receive
commissions on each trade, so their compensation is closely tied with
how often their clients' accounts are traded. The more trades you
make, the more money they make. Highly distressing.
The full-service industry will save itself only when it bases its
incentives on performance, not trading frequency. Your broker should
be working to give you the best consistent long-term, market-beating
return possible, and should receive bonuses based on a percentage of
your long-term profits.
Discount brokers
Discount brokers provide a more affordable means for investors to
execute their trades. They're for do-it-yourself investors. The idea
of paying exorbitant fees to some full-price broker for sub-par
returns makes little sense. But just as you need to go out and select
tools and materials before you can begin to fix things around your
house, you need to learn a little before you go out and pick a
brokerage.
There are lots of discount brokers. We've set up a Broker Center
<http://www.fool.com/dbc/dbc2.htm> to help in your selection process.
In it, we've included a comparison table
<http://www.fool.com/dbc/tables/compare.htm> to allow you to view our
sponsor brokerages, side by side. And you'll find answers to commonly
asked questions, such as:
· How do I open an account?
· What if I can only invest small amounts of money?
· Can I transfer my current account to a new firm?
· What's the difference between a cash account and a margin account?
· Can I buy mutual funds through a discount broker?
· Is online trading secure?
· · We also have a Discount Broker
<http://boards.fool.com/Messages.asp?bid=100146&source=istfoclnk100124>
discussion board, which features the Foolish community providing the
best answers anywhere on choosing the right brokerage. (You can learn
a lot by seeing what people are saying there. Give it a whirl – we
offer a painless free trial for our acclaimed discussion boards.)
Here are 10 considerations as you begin your search:
Read the fine print. Look for hidden costs, such as account minimum
balances, fees for late payments or bounced checks, transaction fees,
and postage and handling fees.
Commission schedules can vary considerably within the same brokerage,
depending on the trade. If you most typically buy 1,000 shares of
stock below $10 a share, use this trade as a test of your prospective
brokers. See how much of a commission you'd pay for your typical trade
with each prospective brokerage.
If you want to trade foreign stocks or options or penny stocks, none
of which we generally counsel doing (well, foreign stocks are OK under
certain circumstances and options can make some sense for some
investors), make sure the brokerage is set up to trade them.
Check out the margin interest rate, if you plan on ever borrowing
money from your broker for purchases. Margin rates vary substantially
from broker to broker. If you're Foolish, you won't think about using
margin until you've been buying and selling your own stocks for a
couple of years. (For more on margin, see Step 12: Advanced Investing
Issues <http://www.fool.com/school/13steps/13steps12.htm>.)
The availability of checking accounts or bill paying may be very
attractive to some. Discount brokers are expanding their banking
services in an attempt to make the most from each customer. Do you
really still need a checking account from a separate bank? A lot of
Fools don't.
Mutual funds: You probably know already that we're not big fans of the
world of underperforming mutual funds, but, heck, maybe you disagree
with us. If so, and you're looking to buy mutual funds, learn which
funds are offered from any prospective discount brokers.
Research and investing tools: We have plenty of research
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91> and
investing tools
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=49>
available right here at Fool.com, but one of the perks of a brokerage
account is (or should be) getting access to additional screening
tools, analyst research reports, stock charts, and more.
Money market sweeps: Does your prospective brokerage sweep any unused
funds into a money market account at the end of the day? Check into
it.
Touch-tone (phone) trading and/or a local office: If you want to place
a trade the old-fashioned way – through automated touch-tone dialing
or by phoning a human broker – see if that's offered. If you want a
real bricks-and-mortar office, find out if there's one near you.
Free perks are free perks. Some are even worth having. Whether you're
talking frequent flyer miles, free trades on your birthday, or even
cold, hard cash placed right into your account, there are some things
out there that could tip the balance in favor of choosing one
discounter over another.
Okay, now that your brokerage search is underway, let's shift gears a
bit and discuss retirement – your retirement, that is, and how you
can best plan and invest for it.
07 Planning for Retirement
Date: 10/7/2003
Keywords: Motley Fool
You have your finances in order, maybe have a Drip or two, perhaps
contribute to your 401(k). You may also have opened a brokerage
account. Kudos!
But what is all this investing for, if not to be used and enjoyed at
some point? Close your eyes and envision yourself sunbathing on the
black-sand beaches of Wai'anapanapa on Maui, for instance. Or sipping
cappuccino in Carrara, where Michelangelo went to choose the stone out
of which he carved his David and his Pieta.
Sculpt thyself
Your retirement plans may now be a mass of shapeless stone weighing
you down. What we propose to do here is to take out our modern-day
hammers and chisels – our calculators
<http://www.fool.com/calcs/calculators.htm>, community
<http://boards.fool.com/messages.asp?id=1040013000000000>, strategies
<http://www.fool.com/strategies.htm>, and the "How to Plan the Perfect
Retirement" How-to Guide
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF2600_01>
– to mold something precise from that stone. You'll find these tools
in our Retirement Area <http://www.fool.com/retirement.htm>. But
before you pound the chisel for the first time (and hack off the femur
by accident), you may be itching for a little guidance.
The six steps
To ensure a successful retirement – whether you want to quit the
workforce at 35 or 70 – you must:
· Think about what kind of lifestyle you want in retirement, and how
much you're going to need per year to support it.
· Figure out how much you'll need on the day of retirement in order to
make sure you can draw the amount you need (see the "multiply by 25"
rule below).
· Take an educated guess at how long you'll be retired.
· Decide where you will live, and whether to rent or buy.
· Ensure you have adequate health, medical, and other insurance for
the family.
· Decide how to fill the hours in a day previously devoted to work.
· · The "multiply by 25" rule
There's a handy (though not entirely accurate) little formula,
developed by mathematicians who are still stuck in a maze somewhere in
Palo Alto, to help you figure out how much money you need to set aside
now to meet a certain annual expense for a long time – for eternity,
in fact. First you figure out what your real rate of return (that is,
adjusted for inflation) is on your savings. For example, assume your
long-term overall annual rate of return on all investments will be 8%,
and that at the same time inflation will run 4%. That gives you a real
rate of return of 4% (8% minus 4%). You divide that 4% into 1.00,
giving you 25. Multiply your annual expense in retirement by that
number to arrive at the "lifetime expense" – that's a very rough
estimate of how much you'll need to have on your retirement date to
cover those costs in the future.
Another way of expressing it is to say that you need to put aside $25
to fund each $1 of annual spending in your budget. If your total
annual spending in retirement will be $50,000, the "multiply by 25"
rule indicates that you need to save $1.25 million before giving up
the paycheck.
Though not perfect, this equation allows you to consider various
scenarios. What if it were possible to cut your retirement spending to
levels well below your current spending? If reducing your expenses
allows you to get by on less income, you'll lower your tax burden as
well. So taking the above assumption, if you were able to bring your
annual spending in retirement down to $30,000, the "multiply by 25"
rule indicates that you would need to put aside $750,000 before
retirement, a considerably smaller sum. Of course, if you invest well,
then you actually have to "put aside" much less and let investment
returns make up the difference.
Keep in mind that this calculation does NOT incorporate Social
Security, pension benefits, money you may earn from work after
retirement, marrying into a fabulously wealthy family, and so on. It
assumes no other sources of income than your investments. This will
(we hope) not be the case, but it's better to err on the conservative
side – to assume that we'll have less. Then, of course, if we have
more than we planned on, we can live the high life (whatever that is).
How long will you be retired?
This has two parts: when you will retire, and how long you will live.
You choose when you retire; there is no right answer. Select a date,
or choose the age at which you want to retire. Whether it's 35 or 55
or 69 or 88 – it's your choice.
Then, to get a genetically informed guesstimate as to how long you may
live, take a look at your parents and grandparents. Who lived the
longest among them? Take that age, add 10 years to it (you're eating
your leafy greens, right?), and use that number.
Subtract from that the age you'll be when you retire, and voila! You
have a working number for how long you may be retired.
Where you stand
In order to arrive at a target amount on your date of retirement, you
must determine your current financial status. If you use a software
program such as Quicken or Microsoft Money, you'll find your work
simplified. Essentially you need to tally up how much money is coming
in right now, and also what you have in terms of assets. You're
invested in the stock market, right? Since you know the date your
retirement is to begin, our online calculators should help you project
how much your portfolio will be worth at that time. You can then
compare that with the amount you know you'll need on the Big Day, and
see whether you need to invest more.
We should mention, of course, the magic of compound interest. The
longer you have for your investments to grow, the larger the growth
will be. That's why there's no time like the present to begin. (And if
you find some way to begin yesterday, go for it!)
Act!
Among the important weapons that may be in your arsenal, you should
check into the following:
· Employer-provided pensions
</retirement/manageretirement/manageretirement2.htm>, otherwise known
as defined benefit plans. These plans are dying off as employers
switch to 401(k) plans or hybrid vehicles such as cash balance plans.
· 401(k)s or 403(b)s </money/401k/401k.htm>. Your employer may match
the contributions that you make to this plan, up to a certain amount
– and that means that you're getting free money. "Free money." Hmm…
we like the sound of that. Couple the free money with tax-deferred
compounding, and you've got a great tool for amassing a sizable stash
by the time you retire.
· IRAs <http://www.fool.com/ira/ira.htm>. If you're eligible, there's
really no good reason why you shouldn't have one – whether you choose
a Roth IRA or a traditional IRA. Each of these provide great tax
advantages, and the flexibility to be invested in the stock market all
the while. The Roth IRA is appealing because, if you follow the rules,
you can withdraw money you've contributed to it, as well as any
earnings on the money, completely tax-free. You can contribute up to
$3,000 per year to a regular or a Roth IRA.
· · Periodically, you must evaluate your progress toward
meeting your retirement needs (we recommend at least once a year), and
then make revisions where required. After all, things change – rates
of return, unexpected expenses, and so forth. So be sure to stay on
top of that changing scene by reviewing your retirement savings goals
and investments annually. And as we pointed out in Step 2
<13steps02.htm>, it doesn't hurt to get a second set of eyes reviewing
your plan. If you're a TMF Money Advisor
<http://www.fool.com/landing/ma/decide.htm?source=imasitlnk600198>
subscriber, make a date with your planner to see if you're on track.
Go ahead, we'll wait. (If you're not a subscriber, perhaps look into
whether our TMF Money Advisor service could help you, with the
individual, independent – and inexpensive – professional advice it
offers.)
The early bird and the can of worms
Great, you're back. Achieving a successful early retirement is another
matter. Planning for an early retirement is much more difficult than
for a "normal" retirement. That's because some unusual hurdles will
crop up, such as health and medical insurance. Medicare isn't
available until age 65, many employers will not allow group plans to
be carried into retirement beyond the 18 months required by law, and
individual health policies may cost in the hundreds of dollars per
month. For the early retiree, then, obtaining adequate health and
medical coverage can put a huge dent in the family's income.
Insurance is often the greatest deterrent to retirement prior to age
- For more guidance on insurance matters, visit our Insurance Center
<http://www.fool.com/Insurancecenter/Insurancecenter.htm>.
Invest well
It should be clear by now that investing well is key to your having
the resources you'll need on the day you retire. The greater your
returns over time, the more money you're going to have.
So how do you evaluate companies in which to invest? One important
step is discussed in the next step: Read financial info
<13steps08.htm>.
08 Get Financial Information
Date: 10/7/2003
Keywords: Motley Fool
Selecting stocks on your own, without the safety net of an index fund,
can be scary. But it can also be fun and very, very rewarding. You'll
need to learn what kinds of companies to seek out, and then you'll
have to evaluate them, to make sure they're moving in the right
direction and are worthy of your trust.
Gather information
No right-minded Fool (and what other kind is there?) would think of
investing in a company based merely on cocktail-party chatter, a
broker's recommendation, or even a discussion board overflowing with
exuberance. Even if the company is one you've discovered on your own,
you shouldn't just run out and buy shares of its stock. First, get
your hands on the company's financial information, and get to know the
situation thoroughly.
To start, call the company you're interested in, ask for the "investor
relations" department, and request an "investor information packet." A
full packet typically contains the following, all of which you want
and should ask for:
· The annual report (most recent)
· The 10-K (most recent)
· The 10-Q (most recent)
· Press releases (all recent ones)
· Analysts' reports (any available up-to-date ones)
· By the way – are you wondering what all this is going to
cost you? Nothing more than a holiday bottle of wine for your postal
carrier who'll be delivering all the packets you order. These packets
are free!
But hey, let's face it – you're online. Nowadays, the Internet is the
place to do the best research. You can get a substantial amount of
information online. You can access all recent SEC filings, including
company 10-K's and 10-Q's, without ever leaving your keyboard. All you
need to know is a company's ticker symbol to acquire news, financial
snapshots, and estimates of future earnings <http://quote.fool.com/>.
Whoops, maybe we're getting ahead of ourselves with that kind of talk.
Sorry. Keep reading and we'll explain.
[By the way, if the thought of finding and researching companies on
your own is stressing you out, consider some of our stock research
newsletters
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91>,
which offer you our stock analysts' best investment ideas – they can
serve as excellent starting points for further research.]
Learn about the company
You've got the company's information packet. Let's have a look. The
first thing you'll want to do is scan everything in order to get a
sense of the company's mission, its products, its attitude, and its
prospects. There are three main financial statements included:
· The income statement
<http://www.fool.com/foolu/askfoolu/2003/askfoolu030402.htm>(or
statement of operations)
· The balance sheet
<http://www.fool.com/school/valuation/howtoreadabalancesheet.htm>
· The statement of cash flows
<http://www.fool.com/portfolios/RuleMaker/1999/RuleMaker990823.htm>
· The easiest of the three to understand is the income
statement, which shows how much money the company made over the last
year and its profits. Next up is the balance sheet, revealing how much
cash, inventories, and debt the company has. The third and most
complex piece is the statement of cash flows, revealing how much money
the company is really making as it works through operations, makes
investments, and borrows money.
When studying a company's financial statements, you should be able to
determine how quickly sales are growing, how the company is financing
its growth, whether it has taken on too much debt, how efficiently
it's collecting its accounts receivable, how much profit it's making
on its products and services, and all kinds of fascinating
information.
You should also be paying attention to trends, to see if the firm's
financial health is improving or declining. And finally, it's best to
compare companies with their industry peers to see how they stack up.
These financial statements will also appear in the 10-Q and 10-K
reports. The 10-K is issued once a year, along with the annual report,
while 10-Qs are issued three times a year, at the end of the
intervening quarters.
The 10-Q summarizes the company's quarterly performance. The 10-K is
dedicated to a company's financials, not its story, and thus includes
information you simply won't find in most annual reports, like insider
stock holdings and brief biographies of the management team. The
latter is of extreme interest to a Fool. We love to read about how the
company chairman filed for personal bankruptcy in 1989, or graduated
from our college.
Press releases are an even more frequent source of information on your
company, and should be read and followed by hands-on investors. Those
who prefer to keep up less frequently with their stocks can usually
safely ignore press releases, and just catch the quarterly reports. Of
course, this works much better with safer, bigger companies. If you
own volatile small-cap growth stocks that move radically based on
every new piece of information, it behooves you to plug into these
things. Do keep in mind, of course, that press releases in general
tend to put a positive spin on news, since they're issued by the
company itself.
We Fools thrive on this stuff. For a more detailed tour of these
telling papers, check out our Crack the Code: Read Financial
Statements Like a Pro
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF2603_01>
How-to Guide– it comes with a money-back guarantee, like most of our
offerings (at least those that aren't free).
Analyst reports
Most companies have been examined and analyzed by one or more
financial analysts. These professionals, most often employees of
brokerage houses, will write reports that include the analyst's
opinion of the stock, as well as estimates of future earnings and
other prognostications. One of these reports might be included in the
packet the company sent you. (If not, the company will provide you
with analyst names and phone numbers, so you can call and make your
own request.) Reading analyst reports can be a truly useful exercise.
For a Fool, some of the most valuable information in the report are
the estimated earnings per share figures. (The better reports print
estimates quarter-by-quarter.) By matching the analyst's quarterly
estimates against the quarterly earnings announcements as they come
out, investors can determine whether a business and its profits per
share are meeting, exceeding, or underperforming analysts'
expectations.
We at The Motley Fool love getting our hands on analyst reports,
recognizing that analysts know a fair amount about how to evaluate a
particular company's prospects for growth. Hey, it's their full-time
job. And, while we don't accept every assertion made by any analyst,
we think that confronting their analyses is a key ingredient to
sharpening our understanding of the story of our companies.
That's the good side to analysts' opinions. (Red Alert. Red Alert.
Fool attack coming. All Wise men of Wall Street prepare to be fired
upon.)
We do not advise you to pay attention to the analysts' ratings on
securities, whether "Strong Buy," "Buy," "Accumulate," "Attractive,"
"Speculative Hold," or whatever. These subjective judgments are very
much slanted according to a blatant and unapologetic conflict of
interest that exists in the brokerage industry. The same firms whose
analysis you're reading also have built their businesses on financing
the companies they're analyzing. Thus, you won't be surprised to hear
that the first buy recommendation issued on a company that just came
public virtually always comes from the very same firm or firms that
underwrote the initial public offering (hmmmm…). (Here's a
particularly egregious example of how out of control things can get
<http://www.fool.com/Specials/2002/02112000c.htm> with analysts.)
Further, and more importantly, if the brokerage firm analyst were ever
to put an outright "Sell" recommendation on a given company's stock,
that company would probably never do any financing business with the
analyst's firm. Thus, you'll almost never see a "Sell" recommendation
from Wall Street. Less than 1% of all analyst reports contain "Sell"
ratings. Wall Street analysts will virtually never be the first ones
to identify a serious problem with a company – hey, it really isn't
their job to do that. Their job is to get you to buy stocks and trade
in and out of them, not lead you to long-term wealth.
Foolish Research Reports
In response to this situation, we at The Motley Fool are now providing
an alternative to the analyst reports of Wall Street. Through our
special research-laden newsletters, Tom Gardner's Motley Fool Hidden
Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>,
The Motley Fool Stock Advisor
<http://investorplace.com/order/?pc=3DR103&r=d>, Motley Fool Income
Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>,
and our year-end report called Stocks 200-whatever year we're in, the
Fool is producing research that is free of inside-the-Street code
words (such as "Hold," which really means "Sell Now"). If you're
interested in trying out some money-back-if-you're-not-satisfied
Foolish research, check out what we offer
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91>.
Misinformation
We'd be remiss if we didn't mention one thing you may encounter in
your quest for financial information – and that is the "hot tip." The
hot tip has many guises. It can appear as investment "information" or
a "can't-miss opportunity" or "the chance to invest in a company that
will revolutionize the industry." The pitch can take place on the
Internet, in print, on the phone, or at a party. It may even appear on
a discussion board.
We have one rule of thumb for such so-called "information": Do your
own research and make your own independent investment decisions. Never
make an investment decision based on one of these hot tips. (For some
advice on spotting investment scams, we've put together a primer on
Securities Fraud: How to Avoid the Cons
<http://www.fool.com/specials/2000/sp000223fraud.htm>.)
Once you've gathered the information that you truly need, we'll show
you what to do with it.
09 Evaluating Businesses
Date: 10/7/2003
Keywords: Motley Fool
Notice that the title of this step is "Evaluating Businesses," not
"Evaluating Stocks." Though evaluating a stock is most often the way
that investment research is phrased, Fools know that when you buy a
share of stock you are really buying a piece of a business.
To figure out how much the stock is worth, therefore, you first need
to determine how much the whole business is worth. You can begin this
process by assessing the company's financials in terms of per-share
values to calculate how much the proportional share of the business is
worth. (For hands-on help, check out our Crack the Code: How to Read
Financial Statements Like a Pro
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF2603_01>
How-to Guide.)
If you own one share of Wal-Mart (NYSE: WMT)
<http://quote.fool.com/uberdata.asp?symbols=WMT> stock, you, along
with members of founder Sam Walton's family and many other
shareholders, own the company. True, the Walton family owns more of it
than you do. A lot more. But, your share still counts. When important
decisions are to be made, the company will send you a ballot and
solicit your vote. And, every time a shopper buys a snorkel, a stereo,
or a set of towels at Wal-Mart, a tiny fraction of the profit that
purchase generates is yours. A very, very tiny fraction. But, don't
let that get you down – there are a lot of Wal-Mart shoppers.
The fate of each share of stock is tied inextricably to the fortune of
the underlying business, and the market's perception of the future
prospects for that business. A common mistake investors make is
thinking of shares of stock merely as slips of paper that fluctuate in
value, instead of as very real chunks of actual ongoing businesses.
Don't make this mistake.
It All Boils Down to Price and Quality
As you learn more about how to study companies, you'll run across many
different measures and tools that investors use in their evaluation.
These tools might include P/E ratios
<http://www.fool.com/school/earningsbasedvaluations.htm>,
return-on-equity
<http://www.fool.com/school/returnonequity/returnonequitypartonedefinition.htm>,
cash-flow valuations
<http://www.fool.com/school/cashflowbasedvaluations.htm>, and so on.
At first, all the valuation tools in your mind might end up in a big
clutter. You'd do well to try and sort them into two categories
eventually, though: price
<http://www.fool.com/school/securityanalysis02.htm> and quality
<http://www.fool.com/school/securityanalysis03.htm>. Here's why:
Bearing in mind that there are really only three kinds of people in
the world – those who can count and those who can't – there are
three main questions you need to answer before you decide whether to
invest in a company:
Is this a strong and growing high-quality company?
Is the company's stock priced attractively right now?
(We stole the above joke from Warren Buffett's 1998 annual letter to
his Berkshire Hathaway (NYSE: BRK.A, BRK.B)
<http://quote.fool.com/uberdata.asp?symbols=BRK.A, BRK.B>
shareholders. At some point, if you really want an education in
evaluating businesses, instead of going to business school, just read
Mr. Buffett's collection of annual letters
<http://www.berkshirehathaway.com/letters/letters.html>.)
If you don't make a point of addressing these questions (however many
there were), you might end up buying grossly overvalued shares of a
wonderful company, or you might snap up shares of a business that's
about to be cut in half at what seems like a bargain price.
Quality
There are a number of ways that you can zero in on a company's
quality. Is it debt-free or up to its ears in interest payments? Does
the firm have a lot of cash? Is it generating a lot of cash and
spending that money efficiently? Are sales and earnings growing at an
admirable clip? Are gross, operating, and net profit margins growing,
as well? Is the management smart and executing well? Is the company
well-positioned to beat out competitors? Does the company have a brand
name that is widely known and admired?
These are just some of the many measures you can take when evaluating
a company's quality.
Price
When evaluating a company's price, you shouldn't be interested in how
many dollars one share costs – you need to measure the per-share cost
of a stock against something. Investors typically take a number of
measures and compare them to the firm's earnings. The
price-to-earnings (P/E) ratio, for example, compares a company's stock
price to its earnings per share. Some companies aren't properly valued
based on their earnings, though (because there may not be any), and
often the price-to-sales
<http://www.fool.com/school/revenuebasedvaluations.htm> ratio is used.
Another earnings-based ratio is the PEG, which compares the P/E ratio
to the company's earnings growth rate.
You can also evaluate price by estimating the company's earnings for
all the years ahead and then discounting them to their present value.
A company's stock price is essentially a reflection of all its
expected future earnings, discounted at an appropriate rate. If your
calculations suggest the total discounted earnings of a company will
result in a valuation of $80 per share, and the stock is currently
trading for $60 per share, you're possibly looking at a real bargain.
Value
Once you have a handle on a company's quality and its price, you can
begin to make a judgment on what the intrinsic value of the company
should be. Before we go any further, know that there are many
different investing styles, and many different ways to value stocks
<http://www.fool.com/school/howtovaluestocks.htm>. Some investors
focus primarily on finding undervalued companies, paying close
attention to a stock's price. Others consider price, but focus more on
the quality of the business. Both of these are Foolish approaches.
What is un-Foolish is simply to look for rapidly growing companies,
regardless of price or quality, or to only examine charts of a stock's
price movements and its trading volume.
Learning More
Success in analyzing individual businesses and ultimately investing in
them is about buying what you understand
<http://www.fool.com/school/securityanalysis04.htm> the best and
constantly refining and adding to your knowledge about companies.
Here are some steps you can take to broaden your range of
understanding:
· Try out the company's product(s) or service(s). Be familiar with how
it is improving and what the demand for it is.
· Read up on the company. Find books and articles on it.
· Check out our discussion boards <http://boards.fool.com/> for any
company you're interested in. Online, you can and should ask questions
of fellow Fools. In particular, check out the Frequently Asked
Questions (FAQ) post that is linked to on the side of many individual
company message board posts. (Remember, we offer a painless free trial
to our discussion boards, where we suspect you'll find a lot of
value.)
· Figure out what the company's business model is. How is it making
money? How is it organized? How might the model change in the years
ahead? On what assumptions is the model based?
· Examine the company's competitive environment. What are its
competitors up to? Is the company likely to fend off attacks? What
advantages does the company have over the competition? Is it at any
disadvantage? How is the industry changing and what challenges does it
face?
· Think about the company's risks. In SEC filings, particularly 10-K
reports, the company's management will have explained some risks that
they see.
· Crunch a bunch of numbers. See just how quickly sales are growing.
See what the firm's debt-to-equity ratio is. Determine what its gross
margins are.
· Talk to people in the business, such as company employees,
suppliers, people in stores that sell the company's products,
customers of the company, people familiar with competitor companies,
and so on. See how they perceive the industry and where it's headed.
See what they think of the company you're studying and its future
prospects.
· · That may seem like a lot to put together – but
remember, that's what this forum is all about, helping Fools
understand and put it all together. To learn more about closely
studying and evaluating businesses, move on to Step 10: Understand
Rule Maker Investing.
Also, if you'd like some company as you seek out promising stocks,
check out some of our research offerings, such as our well-regarded
newsletters: Tom Gardner's Motley Fool Hidden Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>,
The Motley Fool Stock Advisor
<http://investorplace.com/order/?pc=3DR103&r=d>, Motley Fool Income
Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>,
and our many other offerings <http://www.foolmart.com>. We back them
up with money-back guarantees.
10 Understand Rule Maker Investing
Date: 10/7/2003
Keywords: Motley Fool
The Rule Maker investing philosophy begins with the same premise that
all Foolish investment philosophies do:
You are the best manager for your money. The Wall Street Wise telling
you that you don't have the time or the skills to manage your money
profitably are dead wrong.
If you go about making your selections properly, in short order you
can acquire a portfolio of roughly 10 giant companies that make the
rules in our economy. These are companies that, though they are not
immune to business cycles, are extremely unlikely to evaporate. With
curiosity, discipline, and a little elbow grease, you have a good shot
at generating strong returns over the long haul.
Leading brand
The criteria for identifying Rule Makers begin with looking for the
No. 1 brand name in an industry. And not just the No. 1 brand here in
America – we're talking king of the world brands. What companies come
to mind when you think of soda, razor blades, diamond rings, and
microprocessors? We suspect that most people will name Coca-Cola
(NYSE: KO) <http://quote.fool.com/uberdata.asp?symbols=KO>, Gillette
(NYSE: G) <http://quote.fool.com/uberdata.asp?symbols=G>, Tiffany
(NYSE: TIF) <http://quote.fool.com/uberdata.asp?symbols=TIF>, and
Intel (Nasdaq: INTC)
<http://quote.fool.com/uberdata.asp?symbols=INTC>.
Mass market, repeat purchase
Repeat mass-market purchases also characterize Rule Maker companies.
People who aren't NBA stars don't buy many automobiles in a year, so
General Motors (NYSE: GM)
<http://quote.fool.com/uberdata.asp?symbols=GM> fails this test.
(Unless, of course, the NBA expands to include 6,000 or 7,000 teams.
And, even then, we're not sure General Motors is the brand that'll
find multiple purchases each year.) Think instead of things you
routinely use, either because you like to or you have to: soda, casual
clothing, blood-pressure pills, shampoo. Think Coca-Cola, Pfizer
(NYSE: PFE) <http://quote.fool.com/uberdata.asp?symbols=PFE>, and
Procter & Gamble (NYSE: PG)
<http://quote.fool.com/uberdata.asp?symbols=PG>.
Strong historical performance
When searching for Rule Makers, you need to crunch a few numbers –
nothing horrific, just a few basic measures of financial performance.
We're not talking logarithmic progressions, here, but we do seek to be
disciplined with our research. Start with strong historical
performance from the company. You're buying with the intention of
holding for an extended period of time – you must be certain they're
the kind of companies that richly reward their owners. Check out the
10-year record of your companies to make sure they're worthy of
attention.
Profitable and growing business
Rule Makers sport gross margins (gross profits divided by revenues)
above 50%, net margins (net income divided by revenues) of at least
10%, and sales growing faster than 10% per year. Some companies that
pass muster on these counts include drug maker Schering-Plough (NYSE:
SGP) <http://quote.fool.com/uberdata.asp?symbols=SGP> (gross margins
of roughly 80%), Internet infrastructure builder Cisco Systems
(Nasdaq: CSCO) <http://quote.fool.com/uberdata.asp?symbols=CSCO> (net
margins around 16%), and Intel (sales growth topping 12%). The
preceding terms are covered in more detail in our Rule Maker Criteria
<http://www.fool.com/portfolios/RuleMaker/RuleMakerStep6.htm>.
Cash is king
These are companies that have been around for a while and have been
making loads of dough for years. By now they should have a nice big
vault of it, with which they can expand their operations in the
future, not having to borrow money from anybody else. You can find how
fat a company's coffers are by reading the balance sheet. Looking for
a low Foolish Flow Ratio is a special metric of Rule Maker investing.
The Flow Ratio reveals whether a company is managing cash flow
effectively by demanding payment from its customers quickly (an
indication of strength), and paying its obligations slowly.
Strong financial direction
Even more important than past performance, however, is the future.
What direction is the company heading? Since a stock's price will
always be tied to the current value of future cash flows – and how
the market views this scenario – you want the present to look better
than the past. Hunt for rising margins, a company that's generating
boatloads of free cash flow, and low debt. Think about software king
Microsoft (Nasdaq: MSFT)
<http://quote.fool.com/uberdata.asp?symbols=MSFT>, armed with almost
$25 billion in cash and cash equivalents as of this writing. Compared
with industry peers, the Rule Maker candidate should sit at the head
of the class.
Long-term buy and hold
Rule Maker investments are meant to be long term. Once you identify
and invest in these powerful companies, you should, for the most part,
be able to leave your money invested for a decade or longer. This
means you won't be making many buy and sell decisions, and won't be
forking over capital gains taxes to Uncle Sam. These companies should
only be sold if you find that they have become severely overvalued (a
la Cisco in 2000), or if you detect severe financial deterioration.
With some deep-discount brokers <http://www.fool.com/dbc/dbc2.htm>
charging trading commissions of around $10, a Fool could buy 10 Rule
Maker stocks for less than $100, starting with an initial investment
between $5,000 and $10,000. This would meet the Foolish aim of keeping
commission costs below 2% of the invested principle.
There's a lot more involved in identifying and investing in Rule
Makers (hey, there's half a book
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF139_10>
devoted to it), but these are some of the core principles. This
tip-of-the-iceberg treatment ought to give you an idea whether the
strategy might be one to which you want to devote a little more time.
Our Rule Maker goal is to beat the market by a few percentage points
annually. It isn't guaranteed, mind you. Beating the market over a
10-year period isn't easy, but picking quality companies with lots of
cash, powerful brand names, and proven management is a good place to
start.
You can learn more about the specifics of this approach in our Rule
Maker area
<http://www.fool.com/portfolios/rulemaker/about.htm?ref=RMH>.
While the Rule Maker strategy hunts for dominating giants, more
advanced, risk-tolerant investors should check out Step 11, where The
Motley Fool introduces Rule Breaker investing.
And don't forget to consider checking out our well-regarded
newsletters that feature lots of promising investments – The Motley
Fool Stock Advisor <http://investorplace.com/order/?pc=3DR103&r=d>,
Tom Gardner's Motley Fool Hidden Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>
and Motley Fool Income Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024
> – some of the ideas they present will be Rule Makers. We've got
many other offerings <http://www.foolmart.com> that can help you
become a more successful investor, too.
11 Consider Rule Breakers and Small Caps
Date: 10/7/2003
Keywords: Motley Fool
Warning: Rule Breakers are for the most bold and daring of investors.
Those who are brand new to all this investing stuff should understand
the risks involved. So should those who aren't brand new.
Rule Breaker <http://www.fool.com/portfolios/rulebreaker/about.htm>
stocks should make up only a part of any portfolio – and investors
should be prepared to lose the money they invest in these companies.
However, high risk can bring high reward.
Here are the six main characteristics of Rule Breaker companies:
- The company should be a top dog and a first-mover in an important,
emerging field. Being top dog in the left-handed scissors industry
isn't enough. The left-handed scissors industry is pretty mature –
and it ain't going anywhere in the near or distant future. As an
example, in the emergence of electronic commerce Amazon.com (Nasdaq:
AMZN) <http://quote.fool.com/uberdata.asp?symbols=AMZN> is the top dog
and first-mover.
- The company needs to demonstrate sustainable advantage gained
through business momentum, patent protection, visionary leadership, or
inept competitors. Examples include Wal-Mart (NYSE: WMT)
<http://quote.fool.com/uberdata.asp?symbols=WMT> (with net income
gains of 25% during much of the 1980s), Amgen (Nasdaq: AMGN)
<http://quote.fool.com/uberdata.asp?symbols=AMGN> (with patent
protection of its drug formulas), and Microsoft (Nasdaq: MSFT)
<http://quote.fool.com/uberdata.asp?symbols=MSFT> (with visionary
leadership that benefited from Apple Computer's (Nasdaq: AAPL)
<http://quote.fool.com/uberdata.asp?symbols=AAPL> regrettable decision
not to license its technology).
- The market should have rewarded a Rule Breaker's promise with
strong price appreciation, measured by a relative strength rating of
90 or above. (Relative strength ratings appear in Investor's Business
Daily.)
- Look for good management and strong backing. The steel company
(yes, steel!) Nucor (NYSE: NUE)
<http://quote.fool.com/uberdata.asp?symbols=NUE>, led by Ken Iverson,
became a world-class powerhouse by revolutionizing steel production
processes. Also consider the "backing," or supporters of a company.
eBay (Nasdaq: EBAY) <http://quote.fool.com/uberdata.asp?symbols=EBAY>
was backed by executives from Starbucks (Nasdaq: SBUX)
<http://quote.fool.com/uberdata.asp?symbols=SBUX> and Sun Microsystems
(Nasdaq: SUNW) <http://quote.fool.com/uberdata.asp?symbols=SUNW>.
- Rule Breakers should have a strong consumer brand. Again, consider
Starbucks. Its name recognition is much stronger than competitors such
as… um… like…. (Get the point?)
- It's a good sign when the financial media calls an up-and-coming
company overvalued.
To learn more about Rule Breakers, read The Motley Fool's Rule
Breakers, Rule Makers
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF139_10>.
We recommend making Rule Breakers just a part of your overall
investment strategy. A completely nutritious Foolish mix might include
a bunch of Rule Maker stocks, with a few Rule Breakers thrown in to
spice things up.
The beauty of small-cap investing
You should consider including a number of small-cap growth companies
in your portfolio, Rule Breakers or otherwise. Small-caps give the
individual investor a chance to beat the Wise to the punch.
The size and structure of most mutual funds and a pesky SEC regulation
make it hard for funds to establish meaningful positions in
small-caps. In order to buy a position large enough to make a
difference to their fund's performance, they would have to buy 10% or
20% of a small-cap company (which their own guidelines frequently
restrict them from doing).
Before they can do that, though, they have to file with the SEC. By
that time, they've already tipped their hand to the market and
inflated the previously attractive price by buying 5% of the company.
Individual investors who have the ability to spot promising companies
can get in before the institutions do. When institutions do get in,
they'll do so in a big way, buying many shares and pushing up the
share price.
Another reason to buy small-cap companies is that they can grow
quickly. Small companies are in a much better position than their
larger brethren to expand their businesses. Rapidly multiplying
earnings often translate into higher share prices.
The downside of small-caps
Small-caps are for experienced investors. Novices should steer clear.
You wouldn't go up in a lunar orbiter without prior training, nor
should you try small-cap investing until you've cut your teeth on some
large- and mid-cap issues.
You should also stay away from small-caps (all stocks, really) if
you're ponying up your mortgage payment (or any other much-needed
funds) to make the purchase. The money you invest in small-caps should
be money you can afford to lose.
Time – or the lack thereof – is another dissuading factor. Finding
good small-caps is a lot of work before and after you've made your
purchase. If you don't have the time, energy, or inclination to keep
up with the news on your portfolio, you're better off in an index fund
<http://www.fool.com/school/13steps/stepfour.htm>. We're serious about
this. We'd even rather you just pay fees to some expensive mutual fund
out there than go into small-cap investing with a lackadaisical
attitude. (Wow, did we just say that? Whew! Down, boy.)
Finally, if you have a natural aversion to risk, stay away from
volatile small-cap growth stocks. If the mere thought of a 5% drop in
one day gives you an ulcer, you're better off saving your stomach.
Index funds will give you respectable returns without the
acid-blockers.
Useful Resources
You'll also run across some tasty small-caps in our well-regarded
newsletters, such as Tom Gardner's Motley Fool Hidden Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>,
which focuses on smaller companies. Our other newsletters include The
Motley Fool Stock Advisor
<http://investorplace.com/order/?pc=3DR103&r=d> and Motley Fool Income
Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>.
Check out our other offerings <http://www.foolmart.com>, too! We back
them up with money-back guarantees.
Now that you've got small-caps under your belt, proceed to Step 12,
where even more advanced investing issues are confronted.
12 Advanced Investing Issues
Date: 10/7/2003
Keywords: Motley Fool
Derivatives, shorting against the box, ascending trend channels,
50-day moving averages, Bollinger bands… ohmigosh! Yes, there are a
heck of a lot of high-level, complicated topics in investing.
Fortunately for you, most of them are basically nonsense.
You can let out a big sigh of relief, because in this step we won't be
covering or going into excruciating detail about many of these
"advanced" topics. Instead, we'll highlight a few market complexities
– one that's worth running away from (day trading), one that provides
a useful chuckle (technical analysis), and a couple that you might
consider learning more about and perhaps employing (margin and
shorting).
Day trading
We think the best way to accumulate wealth is to buy stock in great
businesses with the intent to hold them for as long as they remain
great. But this is easier said than done. When the stock market is
surging or plunging, or when you learn of one exciting company after
another, it can be hard to refrain from actively buying or selling.
Our business-centric message is further challenged by the likes of
"day traders," who believe they can wring extra profit by following
the stock market by the hour. You've probably seen segments on day
traders on your nightly news. It became a fad, as more and more people
gave up regular 9-to-5 jobs and spent that time with their eyes glued
to computer monitors (and we all know how painful that can be), buying
thousands of dollars of stock at a time, holding it for a few hours
(or minutes!), and then selling. Sheesh.
People "investing" like this aren't really investing. They're
gambling. They're not holding on to pieces of strong companies,
accumulating wealth as the companies grow. They're making bets that
they can out-think others. They aren't participating in the growth of
the American economy – they're betting that they're better guessers
than the next guy.
They aren't. If you've been around investing for a while, you've
noticed that there were significantly fewer advertisements for day
trading in 2003 than there were at the heights of the market in 1999.
Know why? Because most day traders managed to set their money on fire
in the interim.
Technical analysis
Technical analysis dwells on charts of stock price movements and
trading volume. Fundamental analysis, on the other hand, focuses on
the value of companies, studying such things as a firm's business,
earnings, and competition. While investors from the fundamental school
(Fools!) want to understand a business from the inside out,
technicians mostly remain on the outside, observing how the stock
behaves in the market.
Investors who use technical analysis focus on the psychology of the
market, scrutinizing investor behavior. They try to determine where
the big institutional money is going so they can put their cash in the
same places. It's amazing to us to think that anyone might study a
stock chart, see a particular pattern, determine that the stock is
"breaking resistance," and then commit actual money to that
proposition.
It's a shortcut to actual analysis. We're sure that there are folks
out there who have some aptitude at seeing things in the squiggles.
For most people, though, it's just a way to trade more often, and
umpteen scholarly studies show the same thing: The segment of
individual investors who trade the most tend to do the poorest.
Simply put, leave technical analysis alone.
Margin
Buying on margin means you're borrowing money from your brokerage firm
and using it to buy stocks. It's attractive because you can turn a
profit using money that you don't even have. For that privilege,
you're paying interest to the brokerage, just as with any other loan.
(Actually, it's a lot easier to open a margin account than to apply
for a bank loan.) If the market turns against you, you either sell for
a loss – plus interest costs – or hold on until the market picks up,
paying interest all the while.
Investing with margin isn't an automatic no-no, in our opinion. It
should just be used with extreme moderation and caution. Some people,
however, will max out on margin, borrowing 50% of the value of their
portfolio. We think that's far too risky, and something any investor
should avoid.
If you already have been investing for a few years and decide to use
margin, we suggest you limit yourself to borrowing no more than 20% of
your portfolio's value. If you do so and you have $20,000 in your
portfolio, you'll be borrowing $4,000 and putting $24,000 to work for
you. That's called leverage. A little of it can be useful and not too
risky.
However, think very carefully before you use margin. If you're
borrowing on margin and paying 9% interest, you should be pretty sure
your stocks will appreciate more than 9%. If your margined securities
fall below a certain level, you'll receive a "margin call," requiring
an infusion of additional cash.
Only experienced investors should use margin. Indeed, many experienced
investors steer clear of it and do very well without it. However,
there is one reason why, even if you're not interested in buying
stocks on borrowed money, you still might want to open a margin
account…
Shorting
If you've ever swaggered up to a craps table, cleared away the
necessary elbow room, and slapped down a few candy-colored chips on
the Pass Line, you were doing what most of the people at a craps table
do. You were betting with the crowd.
Adjacent to the Pass Line, however, is a cheaper strip of real estate
(usually a vacant lot) known as the "Don't Pass." It's virtually the
opposite bet; you win when the Pass Line crowd loses, and lose when it
wins. Because you're betting against the roller and most of the rest
of the table, betting Don't Pass is considered bad form. The craps
jargon for you is "wrong bettor." Many other bettors will actually
dislike you for doing it, a feeling that will be reinforced whenever
you smile at dice rolls that make them frown.
If you read our discussion boards for very long, you'll notice that
short-sellers aren't generally the most beloved of contributors to
this forum. Doesn't matter – they play a valuable role both here and
in the public markets.
When you short a stock, you are banking on that stock's price going
down. You initiate the process of shorting a stock by first borrowing
shares from a current shareholder. This may sound difficult, but it
isn't. Your discount broker does this for you automatically. You then
sell these borrowed shares at the current market price. Then you sit
and wait, rooting for the stock to spiral downward. While you wait,
you have to pay dividends to the person who actually owns the stock
you borrowed (if the stock pays a dividend) and, in some cases, you
can also be subject to paying margin interest to the brokerage, just
as if you had borrowed money.
When you're ready to cash out of your investment, whether for profit
or for loss, you close out the position by buying the stock back at
the market price so you can return your borrowed shares to the lender
– another thing your broker does for you automatically. That's it.
Shorting can offer a couple of potential benefits for your portfolio.
First, shorting stock is a "hedge" – you're taking compensatory
measures to counterbalance a potentially plummeting stock market.
Outside of its status as a hedge, however, selling stocks short is
also a great way to make money. Indeed, if you make the right choices,
you can make money both ways – as the stocks you own rise and as the
stocks you have shorted wither. It's tremendous fun! In fact, before
we turned Foolish enough to short stocks, we didn't know just how much
fun we were missing.
Second, and more important, the shorting of stocks is vastly
underpracticed by the investment community at large. From a purely
Foolish point of view, this makes shorting stock even more compelling.
That's because Fools relish a good swim against the tide. When most
investors are trying to figure out how many more half-point gains they
can squeeze out of their equities, we're looking the other way. We're
regarding these same securities from the top down, assessing how far
each might fall. The seldom-taken contrary view can be lucrative.
A final note: Once in a blue moon, your broker may be forced to return
your shorted shares to the anonymous lender, usually because he wants
to sell them. Forced into doing so, you'll have to buy back the shares
prematurely – whether you've made money or not. This happens only
with very small companies that have few shares outstanding, and is
usually just a minor nuisance. Put the money somewhere else.
When calculating returns, keep in mind that all the normal steps of
buying and selling a stock are still present, just reversed. Both
transactions still have a cost basis and a sales price. But, for
stocks sold short, the chronological order has been reversed.
Shorting stock is one approach that separates the sophisticated
investor from the novice. Believing that selling shares short is
difficult and highly dangerous, some people pay oodles of money to
enter "hedge funds," mutual fund partnerships whose managers short
stock and go on margin. Having read this far, you already know most of
what these "pros" know, and can do it yourself.
Finally, remember that when your "Pass Line" friends find out you're
shorting stocks, they may start to regard you as Darth Vader. So, wear
dark clothes, a low visor, breathe loud, and milk it.
For more on the pros and cons of shorting, check out our Shorting
Stocks discussion board
<http://boards.fool.com/Messages.asp?bid=100106&source=istfoclnk100124>
and read our Dueling Fools debate
<http://www.fool.com/duelingfools/1998/duelingfools980909short000.htm>
on the strategy. And there's a lengthy discussion of shorting in The
Motley Fool Investment Guide
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF141_10>.
Also, if you're interested, check out our investing newsletters, which
will provide you with monthly suggestions of promising stocks: Tom
Gardner's Motley Fool Hidden Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>,
Motley Fool Income Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>,
and The Motley Fool Stock Advisor
<http://investorplace.com/order/?pc=3DR103&r=d>. For even more Foolish
offerings, visit FoolMart <http://www.foolmart.com>, which is always
open.
And remember, if all this reading has you sweating about your
financial situation, check out our TMF Money Advisor
<http://www.fool.com/landing/ma/decide.htm?source=imasitlnk600198>
service, which offers you personalized, independent, professional
financial planning advice – for a fraction of the cost of a typical
financial planner.
You're almost home-free, Fool. Now, on to the last step to investing
Foolishly.
13 Get Fully Foolish
Date: 10/7/2003
Keywords: Motley Fool
Sure, you can read a pile of Fool books
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=82> and
be more prepared to invest in today's hurly-burly markets than nine
out of 10 people. But how can you become better able to handle the
twists and turns of individual stocks than 99 out of 100 investors?
We've got six words for you, friend, and they ain't "Call market
predictor Ralph Acampora now."
They are "Check out The Motley Fool online." Online you will find
hundreds of additional educational and interactive features, online
discussions, and much, much, more.
So where do you begin?
Get your financial house in order
Your first goal should be to get your personal finances in tip-top
shape before embarking on any Foolish investing. In our Personal
Finance area <http://www.fool.com/pf.htm>, you'll find in-depth
coverage on such matters as getting a broker, paying for college,
banking, taxes, investing for kids, and buying insurance, homes, and
cars. If you've got 60 minutes and $10 to spare, then delve right in
with one of our How-to guides (also known as online seminars)
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=73> on
savings, taxes, buying and selling investments, and disaster-proofing
your finances. They're definitely worth a roll of quarters, and they
sport money-back guarantees, to boot.
Learn the basics of investing
You can then move over to the Fool's School
<http://www.fool.com/school.htm> for an explanation of different
investment vehicles, a tutorial on starting an investment club, the
lowdown on mutual funds, an area that tracks all the major market
indexes, and an explanation of dividend reinvestment plans. For a more
interactive experience, check out our "How to Start Investing" How-to
Guide
<http://www.foolmart.com/Shopping/Product_View.asp?PRODUCT_ID=MF2601_01>.
Help is on the way
We also provide a Help Desk <http://www.fool.com/help/index.htm>, with
everything from Foolishly Answered Questions (FAQs) about anything
imaginable to direct links to our non-stop Ask a Foolish Question
discussion board. We'll answer your questions right there online. If
you see any problems or anything you'd like done more or done better,
simply drop a note at our Improve the Fool discussion board. For
specific advice on your money matters, nothing beats TMF Money Advisor
<http://www.fool.com/landing/ma/decide.htm?source=imasitlnk600198> –
Fool education paired with independent, expert advice.
Generate investment ideas
Our commentaries and takes will plug you into the news coming out of
companies you already own while identifying other potential investment
opportunities – all with a Foolish touch of analysis. Day in and day
out, you'll be exposed to issues and lessons important to individual
investors.
For those who cannot tune in on a daily basis, we offer an archive of
everything we publish for each week in our Today's Features page
<http://www.fool.com/foolwatch/foolwatch.htm>. Bookmark it and you'll
never miss your favorite features again.
Our Quotes & Data <http://quote.fool.com/> area offers a number of
research resources, including earnings estimates, press release
databases, financial information, and historical price charts for
every stock out there. In addition, you can plug into Securities and
Exchange Commission filings and dig for all the cool facts and numbers
that will help you evaluate your investments.
If you're looking for a regular source of new investment ideas, you
can subscribe to one or more of our well-regarded newsletters, such as
Tom Gardner's Motley Fool Hidden Gems
<http://www.fool.com/landing/research/decide_hg.htm?source=ihgsitlnk200208>,
Motley Fool Income Investor
<http://www.fool.com/landing/newsletters/incomeinvestor.htm?source=iiiedilnk925024>,
and The Motley Fool Stock Advisor
<http://investorplace.com/order/?pc=3DR103&r=d>. Each month they'll
provide you with compelling new stock ideas. You always need to decide
for yourself which stocks are right for your portfolio, but these
newsletters can give you an important head start. We've got other
offerings
<http://www.foolmart.com/Shopping/Catalog_View.asp?CATALOGID=91>,
available, too - check them out!
Talk with others
On our thousands of discussion boards <http://boards.fool.com/>, you
can debate the value of publicly traded stocks, talk over the merits
of a new approach to investing, get money-saving tips, or just ask
whatever question happens to pop into your head. (You can also enjoy
many purely social boards, along with boards centered around
non-financial topics, such as pets, children, sports, jobs, quitting
smoking, religion, cooking, and many other things.) Full access to
hundreds of boards costs as much as a modest magazine subscription,
and we offer a painless, no-credit-card-required free trial, too. You
owe it to yourself to check it out!
Your Fool
When you register
<http://www.fool.com/community/register/RegisterUS.asp?source=default>
with the Fool, you can set up your own, customized Fool page
<http://my.fool.com/Index.aspx>. "My Fool" allows you to quickly view
your portfolios and favorite Fool features all on one page. You can
also change your Fool preferences such as your email address, your
password, and your personal profile. Finally, My Fool lists all of the
perks we offer you as a member of The Motley Fool. Check My Fool often
to see the new offerings.
Bringing it all together
Investing is not just something you do once – it is an ongoing
process that requires time and attention. A solid, well-diversified
portfolio that moves beyond simply buying an index fund requires
work… work that you can do at The Motley Fool online, sharing with
other Fools as you go along. Whether it is in our educational areas or
out on the discussion boards, you can hang out with Fools and work
together to beat the pants off Wall Street. You're not alone.
Welcome, and Fool on!