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Basics of Financial Investing – Part 4

General Investment Selection

This article deals with a variety of general approaches to making investment selections. The first rule focuses on having realistic expectations.

Investment opportunities that seem too attractive are all too likely to have some hidden problems. The next several rules deal with two types of stocks: value and growth stocks. Both types have their proponents. Along the way a theoretical model, the dividend discount model, is introduced. Most of the remainder of the article deals with the value or lack of value of such matters as stock splits, analysts’ recommendations, managers’ ownership position in their companies, collectibles, tangibles, and IPOs. Finally, the need for approaching investing from a broad perspective is considered.

Be very skeptical of ‘‘investments’’ that promise returns that seem too attractive

Expected returns on investments tend to vary with their risk. Higher-risk investments tend to offer higher potential returns than do less risky investment opportunities. Risk-averse investors can be induced to buy high-risk investments only if they expect the returns to be high enough to justify taking the risks. Investment opportunities vary all the way from being very-low-risk, low-expected-return investments to very-high-risk, high-expected-return investments.

Long-term government bonds are viewed by most people in the investment community as having essentially no risk of default. Because of their high level of safety, such bonds usually offer returns in the mid to high single digits (depending upon inflationary expectations). Investment-grade corporate bonds (having a modest risk of default) are usually priced to yield no more than a couple of percentage points above the yields on government bonds of comparable maturity. High-yield, non–investment grade (junk) bonds are normally priced to yield several percentage points above investment-grade corporates. If, for example, inflation is expected to run at 2 percent, long-term government bonds might yield 5 percent, investment-grade corporates 7–8 percent, and high-yield junk bonds 11–15 percent.

These promised rates of return exemplify what you can reasonably expect to be offered for the amount of risk that you are willing to tolerate. Note that these are the yields to maturity that the borrower promises to pay. Not all bonds pay what they promise to pay. Some default. Losses from default, to the extent that they occur, will cause the actual returns to be lower than promised. So, for example, if the junk bond portfolio suffers default losses equivalent to 3 percent per year (a reasonable average for default losses on junk bonds) and promised a yield of 12 percent, its default-adjusted average yield is reduced to 9 percent (12 - 3 = 9). If any bonds are sold prior to maturity, actual realized returns will also be affected by changes in market prices and interest rates.

Over long time periods, bond investors, even those willing to take substantial risks, are unlikely to achieve returns much in excess of 10 percent and may well be quite pleased with somewhat less. Similarly, long-term returns in the stock market have averaged 9 to 11 percent. These 9 to 11 percent returns are average rates that tend to be earned on relatively risky investments. So, if you are offered an investment opportunity with a projected return well above this 9 to 11 percent range (e.g., 20% or more per year), you should proceed with extreme caution, if at all.

Very high projected returns are likely to result from one or more of the following three sources:

  • Extremely high risk
  • Unrealistically optimistic assumptions
  • Fraud

Some investments do have the potential for very high returns coupled with a great deal of risk. Some examples of high-risk investments that may, in individual cases, generate very attractive returns include: futures and options contracts with their high degree of leverage, defaulted bonds with some chance of a substantial recovery, wildcat oil wells that might turn out to be a gushers, and certain IPOs and penny stocks that have an intriguing story. But their high-risk level implies that those who assemble a portfolio of such investments are likely to own a lot of losers mixed in with their winners. If the overall portfolio return is to be attractive, the high returns on the successful portfolio components must be sufficient in number and magnitude to offset the losses on the unsuccessful components. One may still be able to achieve a bit of a premium return from a diversified portfolio of carefully selected high-risk investments. Profits on the winners in such portfolios may be sufficient to offset the losses on the losers. Such premium returns are, however, far from assured. High risk is no guarantee of high returns. Indeed, investments in high-risk assets are almost as likely to produce very poor results as very good results. That is why they are called high-risk investments.

Unrealistic assumptions are another problem. Grant me my first premise and I can prove anything. Let me slip one carefully selected assumption into the analysis and I can easily project extremely high returns. As an example, consider a very straightforward covered option writing strategy: You buy a stock at 25 and write a six-month call option for 2 with a strike of 30. The stock pays a dividend of $0.25 a quarter. What is the return on your covered option position if the option is exercised? Gain on the stock purchase = 5 (30 - 25 = 5); option price = 2; dividends = 0.50; total potential profit of $7.5 per share (5 + 2 + .5 = 7.5). A profit of $7.5 on an investment of $25 amounts to a 30 percent return in six months or 60 percent annualized. An annual return of 60 percent is fantastic! Achieve a return of even half that high for a few years and you will quickly become very wealthy. But don’t count on it. The assumption that produced this return? That the stock’s price rises high enough quickly enough so that the option is exercised. The stock’s market price must move from 25 up to 30 or more in six months for the option to become in-the-money and therefore attractive to be exercised. It could happen. A five-point increase on a $25 stock is, however, a rather large move for a relatively short time period (20%, which is equivalent to 40% annualized). Only a small percentage of $25 stocks will move up to 30 in any given six-month period.

Six months from now the stock is much more likely to remain below 30 than it is to have risen from 25 to 30 or more. So what is your return if the stock’s price stays below 30? What if the stock’s price just stays at 25? The return is still attractive: 2 + 0.5 = 2.5 on an investment of 25, a gain of 10 percent, which is equivalent to a 20 percent annualized return. What could go wrong? The company could fail to declare the dividend and the stock could fall to 20. A stock is about as likely to fall from 25 to 20 as it is to rise from 25 to 30. If the stock’s price does fall to 20, you still retain the 2 points that you received from the option sale, but you are 5 points underwater on the stock.

You would have a loss of 5 on the stock partially offset by 2 from the sale of the call. Thus you have a net loss of 3 points (5 - 2 = 3) on a stock position costing 25 (a loss of 12%, or 24% annualized).

Clearly the projected success of the covered option-writing strategy that I just outlined depends crucially on what happens to the market price of the underlying stock. The results projected for most, if not all, such strategies are dependent upon the underlying assumptions. You need to identify and then evaluate the reasonableness of each of these assumptions before you proceed. Only if you are comfortable that the assumptions are realistic should you accept the feasibility of the analysis and resulting profit-projections.

High risk and optimistic assumptions are one thing. Fraud is quite another. If you invest in a high-risk venture or one based on unrealistic assumptions, you may get burned. But at least you have a fighting chance of achieving a reasonable result. Even if things don’t work out as planned, you will usually be able to salvage something of value from the amount that you originally invested. So, for example, if you buy a junk bond that later defaults, you will end up with a claim in a bankruptcy proceeding. That claim may eventually produce a recovery equal to a portion (e.g., 20% or 50%) of the bond’s face value. If you bought the bonds cheaply enough, your investment may even show a profit. If, in contrast, you buy into an investment fraud, you are almost certain to lose everything that you put at risk.

The most famous of investment frauds was concocted by one Charles Ponzi in Boston in 1919. Ponzi claimed to be able to purchase postal money orders in Europe at a steep discount and then redeem them in the U.S. for their full value. He said he needed capital from ‘‘investors’’ in order to purchase the money orders in bulk. He offered ‘‘investors’’ astronomical returns, such as 45 percent for an investment of sixty days. Mr. Ponzi could deliver these kinds of ‘‘returns’’ in only one way. He used the money brought in from new ‘‘investors’’ to pay out the monies that were due to old ‘‘investors.’’ He also depended heavily upon the greed of existing ‘‘investors,’’ who he urged to continue to let their money ride. He embezzled some of the funds entrusted to him in order to live high on the hog. The rest went to pay out the astronomical returns to those ‘‘investors’’ who demanded their promised payment.

Eventually, a Boston newspaper reporter exposed his scam. Then everything came crashing down. Ponzi was convicted of fraud and sent to prison. He later died in obscurity in Brazil. But he did achieve a kind of immortality. The type of scheme that Ponzi was practicing soon came to be named after him.

Ponzi schemes utilize an investment pyramid. Such a scheme could, for example, take in a million dollars (50%) in period one, keep $500,000 for the scammer, and pay out $500,000 (50%) to ‘‘investors.’’ Then take in $2 million in period two, keep a million dollars for the scammer, and pay out $1 million (50%). In period three the scheme would need to take in $4 million to stay on track. Soon the amount of new money needed to be raised to keep the scam going grows very large.

Contributions from new or existing suckers are depended upon to fund the ever-growing need for payouts. Such a scheme can last only as long as an ever-larger group of new participants (suckers) can be enticed into the program. Once ‘‘investors’’ begin to seek to withdraw their funds in significant numbers, the cupboard is quickly emptied and the Ponzi is exposed for the empty shell that it is. A very few participants who get out before the collapse may avoid a disaster. Under the bankruptcy code, however, even they may be required to put back the money (called a preference) that they got out near the end of the scheme. Usually the people who assemble these types of schemes have stolen and spent a large fraction of the money contributed by the participants. Little or nothing is left to be distributed to the disappointed ‘‘investors.’’

Clearly, you want to avoid getting sucked into a fraud such as a Ponzi scheme. But, how do you know if a particular investment opportunity is some kind of fraud? The first tip-off is a promise of an unreasonably generous (e.g., a 50%) return. The old saying, If the offer seems too good to be true, it probably is, remains a very useful guide.

Another guide: Never invest in what you do not understand. The fraud that was Enron is a good example of the type of company that many people invested in, even though they had little idea of its business model. Enron was said somehow to be in the business of buying and selling energy. And yet few if any of the analysts who recommended its stock really understood how Enron was supposedly producing the income that it falsely claimed to be earning.

A third guide: Be aware of the kinds of schemes that have been used in the past. One such example is based on the chain letter principle. Each participant must bring in two new participants to move up the chain. When the participant’s name reaches the top of the list, he or she receives the contributions from each of the participants at the bottom of the list. Suppose the entrance fee is $1,000 and the chain has four levels, with each level double the size of the one below it. The person at the top of the pyramid will be above two at the second level, four at the third, and eight at the fourth. Put $1,000 in at the bottom and get $8,000 back when your name reaches the top level. Why not risk $1,000 to get back $8,000, especially if you think that you can talk two friends into coming into the pool? If they each find two friends who, in turn, find two friends each, you have gotten to the top to get your $8,000.

But if you take this route, you will encounter a couple of serious problems. First, this type of arrangement is illegal. Once the appropriate authorities realize what is being done, they will step in to stop it. If that happens before your name reaches the top, you are sure to have lost your $1,000. If you were one of the organizers rather than simply a naive participant, you are now in legal trouble. Second, these pyramids must grow very large very quickly and continue to expand at a rapid pace until they grow so large that they can no longer continue the rapid pace. Once they stop expanding, they quickly collapse. Finding enough suckers to keep the pyramid going and growing becomes increasingly difficult as time passes. Some people are skeptical of such seemingly easy money; they won’t buy. Others are already in and waiting to see how they will come out. They already have as much money at risk as they want. Still others would like to, but just can’t come up with the initial ‘‘investment.’’

Finally, many people perform a bit of analysis and conclude that the scheme will soon collapse of its own weight. As a result, finding two friends to buy in is not always easy. Even if you do find the two willing participants, you have some obligation to these friends as a result of your getting them into the program. If the scheme disintegrates after you receive your $8,000 but before they get theirs, what do you say to them? Or, suppose it collapses one more level down? What about your friends’ friends? Aren’t you likely to know them, too? Sooner or later the schemes will collapse. Do you really want to be a participant in such situations even if you are lucky enough to come out ahead?

The above description of a pyramid scheme is simple and straightforward. Often the chain is more carefully disguised. A pyramid scheme does not need to involve money. It could call for contributions in savings bonds, ounces of gold, or bottles of wine, for example. Sometimes the scheme is embedded in a seemingly legitimate business ( Dare To Be Great, for example, an ostensible marketing syndicate that was largely in the business of selling franchises to one group, which would then seek to sell more franchises to another group, and so on).

By no means are all investment frauds based on the chain letter or even the Ponzi scheme concept. Some of the most egregious schemes have relied upon the generous nature of many people. The advertised appeal is to make money by doing good. One such fraud involved the sale of what was touted as participation in a religious theme park to be called Bible City. Rural God-fearing folk throughout the Midwest were offered an opportunity to buy into the ‘‘project.’’ In fact, no legitimate theme park was ever planned. The promoters were selling a giant fraud. The ‘‘investors,’’ however, just could not believe that Bible City wasn’t the real thing. Similarly, many frauds have been perpetrated by Mormons on other Mormons, who are particularly inclined to trust their fellow church people.

The most mundane medium may be the basis for a fraud, as the great salad oil scandal illustrates. In this instance, a dealer in fats and oils sought a bank loan using his salad oil inventory (a liquid asset) as collateral. When the loan officer checked the borrower’s (salad oil dealer’s) tank, it registered as full. The loan collateral was judged sufficient. Later, the bank was asked to double the size of the loan. When the loan officer came to inspect the facility and its collateral, he saw two tanks. Each was found to be full of salad oil. A third tank and then a fourth appeared and each was used to collateralize an addition to the loan. The process continued with additional tanks and additions to the loan. Eventually the pattern became too suspicious. A careful analysis revealed that a single tankful of salad oil was being pumped from tank to tank just in time to show each tank as full when checked. Clearly almost anything can be the basis for a fraudulent investment scam.

To sum up, promised or projected returns that seem too high should be taken as a red flag. Such anticipated returns are very likely to be due either to very high risks, to unrealistic assumptions, or to outright fraud.

Fad/growth/story stocks are particularly vulnerable to general market declines. Be cautious with such stocks, especially when the market seems frothy

Two major schools of investment analysis approach investment selection from very different perspectives. The growth stock school prefers companies that are projected to show rapid increases in sales, assets, earnings, and eventually perhaps dividends. Growth stock advocates are willing to pay a high price relative to current earnings (a high price earnings, or PE, ratio) in order to buy stock in a company that they expect to grow rapidly. Such investors believe that the kinds of companies that they prefer as investments will grow much larger and be much more profitable in the future. They point to companies such as Walmart, Dell, Microsoft, or more recently eBay or Google as examples of the types of stocks they would like to have bought when these companies were just getting established. An early purchase of such stocks would indeed have produced phenomenal returns. The same was said about IBM, Xerox, and Polaroid in an earlier era. More recently, however, IBM has been a lackluster performer, Xerox has been struggling, and Polaroid had to file for bankruptcy. Strong performers of one era do not necessarily remain strong performers forever.

Value stock investors, in contrast, prefer to assemble portfolios of companies whose stock prices are low relative to their tangible intrinsic values. They focus attention on dividends, book values, and especially earnings (low PE) as measures of intrinsic value. While not averse to the potential benefits of growth, value investors are unwilling to pay a large premium for what they fear may be no more than a hope of high future growth rates. Value investors believe that the market often neglects the kinds of stocks that they prefer. This allegedly unwarranted neglect is exactly why these types of stocks appeal to value investors. Such ‘‘neglected’’ stocks are often under-priced precisely because the market is overlooking their virtues. When (if) the market rediscovers the favorable aspects of such companies, their stock prices will rise. Or at least that is what value-oriented investors expect (hope) to happen.

Value investors subscribe to the so-called theory of contrary opinion: ‘‘Buy what the market doesn’t like when it is out of favor because in time the market’s view is likely to change.’’ It is kind of like buying Christmas ornaments in January. By no means do all stocks identified as value stocks turn out to be undervalued any more than all supposed growth stocks turn in rapid growth. Value investors, however, believe that these types of stocks tend to be the better buys.

The debate between value and growth stock investors boils down to the following question: Do value stocks, on balance, outperform growth stocks, or vice versa? In other words, would a well-diversified portfolio of value stocks tend to outperform or be outperformed by a similarly well-diversified portfolio of growth stocks?

In some periods, the stocks favored by the growth stock school tend to do best. At other times the value stock school’s choices are more in vogue. Some studies suggest that, for long-term holding periods, value stocks tend to be the better buy. The evidence for this conclusion is not overwhelming, however.

What can be said with a significant degree of confidence is the following: In a major market downturn, the stocks that tend to get hit the hardest are the very stocks that were bid up the most on optimistic expectation for their future growth.

Accordingly, one of the worst times to own a heavy concentration of high-PE growth stocks is when the market is about to experience or is in the process of experiencing a dramatic fall. When the market’s mood turns negative, it is likely to turn especially negative on those stocks whose story is largely in the future (growth stocks). So, when the market appears frothy, one should be especially cautious about owning high-PE speculative stocks. To implement this advice, however, you need to be able to identify when the market is nearing a top and about to experience a major decline. That is not an easy task. But it may not be impossible.

When, however, the PE ratio of the overall market is well above its normal range and when a lot of investors and many analysts are rejecting the old wisdom on the importance of assets, cash, and earnings, and when the IPO market is hot for concept stocks, the market can be described as frothy (e.g., the late 1990s). It may well become more overpriced before it changes direction, but change direction it will. It is just a matter of time.

Use the PE ratio as one index of how expensive a stock is

Both value and growth stock investors utilize the PE ratio (the ratio of the stock’s per-share price to its earnings per share) as a measure of a stock’s relative price. A theoretical relationship called the dividend discount model (DDM) has been developed by the finance profession to explain the determinants of the PE ratio. This model is based on the proposition that the price of a stock equals the present (discounted) value of its expected future income stream. According to this model, a stock’s PE ratio is a function of just three variables: its payout ratio, expected growth rate, and the appropriate discount rate. See below:

Dividend Discount Model

PE = payout / (rg)

where:

payout = dividend rate/earnings per share

r = appropriate (risk-adjusted) discount rate

g = expected long-term growth rate for dividends and earnings

Let’s explore the operations of this dividend discount model with an example.

Consider the case of a company that pays out half of its after-tax earnings in the form of dividends and has a market-determined discount rate of 12 percent applied to its expected income stream. Thus payout = .5 and r = .12.

We can use the DDM to see how its expected growth rate will affect its PE. If the firm is expected to grow at 8 percent, the DDM formula solves as follows:

PE = .5 / (.12 - .08) = .5 / .04 = 12.5

If the expected growth rate is 10 percent, the solution for the PE becomes:

PE = .5 / (.12 - .10) = .5 / .02 = 25

For an expected growth rate of 11 percent, the formula yields a PE of:

PE = .5 / (.12 - .11) = .5 / .01 = 50

So we see in this example that expected growth rates of 8, 10, and 11 percent correspond to PEs of 12.5, 25, and 50 respectively. Thus, a stock with those characteristics (payout = .5, discount rate = 12%) that generates an EPS of $1 could, for example, sell at 12.5, 25, or 50 depending upon its expected growth rate. The faster its earnings are expected to grow, the higher its PE.

Clearly, the growth rate that the market expects a company to achieve plays a large role in the pricing of its stock. Small changes in expected growth rates can produce large changes in the market price. High PEs reflect market optimism about the firm’s growth prospects.

A similar relationship obtains for the overall market. The more optimistic the market’s view of the economy’s growth prospects, the higher the major market indexes’ PE ratios tend to be.

The stock market’s expectations for a particular company may or may not be realistic. If the market overestimates a company’s growth prospects, its stock’s price will be inflated. Once the market realizes its error, the price will decline; perhaps by a lot. Suppose the market initially expects a stock’s earnings to grow at an 11 percent rate with a PE of 50. Now assume that somewhat later the market reevaluates the situation so that it now expects the growth rate to be 8 percent. For the above example, the PE would fall to 12.5, or one-fourth the prior level. Indeed, stock prices can move around quite a bit as the market’s expectations for future growth rates rise and fall.

PE ratios are also affected by both market interest rates and risk levels

Recall that the dividend discount model’s denominator is the difference (rg) where r is the appropriate market-determined discount rate and g is the market’s expected long-term growth rate. For a given payout ratio, the smaller the difference, the higher the PE ratio. That difference (rg) will be affected by changes in either r or g. We have already explored the impact of g (the growth rate) on the PE ratio. Now consider the PE ratio impact of r (the discount rate). As r increases, so does the denominator (rg). An increase in (rg) lowers the value of the fraction, payout/(rg), which in turn is equal to PE. Thus the higher the discount rate, r, the lower the PE, holding the other variables (g and payout) constant. But what determines the value of r?

The discount rate, r, can be decomposed into two parts, the risk-free rate (RFR), and the appropriate risk premium (RP): r = RFR + RP. That is, when the market, through the interplay of supply and demand, establishes a market price, it implicitly assigns that investment a discount rate to be applied to its expected income stream. This discount rate is the sum of the economy-wide rate for risk-less investments and an additional increment that reflects the risk level of the individual investment.

The market views government bonds as essentially being devoid of risk. Accordingly, the yields on these bonds should provide a rather reliable proxy for the risk-free rate. At any particular point in time, this market-determined risk-free rate is the same for all investments. Changes in the risk-free rate will affect the overall level of security market prices. The risk premium, in contrast, will vary from asset to asset depending upon the risk of the particular investment. Low-risk investments (e.g., high-grade corporate bonds) will have lower-risk premiums than high-risk investments (e.g., speculative bonds).

Changes in the market’s view of an individual investment’s risk will influence its price. If the market believes that a stock has become more (less) risky, its discount rate (r) will go up (down) and its price will fall (rise), other things being equal. That is, as the risk premium (RP) changes, so will r, and in turn so will (rg), which in turn changes the fraction, payout/(rg) = PE.

Thus we see from the prior discussion that individual stock values depend crucially on two factors:

1.The market’s expectations for its future long-term growth rate.

2.The market’s view of its risk.

Any attempt to uncover securities on which the market has placed an inaccurate value needs to take careful account of these two key factors: expected growth and risk. Stock values tend to rise with their expected growth rates and fall as their risk increases.

Another important ratio for stock analysts is the dividend yield. Value investors focus on dividends as an important indicator of intrinsic value

The payout ratio (the ratio of dividends to earnings per share) is the third independent variable in the dividend discount model (PE is a function of r, g, and payout). Most investors, however, prefer to work with a different dividend ratio when it comes to exploring the relationship between dividends and stock prices. A stock’s dividend yield is its current indicated annual dividend rate divided by its price per share. If a stock selling for $20 pays an annual dividend of $1, its current yield is 5 percent (1/20 = .05). A stock’s dividend yield is one part of what is called its total return. The total return earned on a stock investment reflects the impact of both dividends and any appreciation in its price. Thus the total return is the sum of the dividend and price appreciation (which can be either positive or negative):

Total Return = (Dividend / Price) + (ΔPrice / Price)

where: ΔPrice = change in price

If the $20 stock with a 5 percent dividend yield also experienced a price rise of $2 over the year, its return from price appreciation would equal 10 percent and its total return would be:

1/20 + 2/20 = 5% + 10% = 15%

Dividends are an important source of investment income. For many stocks, the dividend yield is a large part of its total return. Furthermore, the dividend tends to be a more reliable form of return than the other total return component, the price appreciation. The price increase that the investor anticipated often does not occur, or if it does, the price rise takes place in fits and starts. Indeed, stock prices can, and all too often do, go down as well as up. To earn that part of the return that takes the form of dividends, in contrast, requires only that the firm continue to make the payment.

A company that has begun to pay a dividend on a regular basis is likely to continue to do so as long as the payments can afford to be made. Similarly, once a dividend has been increased to a given level, managers generally prefer to maintain the new higher rate rather than reduce it. The market generally views reducing or eliminating the dividend rate as evidence of a problem at the firm and a failure on the part of management. The firm’s managers would much prefer to be able to increase their company’s dividend rate from time to time. A rising dividend rate is generally viewed by the market as a sign of progress and tends to enhance the firm’s stock price.

Clearly the managers’ desire is to maintain their firm’s dividend rate at least at its current level. Still, no law prevents managers from reducing or eliminating their firm’s dividends. Unlike the coupon rate on a bond, paying a dividend is completely within the discretion of the firm’s board of directors. If the board does not believe that the firm can afford to pay the dividend, or if it believes that the firm has better uses for the funds, the board has every legal right not to declare and thus not to pay a dividend. Unlike interest payments on debt, dividend payments are totally discretionary.

Many companies choose not to pay dividends. They may hope to pay them someday, but do not pay dividends currently. Such companies are generally either plowing all of their earnings back into the company in an effort to grow rapidly or are not generating sufficient free cash flow to afford to pay a dividend. Dividends require cash, which is often a scarce commodity, even for profitable firms. Don’t ever confuse profitability with liquidity. A firm can report high profits but, because its funds are being used to finance a rapid rate of growth, can be very short on cash. A firm that grows rapidly generally consumes more cash than it generates. It must then raise additional capital in order to help fund its growth. Such a firm has no available cash to pay dividends.

Tax considerations also enter into the determination of a firm’s dividend policy. If a company’s earnings grow, its stock price is likely to rise. The income produced by that stock price increase will be taxable only if and when the shareholder sells his or her shares. Dividends, in contrast, become taxable upon receipt. Investors cannot avoid incurring the tax liability on any of the dividends that they receive even if they reinvest the payments in the dividend-paying company’s own stock. Accordingly, investment income in the form of dividends may be somewhat less attractive to some investors (especially those in high tax brackets) than income in the form of unrealized price appreciation. Such investors tend to prefer to invest in firms that plow their profits into growth-producing projects rather than pay them out as dividends. Other investors prefer the cash income. They may look to those dividend checks as a supplement to their other sources of income. They gravitate toward firms that pay generous dividends because they prefer current income over an equivalent amount of potential price appreciation. The higher (lower) your marginal tax rate and the lower (higher) your need for current cash income, the less (more) attractive dividends will be for you. One of your important strategic decisions as an investor is to determine your preference for current income. If you opt for high-dividend-paying stocks and bonds with attractive yields, you will receive a substantial percentage of your return in the form of current income. That current income has the advantage of being immediately available for spending, but it also has the disadvantage of being taxed upon its receipt.

Avoid (or sell) stocks of companies that engage in reverse splits

A split is a transaction in which the company alters the number of its outstanding shares without buying or selling any of its stock or altering the relative holdings of any shareholder. The act of splitting its shares has no impact on the company’s assets, liabilities, or income level. In a stock split, the number of shares held by each shareholder changes proportionately. No one ends up with a greater or lesser ownership percentage of the company as a result of a split.

A split can be designed either to increase or decrease the number of shares outstanding. The vast majority of splits are forward splits in which the number of shares outstanding is increased. A two-for-one split, for example, doubles the number of everyone’s shareholdings. Someone who owned 100 shares before the split now owns 200 shares. After the split, every shareholder has twice as many shares as before. The value-producing fundamentals of the overall company (payout ratio, growth potential risk, and appropriate discount rate) have not been changed by the increase in the number of shares outstanding. Accordingly, the post-split market price of the stock will typically fall to about half its pre-split level (thereby maintaining a constant market value for the company). The overall market value of a company’s equity (over and above its outstanding debt) is equal to the product of the per-share price of its stock and the number of shares outstanding. With twice as many shares at half the price, the market value is unchanged.

Companies that split their shares generally do so in order to move their stock’s per-share price into what they believe to be a more desirable price range. For example, many investors are likely to view a stock trading at $200 a share as, in some sense, too expensive. They would rather own 100 shares of a $40 stock ($4,000 worth of stock) than 20 shares of a $200 stock (also $4,000 worth of stock). Such investors may think that a $40 stock can more easily double to $80 than a $200 stock can double to $400. Accordingly, managers of a company with a $200 stock may be troubled with its high absolute price level. They may wish to take some action that will lower their company’s stock price while maintaining the company’s overall value. Splitting this $200 stock five-for-one will reduce the per share price to around $40 ($5 x $40 = $200). Such a level may seem more appealing to the investment community.

This theory that a stock’s price needs to be in the proper range to be fully appreciated by the investing public has not been supported by those financial economists who have studied the matter. Stock prices are largely determined by the firm’s profit performance and growth potential. The number of its outstanding shares plays little or no role (other than scaling). Nonetheless, managers who make decisions about splitting their companies’ shares do appear to believe that moving the stock price into the desirable range enhances its marketability and thus its price.

Forward splits are usually preceded by a price rise in the relevant stock. Over a period of time the stock’s price may have increased from $15 to $50 and then to $90. As a result of this price increase, the stock has risen out of the range that the managers prefer. A three-for-one split would put the price of this $90 stock back to around $30. Such a forward split is designed to reduce the stock price to a level that is thought to be more attractive to investors.

The stock market has tended to rise along with the growth of the economy and the resulting increase in corporate profits. Most individual stock prices also tend to go up, at least in the long run. Thus individual stocks are much more likely to be rising above than falling below the desirable price range. As a result, most stock splits are forward splits designed to reduce the price per share by increasing the number of shares outstanding.

Stock prices can go down as well as up. Sometimes a stock’s price falls so low that the company wishes to take some action to move it to a higher level. Perhaps a stock that had been trading for $15 falls to $5 and then to $1. This kind of dramatic price decline is likely to result if the company incurs a series of substantial losses, causing the market to sour on its prospects. At a price of $1 per share, the stock is referred to as a low-priced or penny stock. Low-priced stocks are generally viewed by the market as speculative and of low quality. Indeed, most brokerage firms will not allow stocks with prices below $3 per share to be used as margin collateral. Some have a $5-per-share marginability threshold. Stocks whose prices drop so low that they are no longer marginable tend to be less attractive to investors than those that remain marginable. Indeed, stocks that fall below the marginability threshold may trigger margin calls, putting further selling pressure on their price.

If the firm, whose stock sells for a low per share price, could increase its earnings and/or its dividend rate, that improvement in fundamental performance would probably lead to a higher price for its stock. Such an attempt to improve performance is difficult to implement, takes time, and often does not succeed. Accordingly, the firm’s manager may choose to undertake a reverse split in order to move the stock’s price up more quickly. A company having a stock trading for $1 that then engages in a twenty-for-one reverse split would hope to see its shares’ price rise to about $20.

Neither forward splits nor reverse splits create or destroy any underlying company value. A company’s total market value is based on its assets, earnings, cash flow, risk level, growth prospects, and other factors, not on the number of shares outstanding. And yet, as a general rule, stocks that forward split tend to rise in price after they split, and those that undertake reverse splits tend to fall. The companies that engage in reverse splits are thought to be signaling to the marketplace (unintentionally) that they do not have confidence in their ability to move the price up the old-fashioned way: by earning it. Those firms that forward split, in contrast, are signaling their confidence in the future growth prospects of the company.

Analysts’ forecasts and recommendations are not what they seem. Read them with a very skeptical eye

Most investment analysts are intelligent, well-trained, highly paid experts. They generally specialize in the stocks of companies in a particular industry, have access to senior managers in the companies that they follow, and often have particularized knowledge of their chosen industry’s technology. If any outsiders working with publicly available information should be able to understand the companies and industry that they cover, investment analysts should. Does this mean that when an investment analyst (or even a group of investment analysts) recommends buying a particular stock, it is an attractive investment? Not necessarily, and indeed, not in general.

First of all, investment analysts’ recommendations tend to be positively based. The vast majority of their recommendations are to ‘‘buy.’’ Analysts rarely recommend a sale. Short sale recommendations are even rarer. At least two factors help account for analysts’ reluctance to issue negative opinions on their list of companies. First, the analysts need to maintain cordial relations with the companies that they follow in order to maintain continuing access to knowledgeable insiders. Hard-hitting negative reports are likely to close those doors. Second, investment banks for whom the analysts work may be seeking business from the same companies that their analysts cover. Thus their employers will not want their analysts’ recommendations to harm their own business prospects. Recent reform efforts are designed to remove this conflict of interest. Time will tell whether these reform efforts will be successful. In any case, most analyst write-ups are heavily biased in favor of buy recommendations. Indeed, anything less than a strong buy should be taken as a negative. An analyst who issues a neutral, weak buy, hold, or even accumulate on weakness recommendation should be viewed as issuing a disguised sell recommendation.

Do the biases and other problems present in many analysts’ reports mean that you should ignore what they say? No. Such reports often contain useful information and insights. While the actual recommendation to buy, hold, or sell should be largely ignored (particularly if it is a buy recommendation), the totality of the report should be read and digested. Often the body of the report will reveal much more of what the analyst really thinks than is contained in the buy-hold-sell recommendation. Moreover, analysts in the aggregate tend to reflect the market’s overall wisdom vis-a`-vis the stocks that they cover. Accordingly, their views provide the investor with useful benchmark information on the market’s consensus view of a particular stock. A buy decision on your part indicates that you tend to believe that the stock is undervalued by the market, and a sell decision reflects the opposite view. So you should buy (sell) a stock if you are even more (less) optimistic than the consensus view of the analysts.

If senior managers are selling their company’s stock, you should probably avoid the stock or sell your own shares if you have any. If the senior managers are net buyers, that is a plus for the stock. You may want to buy it

Trading on material, nonpublic information is illegal. When insiders such as senior executives or members of the board of directors buy or sell stock in their own company, they are not generally doing so because of any specific inside information. They are no more likely to want to risk being sent to prison for violating the law than you or I. Rather, when insiders are net buyers (sellers) of their own company’s stock, it is frequently because they believe that things are (or are not) going well for their company. At other times they may be selling because they wish to diversify or need money for personal reasons. While far from a perfect forecaster, the buy/sell decisions of insiders do offer useful signals. If the insiders expect their company to have a bright future, they are more likely to be buying. If they view the company’s prospects as bleak, the insiders are more likely to be selling. These insider trades must be reported to the SEC, which then makes information on their trading publicly available.

If senior managers have a large stake in a company, it may enhance the investment’s attractiveness

One way that managers signal their degree of confidence in the company that they manage is by their investment portfolio decisions. When senior managers own a large and growing stake in the company for whom they work, that level of manager ownership suggests that the company’s prospects are attractive. The managers of such companies will share in its success and therefore have strong incentives to produce positive performance. If their holdings are small, their incentive to produce favorable performance for the shareholders may not be as great.

Similarly, the degree to which the managers take advantage of their positions to have themselves awarded high pay and executive perks is a useful indicator of how diligently they are working for the shareholders as opposed to how much they are doing to feather their own nests. The more out of line (on the high side) the executive compensation is, the less likely is the company to produce favorable performance for its shareholders. As an example, both Bill Gates, of Microsoft, and Warren Buffett, of Berkshire Hathaway, take very small salaries for themselves. Because of their large ownership positions in the companies that they manage, they have profited handsomely from their companies’ success. These two gentlemen just happen to be the two richest people in the United States.

A large manager stake in a company can help align shareholders’ and managers’ interests. A very large manager stake, however, often has a downside. A manager who owns a controlling interest (either individually or via a family group) may treat the company as if it is his or her own private firm (fiefdom). Such an attitude may impact dividend policy, reactions to takeover offers, decisions to retain unprofitable business units, the hiring of relatives, and so on. Such an ownership structure often works to the detriment of minority shareholders. Be wary of a company whose management owns a controlling interest in the firm. Such a company may be run for the benefit of the insiders rather than its public shareholders. A particularly egregious situation arises when the corporate structure allows the control group to retain a large percentage of the company’s voting power with a relatively small percentage of stock ownership. This structure may be accomplished via special super voting rights shares. For example, super shares may be allocated ten votes compared to one vote for regular shares. Realize that such a structure permits the control group to run the company more or less as it wishes. Also be wary of companies that award inordinate amounts of stock options to their senior executives.

Modest amounts of such options help align shareholder and manager interests. Large awards tend to dilute the non-manager shareholders’ ownership. Managers of well-run companies deserve to be rewarded for effective management, but there are limits.

Avoid collectibles as an investment, unless you are already an expert in the area

Baseball cards, Beanie Babies, Cabbage Patch Kids dolls, and many other items (stamps, coins, antiques, antique and classic automobiles, etc.) have become collectibles. Such items may experience dramatic price increases when they are hot. Just about the time that the fad is beginning to lose steam, novice investors may be enticed into the market. Having seen prices double annually for each of the last several years, they may become involved, thinking that they have found the key to great wealth.

True, some collectibles do have a long history with significant periods of major price increases (paintings by old masters). In other cases, the fad dies back as quickly as it started (Cabbage Patch Kids dolls and Beanie Babies). As with the securities market, the past price history for a particular type of collectible provides little or no guidance to its future. Even well-established collectibles (coins, stamps, etc.) have a number of major drawbacks that limit their appeal as investments.

First, collectibles largely trade in a high markup dealer market. When you buy and sell stocks, bonds, mutual funds, options, and the like, you usually trade through a broker who earns a commission. That is, you are actually buying from the seller or selling to the buyer with the broker facilitating the transaction. The total impact of commissions and bid-ask spreads is, typically, no more than a few percentage points and often less than 1 percent of the asset’s market value. With collectibles, which tend to be relatively unusual, one-of-a-kind items, you would generally buy from a dealer. Similarly, when you wished to sell part or all of your collection, you would be likely to sell to a dealer. Dealers constitute a very large part of the collectibles marketplace.

Such dealers need to make enough money from their buying and selling of collectibles to be able to cover all of the costs associated with maintaining their store or other selling facility. In particular they need to be able to earn a return on the substantial sum of money that they have tied up in inventory. What he or she buys from you may sit on the shelves for months, or even years, before it is sold to another collector. These dealers will generally try to pay as little as they can get away with for what they buy. Indeed, many dealers make a substantial percentage of their profits by buying cheaply from uninformed sellers and quickly reselling to another dealer at a higher price. The dealer who buys may already have a collector lined up at a still higher price.

For collectibles, the difference between what a dealer will sell an item for and what he or she will pay for it can easily be 20, 30, or even 50 percent of the retail selling price. Most dealers will charge what the market will bear when they sell.

To top it off, you will often have to pay sales tax on the purchase. This high markup represents a steep barrier to overcome for those who invest in collectibles. You may sometimes be able to reduce or even eliminate the markup by buying and selling at auctions, over the Internet, or directly with other investor/collectors at club meetings. Nonetheless, the average markup on your acquisitions will still tend to be high compared to the costs of buying and selling securities. As a result, the item that you purchase may need to appreciate by 20 to 50 percent before the dealer will buy it back for what you paid for it. It will need to appreciate even more if you are to earn a profit. That is a heavy burden for any investment.

Second, the value of most collectibles is very sensitive to the item’s condition. A collectible item in like-new condition is worth much more than an otherwise identical item that has been well worn through heavy use. With coins for example, an un-circulated (shiny, no wear) particular coin is usually worth many (maybe hundreds of) times what a well-worn twin will bring in. This reality has several implications. Collectibles must be carefully maintained if they are to retain their original-condition value. You should never use what you collect for its original intended purpose. Quilts or oriental rugs that are used and soiled in the process will lose much of their collector appeal.

Similarly, baseball cards that have become bent or soiled through mishandling are worth much less than those in pristine condition. Subtle differences in quality/condition can have a large impact on value. When buying an item, the dealer may assure you that the quality is high. When the dealer (sometimes the same dealer) is offering to buy it back from you, you may be told that the quality is appreciably lower. A large difference in value is at stake. Clearly, you need to be able to judge an item’s condition yourself rather than rely upon what the self-interested dealer tells you. A high level of expertise is needed in order to judge a collectible’s quality/condition reliably. Books are written on the subject. In some areas (e.g., coins), grading services have arisen to provide a certification-of-condition service. Evaluation of a collectible’s condition is, however, inherently subjective.

Third, many collectibles are relatively easy to counterfeit. Such counterfeits are generally a simple matter for experts to detect. But they may not be so obvious for novice investors. Counterfeits are particularly likely to appear when the market price is high relative to production costs and where copies are easy to make. So, for example, a rare and valuable baseball card can be copied with a color printer and then, with a bit of cardboard, a stack of counterfeited copies can easily be turned out. The counterfeit won’t mislead an expert, but it may well fool a novice. Similarly, the date on a coin such as 1944 can easily be altered to 1914 with a tiny grinding wheel. A 1944 D penny is common, while the 1914 D is rare. The ‘‘D’’ indicates that the coin was made in the Denver mint.

Fourth, collectibles tend to be subject to fads. These fads often grow into speculative bubbles and then end quickly and without warning. Once the fad has past, selling such collectibles for anything close to what you paid is difficult at best. The hobby (such as Beanie Babies) will continue to exist, but with a much lower level of popularity.

Fifth, collectibles do not produce any cash income (dividends, interest, rent, etc.). The only profit that can be derived from an investment program in collectibles must come from price increases (if any). Collectors derive enjoyment from having, adding to, and on occasion completing their collection. Investors, who are likely to be involved purely for the hoped-for profit, are much less likely to derive a similar benefit.

Sixth, while the supply of any specific collectible is generally fixed, the supply of similar items is not. So, for example, the supply of baseballs signed by Babe Ruth is limited to the number that he signed during his lifetime. The potential number of baseballs signed by home run champions is, in contrast, unlimited. Any type of collectible that becomes popular is likely to experience a growing supply of similar items made available to collectors. As more and more merchandise hits the market, the pressure on the prices of existing items increases. The Franklin Mint and similar concerns are known for producing just as many manufactured collectibles as the market will absorb. A growing supply is the enemy of scarcity and rising prices.

Seventh, collectibles require a certain amount of maintaining. Specifically, they must be stored and should be insured (fire, theft). Collectibles take up space. A large collection (e.g., antique automobiles) may take up a lot of space. Some types of collectibles, such as stamps and first editions of books, need to be stored not only in a safe place but under the proper climate conditions. Too much heat or humidity can be destructive. Since collectibles are often valuable, they may need to be stored in a secure place such as a safe or safe deposit box. Insurance for valuable collectibles is available but costly.

None of the above implies that you can’t make money investing in collectibles. If you discover an old attic filled with a treasure trove of nineteenth-century campaign buttons, you have found something of considerable value.

Similarly, if you have been a collector of English porcelains for the past thirty years and really know your subject, you could make some money buying from those who are less knowledgeable. You may occasionally find a valuable piece available for a song at a flea market or garage sale. But, if you are a novice entering a particular collectible area as an investor, the odds are very much against you.

If you really do want to invest in a collectibles area, begin by becoming a true collector. Learn the hobby and come to appreciate it on a small scale with a commitment of no more than a modest amount of your funds. You should continue as just a collector for a number of months, or preferably years. Join a club and read some books about your new hobby. Then and only then will you be positioned to try to make money as an investor. Before actually investing any serious money in collectibles, try your hand at selling some of your existing collection. This effort should provide a reality check on your ability to exit the market.

Drawbacks To Investing in Collectibles

  1. High markups (20, 30, 50 percent, or even more)
  2. Condition, condition, condition (huge value impact)
  3. Counterfeits (all too easy to make)
  4. Fads/bubbles/busts (frequent, unexpected)
  5. No cash income production (only potential price appreciation)
  6. Expanding supply (manufactured collectibles)
  7. Storage and insurance costs

Unless you have extensive expertise in the area, avoid tangible and other offbeat investments.

A good rule for all types of investors is never to invest in something you don’t understand. With nonstandard investments, the rule should be don’t ever invest unless you really understand the area extremely well.

Tangible investments include such items as gemstones, precious and strategic metals, raw whiskey, wines, and spirits. Much of what has already been said about collectibles applies to the market for tangibles: Markups tend to be very high (precious metals are an exception), no cash income is produced, the market can be faddish (blowing hot and cold), and dealers in the market are generally much more interested in selling than buying (unless they are able to buy very cheaply from an uninformed seller).

Consider diamonds as an example. Diamonds are beautiful stones with undeniable intrinsic value. Diamond prices have tended to rise over long periods of time. But the markup from start to finish is huge. Take a nice diamond ring that a jeweler would sell for $1,000 (after a 50% discount from the so-called appraised value) to a pawnshop and see just what you can get for it. You would be lucky to be offered $100. Then use a jeweler’s loop to examine stones of various quality. How good are you at determining the three C’s: clarity, cut, and color? A nice clean, white stone is worth many times the value of a slightly colored one with a modest number of carbon spots that are visible only under high magnification. Could you trust yourself to tell the difference?

Realize that the market for each of these tangible investments is largely composed of people who earn their living by doing business in the area. Those on both the buy and sell side of this market generally have years of experience and a great deal of their own money at stake. If such dealers are willing to sell some tangible asset to you for a price of X, they probably do not expect to have to pay you or someone else significantly more next year to replace it.

Rather, they are selling to you for X what they can buy now for enough-less-than-X to make the sale worth their while. Moreover, if they thought the price was likely to rise dramatically in the next few months or years, they would probably be stockpiling the item in order to capture the anticipated profit for themselves.

Investing in non-tangible, offbeat assets such as vacation time-shares, copyrights, Lloyds guarantees, Broadway shows, minor league sports teams, and so forth is even more fraught with danger for the unwary. Clearly, less experienced investors should generally avoid such potential investments.

Avoid the stocks of hot IPOs in the immediate aftermarket. Their prices very often come down substantially, once reality sets in

When what had been a private company first sells stock into the public market, the sale process is called an IPO (initial public offering). The market for IPOs blows hot and cold. When it is hot (such as in the late 1990s), stocks with an exciting story (e.g., dot.com stocks) tend to rise dramatically on the day that the company goes public. Some stock prices double or even triple on the day of issue. In a few cases these price run-ups may be justified. Most of the time, however, the investment bank that assembles and brings the deal to market has already realistically assessed the pros and cons of the new company’s market value. The investment bank/underwriter may want to price the new issue a bit on the low side in order to facilitate the sale. Neither they nor the company going public have an incentive to leave huge amounts of money on the table. The investment banker’s fee is based on the amount of money raised. The greater the sale proceeds, the greater the underwriting fee. Why should a company that is offered to the market at $12 a share trade up to $30 on the first day? If it was really worth $30, why wasn’t it priced in that range to begin with? Who has a better idea of the new company’s value? The speculators who bid the price up in the post-IPO aftermarket, or the underwriter who, after extensive due diligence, brought the issue to market in the first place? The investment bankers who put a price on the issue do so only after a careful analysis of its risks and potential. Bringing new companies to market is a significant part of the investment banking business. Investment banks are generally staffed by experienced professionals. These experienced professionals can usually be expected to do a creditable job.

While investment bankers do have some expertise in bringing companies public, they can and do make mistakes. The new company could be worth more than the underwriters project. But, it could also be worth less. The underwriter’s valuation is probably just about as likely to be too high as it is to be too low. If the initial valuations of these investment bankers were consistently too low, they would not be able to stay in business. Companies planning to go public would surely seek to avoid those investment banks that acquired a reputation for bringing their clients to market too cheaply.

Usually after these large post-offer price run-ups, the newly public company begins to report results that don’t live up to the expectations of those who initially bid up the price. As reality sets in, the company’s market price tends to fall back to, and often below, the original issue level. If you acquired your shares at the high aftermarket prices, you would have gotten burned. Accordingly, one should avoid these kinds of markets.

If making money by purchasing these hot IPOs in the immediate post-issue market is likely to prove costly, perhaps selling these hot stocks short may appear to be more appealing. The problem with such a strategy is one of timing and the potential for bad luck. Overpriced stocks can, and often do, take time before they come to ground. The short seller can get badly whipsawed as an overpriced stock is speculated to ever-higher levels of irrational exuberance. Moreover, a percentage of these speculative issues will turn out to be real winners on fundamental grounds.

Take an eclectic approach to investing

Many different forces move the stock and bond markets. These market-moving forces can influence a wide variety of topics. Investors who wish to understand how these various matters impact the financial markets will find some degree of expertise in a variety of disciplines to be helpful. The following list is by no means all-inclusive:

Finance: Investors need some knowledge of interest rates, compound value, present value, leveraging, valuation theory, portfolio theory, risk analysis, market microstructure, and many other finance concepts.

Economics: Economic (monetary and fiscal) policy, the theory of the firm, scale economies, competition and monopoly, and many other economic concepts are relevant to many investment decisions.

Political Science: Economic policy is made in an inherently political environment. Changes in fiscal policy generally require congressional action. The Federal Reserve’s implementation of monetary policy is also subject to political forces. Similarly, trade, antitrust, regulatory, environmental, labor, and other areas of governmental policies are subject to many and various political pressures.

Law: Legal issues subject to judicial action often impact investment valuations. Commercial, antitrust, bank, environmental, securities, bankruptcy, labor, pension, regulatory, and various other types of law often influence investment values.

Accounting: Balance sheets, income statements, and statements of cash flow are all key financial statements designed to provide information on the economic position and performance of companies. The accounting process that results in the production of key numbers such as earnings per share contains much discretion and subjectivity. Understanding the process can help uncover misstatements that often arise as a result of overly optimistic (or pessimistic) choices.

Demography: The greatest generation, baby boom generation, generation X, generation Y, and so on tend to have differing needs, tastes, and preferences. An understanding of how demographic trends will lead to changes in the market for various goods and services (three-wheel bicycles versus video games, for example) can help identify growth and non-growth opportunities.

Psychology: Market and investor psychology have an undeniable impact on investment performance. An understanding of one’s own psychological makeup can, for example, help avoid some common errors of investing.

Science and Technology: In this age of high tech, nanotechnology, high-energy physics, cyberspace, and so forth, knowledge of basic and applied science can be very helpful in understanding the economic positions of many types of firms.

Meteorology and Climatology: Many industries such as insurance, petroleum, construction, and agriculture are sensitive to weather and related impacts (floods, earthquakes, volcanoes, tidal waves, etc.).


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