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Basic Concepts
P/E Ratio
The most common metric for valuing a stock. The current price of the stock is divided by the prior four quarters of earnings. For future stock price valuation the projected 4 quarters of earnings are used. Stock prices are determined by two things; earnings and expectations of earnings. The higher the earnings or expectations of earnings, the higher the P/E ratio. The same metric is used for stock indices like the Dow Jones Industrial Average (DOW) or the Standard and Poor’s 500 (S&P). The combined prices of all the stocks in an index is divided by the combined earnings. This is a key long term indicator of valuation when seen in its historical range within the context of the current and future economic picture.
Mutual Funds - (for simplicity, only open ended funds are discussed here)
In simple terms, a mutual fund is a collection of many investors’ money, managed by an organization for the purpose of making money. The funds are usually invested into specific types of assets, according to specific objectives and limits as listed in a prospectus.
More specifically, a mutual fund is a sponsored entity intended to receive and combine the assets of many investors and be managed according to specific limitations, style, financial instruments, and objectives called out in a prospectus. The fund must have all of the purposes, risks, costs, etc. included in the prospectus for full disclosure. The advantage of having these specifics is to provide the investor legal protection and the ability to isolate and segregate assets to a specific set of risks. The disadvantage is that the investment style may be subject to prolonged under performance over years. The sponsors of funds ideally prefer investors to keep investments in the fund for long periods ( the Buy and Hold philosophy which will be covered soon). Fortunately, in most cases the investor can move their assets at any time for any reason.
Net Asset Value (NAV)
The sum of all assets in the fund. As in stocks, each mutual fund has a 5 character ticker symbol. Pricing is done at the end of the day after all the assts have a final price. The Net Asset Value of the fund is then calculated and usually available a couple of hours after the market is closed. Any trades, switches, exchanges, etc, are done after that value has been determined. In volatile markets, it is important to determine if the market is up or down significantly before the end of the day before making any exchanges or redemptions as the net effect may be significant.
Asset Allocation
In simple terms, asset allocation means dividing your money into groups of assets that react differently to diverse market factors. Asset allocation is also referred to as diversification. This helps to reduce volatility at the cost of a faster long-term growth rate. It provides advisors and employers legal protection and is the most misused approach by the majority of individual investors. Let’s face reality here. The simple truth is that volatility, greed, and emotion do not mix well for the average investor. Throw in the lack of knowledge and experience and you have someone that will separate himself from his own money and then blame everyone else for his bad luck. Thus, everyone is regularly advised to diversify their portfolio.
Asset Classes
Assets are divided into classes in order to define and isolate their characteristics. The classes are determined by the combination of general category, focus, and investment style. Analysts, investors, and the rest of the industry can then more accurately manage investment risk by choosing the asset class to work with. The number of asset classes is in excess of 50 and keeps growing as the industry develops more investment instruments. Asset classes can include but are not limited to real estate, CD’s, money market funds, stocks, bonds, and mutual funds that invest in any number of things.
Investment Styles
Mutual funds are generally categorized into stock, bond or a blend of both. Stock funds can specialize in purchasing of large, medium, or small companies with either Value or Growth characteristics. The Value style looks for under priced, out of favor companies to invest in while the Growth style looks for companies that have extraordinary earnings growth prospects.
Bond funds have a large universe of bonds to pick from. The quality can be very high AAA rated to junk bonds. Their maturities can be very short to many years long.
Each fund has a graphic representation for investors to quickly recognize its’ characteristics and most mutual fund rating companies use it.
Asset Correlation
Asset classes can react to market events similarly or differently. If they are similar they are said to be highly correlated. If they react differently, they are non-correlated. An investor is diversified or has an Asset Allocation that has asset classes that are non-correlated to reduce volatility and risk over the long term.
Risk Tolerance - (or sensitivity to market downtrends)
In simple terms, the point at which your emotional reactions to changes in the value of your portfolio cause you worry.
The first thing that you must recognize and understand is that the stock market is always fluctuating and that you cannot get swept up in the daily movements. It is these market fluctuations that provide the opportunities to grow investments faster. A novice investor’s first reactions to market declines is to move their money into something safe like a money market fund. This is exactly the opposite of what you should do. If your investments are moved into money market funds when the market is down, in general, you have no chance of growth when the market recovers. When the market is going up investors tend to get caught up in the euphoria, get greedy, fail to recognize the increasing risk, and lose their objectivity. You have a higher probability of your investments losing value after market increases. This is where the strategic fund switching guidance helps you to understand what is moving markets, the risks and better courses of action than inaction.
A very simple test of your risk tolerance is if you are not sleeping at night worrying about your money. You either need to get more confidence about what you are doing, get a better understanding of the risks, or stop subjecting yourself to the amount of risk you are exposing yourself to. I believe that as you pay more attention to your investments and follow my market opinions by reading my blog, your understanding of the risks will improve and so will your risk tolerance.
Long Term Investing (or Buy and Hold) - I love this one.
The first and biggest question is why. The answer depends on who is asking. If you are an “Old Money” family, then you might have a controlling interest in the family business and you want to maintain influence and control. If you are a mutual fund company, you want to keep your funds volatility and turnover costs low and fees constant. If you are an investor in stocks/equities you want the expected higher returns. Everyone is aware that stocks/equities go up and down. The markets have proven over the long term to always go up with some volatility in the short term. But, successful investing is buying low and selling high. We know this! So why are we told to Buy and Hold? Because, individual investors are the least capable of knowing when to buy or sell and will usually do it at the wrong time. The assumption is if you expand the time frame to long term, individuals will be more successful.
Retirement plans are by definition long term. Your purchases are on a regular basis over a long period. They are made when the markets are up and down. In this way, your average cost is lower (Dollar Cost Averaging) and theoretically, when you retire your investments hopefully have grown along with the overall stock market.
Long term investing is a vestige of Post World War II when the markets didn’t move to fast, transaction costs were regulated, and advances in technology had yet to arrive. Now we experience short market fluctuations significant enough to cause us to worry and react by making investment changes after the fact which is worse than ignoring the portfolio altogether resulting in no changes.
Understand that long term investing is a concept solely related to the goals of the investor. If one already has significant wealth, then growth may not be the primary goal. It may be capital preservation. Long term investing might then entail individual bonds with a set return of your capital and steady dividends. Of course even then, if the risk of yields increasing begins to jeopardize the principal, then preservation of capital would entail liquidating those bonds as Warren Buffett did in October of 2008. If one is trying to accumulate wealth, then investing in stocks or equities over many years is necessary. But, (and this is where the confusion begins) that doesn’t mean that one must stay in stocks/equities continuously (Buy and Hold).
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