Before entering the world of investing, it is important to
honestly analyze your present situation. Doing so will allow you
to effectively manage your own money in a way which maximizes
returns while limiting unwanted risk. Questions to consider
include:
What is my investment goal? How much time do I have to attain
this goal?
Methods of saving for a down payment on a house differ greatly
from saving for retirement. The reason for this lies in the
factoring of time. Over short periods of a few years, individual
companies and the stock market as a whole can experience
dramatic fluctuations which in no way represent longer-term
trends. Because of this possibility, a smaller percentage of
your portfolio should be allocated into stocks as the time for
cashing in your investments draws near. Conversely, the longer
the time period you have to invest, the more aggressive your
portfolio should seek higher returns.
How much do I initially have to invest? How much can I afford to
consistently add later?
Einstein described compounding as "The Eighth Wonder of the
World" and for good reason. Being able to earn interest on your
interest allows investments to increase exponentially faster
than with simple interest. A one-time investment of $5000
earning 10% interest compounds to a total of over $54,000 after
25 years. Using simple interest, it would take over 95 years to
reach the same amount. Naturally, the larger your initial
investment and the more you can afford to add later on, the more
you can expect to gain in returns.
Am I carrying any high-interest debt, such as on a credit card?
Before saving for future events, you should consider your
present finances. Paying off any high-interest loans function as
an "automatic" return. Writing a check to Visa to pay down your
debt may not feel as satisfying as starting a nest egg, but by
eliminating those 22% interest payments, you have effectively
"made" a 22% return. Although you need not completely eliminate
your debts, getting such payments into a reasonable area should
be a more pressing priority. This fiscal reckoning is also a
good time to examine budgeting and expenditures. Look for
unneeded or overpriced purchases, and consider the feasibility
of paring them down and saving the extra money. Unused gym
memberships, that $5 whipped mocha-hazelnut cappuccino, and
extra cable channels all add up. The true cost of these and all
other purchases involves understanding the "time value of
money", but for now it should suffice to say that $5 added to
the previously mentioned investment account compounding 10% for
25 years turns into $54.17.
What is my risk tolerance? What will my investing style be?
These questions lead us to selecting individual investments.
Consider your investment timetable for when you'll need the
money, recognizing that more conservative selections should be
made the shorter the window. Everyone's risk tolerance is
different; while one person may feel comfortable with small-cap
biotechs another may need a blue chip to feel equally sound.
Analyzing the risk to reward ratio here is a good first step.
The more risk you take on, the more you should expect to get in
return if your investment pays off. The inverse is also true:
the more stable an investment, the less return one should
expect. Government-backed I Bonds pay over 6%, but involve tying
up money for years in order to fully benefit from them. While
this gives you one target, the average return of the broader
market indices is about 11% per year. There are two primary
schools of thought about investing: growth and value.
Growth
Growth investing is a higher-risk strategy which focuses on
finding smaller companies poised to rapidly grow earnings.
Stocks here tend to be micro-caps or small-caps, and the
occasional mid-cap (under $10 billion). In their younger lives,
many of the well-established companies of today found themselves
considered here (Think of Apple Computers (AAPL) or Starbucks
(SBUX)). Growth companies can be found in many different
sectors, although such companies often have similar traits. A
growth company usually has a unique product or service to offer
which can fundamentally change how business is done. When found
early enough in their growth cycles, these companies have the
potential to return enormous profits to investors.
Value
Value plays usually are found in larger companies, although the
strategies used to find them can be applied to smaller
corporations as well. Looking for value stocks is similar to
looking for values in a store: find a good product at a price
below what you would normally expect to pay. These bargains are
often found in the form of companies which have been unfairly
beaten down through overselling. Finding value stocks usually
involves using a discounted cash flow model (DCF) to find a
company's intrinsic value. This is the form of investing
advocated by Benjamin Graham, and popularized by Warren Buffett.
GARP
GARP, or Growth At Reasonable Price, is a combination of the
above forms. As the name implies, the focus is finding growing
companies trading at reasonable prices. Quick measures of this
include the PEG ratio (Price to Earnings to Growth) and Forward
P/E. Although not a specific style, GARP is utilized by many
investors because of its flexibility. The average, diversified
portfolio will have many GARP-type stocks in it.
Once you know your goals, the amount your going to invest, your
relatively debt free and know your risk tolerance it's time to
look at the market and start thinking about selecting stocks.
Getting Started: Learning the Market and Selecting Stocks
If you were going to spend several thousand dollars on a
refrigerator or television, you would thoroughly research the
market for those goods to find the product which best suited
your needs. Investing is no different. Before buying into a
company, you should be well-acquainted enough with it to give a
short presentation. Knowing the basics of how a company
operates, what it sells, how it makes money, how much money it
makes, and what kind of growth the company is expected to
experience are all crucial questions that any investor should be
able to answer.
Developing a better understanding of the stock market is a long,
but hopefully rewarding, process. Immediately investing in
stocks with real money, however, is equivalent to taking a test
without being introduced to the material. Formerly called "paper
trading", beginning investors would normally spend several
months tracking their stock picks without having real money on
them.
Thanks to technology, you can now find sites that automate (for
free) the process of tracking price changes for you on the
internet. Simulated investing is a risk-free way of beginning to
understand market fluctuations and the forces driving them.
Examining these trends will payoff in the future, as an
increased understanding of the stock market can only help you on
your path to building wealth.
Once you become comfortable picking your own stocks, you can
still continue to "paper trade" online, as it offers the
opportunity to explore and experiment with other investing
styles. Gordon Gekko, the famed villain in Wall Street played by
Michael Douglas, said "Information is the most valuable
commodity I know of". Ignoring for a moment that the movie ended
with indictments for insider trading, the statement is true: you
will not regret being an informed and intelligent investor.
The market is constantly changing, but by learning the ropes of
investing you too can pull off a "One Up on Wall Street".
About the author:
Jim Stevenson, AKA: Im Not Warren Buffet, is a staff writer and
can be reached on the message boards of www.eInvesting.com an
Investing forum and Stock Market Simulator.
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