What is an investment plan?

Basically, an investment plan is your plan to achieve a certain financial goal. That is quite obvious, but people tend to forget about goal setting. They say “Who needs planning? I just want to be rich.” This is a straight road to financial hell. If you don’t know what do you want, then you won’t have any guidelines for your actions, and you’ll probably be under emotional stress. Fear and greed are very powerful emotions and they can drive you to the undesired outcomes.

In order to help you, the first thing you will need to know is how much money you can invest. This could be an amount for a week, month, year or some other period of time. If you are in debt, your first step is paying it out. You should, also, consider future investments amount. For example, if you are going to be married and you are the only one that works, it is likely that your investment capability will be lower in the future.

The next step is to resolve how much do you need and when. Using these parameters, you can calculate the return rate of your investments. For example, let’s say that you are going to invest 600$ per year (that’s 50$ per month) and that you want to withdraw 20,000$ after 20 years. This means that your average return rate should be about 4.6% per year, which is not very high rate. In the previous 20 years average return rate of Dow Jones was 10% per year.

Return rate	Net sum after 20 years with yearly addition of 600$	Net sum after 20 years with yearly addition of 900$	Net sum after 20 years with yearly addition of 1200$	Net sum after 20 years with yearly addition of 1800$
3%	16606	24909	33212	49818
4%	18581	27872	37163	55745
5%	20832	31247	41663	62495
6%	23396	35093	46791	70187
7%	26319	39479	52638	78957
8%	29654	44481	59308	88961
9%	33459	50188	66917	100376
10%	37801	56702	75603	113404
11%	42759	64139	85518	128277
12%	48419	72629	96838	145258

You can calculate the resulting amount of money for any yearly addition. Let’s say that you could invest 3000$ per year and that after 20 years and that you would like to have 200,000$. That means that you should have return rate between 10% and 11%. 5 times 600 is equal to the 3000$, 5 times 37801 is equal to the 189005$ and 5 times 42759$ is equal to the 113795$.

This way you can determine required return rate and the types of investment. Also, it can happen that your desire doesn’t match reality. For example, if you wish to invest 600$ per year and you want 100,000$ after 20 years that would mean that you need return rate of around 18% and that is very unlikely to achieve. Therefore, you should lower your expectations or you should increase your yearly addition.

With these parameters, you can find asset allocation that should give you required result with the lowest possible risk. There is a theory that helps you to do this. We will elaborate this in details some other time. Let’s just say that with this you can select assets that should be in your portfolio.

To sum it up, investment plan takes into account your desire and as a result it finds out what kind of assets you should have.

Four mortal sins in investing

Why four mortal sins and not ten? Well, why not? Four is a nice number and if I find the fifth mortal sin, I will certainly inform you about that.

1. Buying on rumors or recommendations
   
   Having hundreds and thousands of opportunity for investing, it is hard to choose the right ones. There is a lot of information floating around, and it is hard to process all data. Therefore, people tend to use shortcuts. For example someone could tell you about marvelous product by XYZ company, and you buy stocks of that company in belief that the price of that company will grow. The net result is usually negative.
   
   Does this mean that I shouldn’t trust anybody? Exactly! The person that recommends you something, or spread the rumor probably would not sign that if you loose money he will cover it.

2. Belief in „money for nothing“
   
   Belief that there is something for nothing is widespread. Why is that so, I wouldn’t know. Analogy in animal world would be that a lion is lying in the shadow of a great tree, and the zebras are throwing themselves before the lion committing suicide. Occasionally you might get lucky, but only occasionally.

3. Not having an investment plan
   
   What is an investment plan? It is your statement about what do you expect and what are you willing to do to achieve that. As with other plans, after a certain period of time you should investigate if there is a need to change it. Usually reduce your expectation and/or increase your activity to achieve the goals.

4. Not following your investment plan
   
   Once you set the plan, it is of absolute necessity to follow your plan. If you react at a certain moment and do something that is not planned your expectation could be unfulfilled. What can you do then? You have no information if this plan works or not because you have changed it. So, you can only start again with less money.
   

But be aware! There are a lot of emotions in investments, and it is very easy to forget about rules. I happened to be the “victim of rumors” a couple of times. The interesting thing about this is that I did know these rules, but forgot them when “excellent opportunity” appeared. Therefore you should practice self discipline as much as possible. That is good for you in other areas in life.

Earnings per share

The simplest form of Earnings per share is calculated like this: Earnings per share = Profit/(Number of shares). As number of shares can differ from period to period, weighted average can be used. For example, if there were 1000 shares outstanding for 3 months and 2000 shares outstanding for 9 months then weighted average of common shares is equal to 0.25x1000 + 0.75x2000 = 1750. If the total profit is 2000$, then Earnings per share would be
EPS = 2000$/1750 = 1.14$. The main idea is to calculate how much profit each share generates. In general, the greater EPS the better. Of course, this parameter alone is not sufficient to compare two companies. Based on the period that we observe we can have Trailing EPS that is based on last years figures, Current EPS that is based on this years figures and projections until the end of the year. The Future EPS is projection entirely.

EPS can be used to compare two companies, but in this model the cost of a share is not taken into account. For example if two shares have the same EPS, but one of them is 100$ and another one is 200$. The first share generates the same profit for less money. Also, average EPS is different for different industries.

This measure of a company's financial health is available from the quarterly 10K reports that publicly traded companies must report. The reports can be found on the Internet: http://www.sec.gov/edgar/searchedgar/webusers.htm.

Cash flow statement

Cash flow statement is a mandatory part of a company's financial reports since 1987. Cash flow statement records the amounts of cash entering and leaving a company. The cash flow statement enables us to understand where its money is coming from, and how it is being spent. You probably wonder where could you find those financial reports? U.S. Securities and Exchange Commission, (SEC) maintains the database available on the Internet on this location http://www.sec.gov/edgar/searchedgar/webusers.htm. There you can find a lot of information about the companies on the stock market, and one of them is the cash flow statement.

Cash flow statement looks like this (Microsoft):

MICROSOFT CORPORATION
CASH FLOWS STATEMENTS
(In millions)(Unaudited)

	Three Months Ended March 31,2006	Three Months Ended March 31,2005	Nine Months Ended March 31, 2006	Nine Months Ended March 31, 2005
Operations
Net income	2,977	2,563	9,771	8,554
Depreciation, amortization, and other noncash items	177	282	642	573
Stock-based compensation expense	374	617	1,352	1,913
Net recognized (gains)/losses on investments	(59)	(223)	(264)	16
Stock option income tax benefits	—	37	—	264
Excess tax benefits from stock-based payment arrangements	(23)	—	(67)	—
Deferred income taxes	(271)	(292)	(229)	69
Unearned revenue	3,670	3,212	10,372	9,165
Recognition of unearned revenue	(3,615)	(3,241)	(10,656)	(9,469)
Accounts receivable	972	1	368	464
Other current assets	(134)	(130)	(828)	41
Other long-term assets	(4)	40	(12)	65
Other current liabilities	229	803	(69)	283
Other long-term liabilities	270	334	743	691
Net cash from operations	4,563	5,003	11,120	12,630
Financing
Common stock issued	442	354	1,909	1,636
Common stock repurchased	(4,675)	(2,427)	(15,226)	(3,751)
Common stock cash dividends	(925)	(885)	(2,628)	(35,253)
Excess tax benefits from stock-based payment arrangements	23	—	67	—
Net cash used for financing	(5,135)	(2,958)	(15,878)	(37,368)
Investing
Additions to property and equipment	(302)	(203)	(833)	(552)
Acquisition of companies, net of cash acquired	(83)	(11)	(333)	(12)
Purchases of investments	(10,082)	(13,085)	(45,643)	(58,798)
Maturities of investments	1,208	1,454	2,900	28,191
Sales of investments	8,755	10,032	46,836	45,339
Net proceeds from securities lending	1,337	—	1,337	—
Net cash from (used for) investing	833	(1,813)	4,264	14,168
Net change in cash and equivalents	261	232	(491)	(10,571)
Effect of exchange rates on cash and equivalents	7	(8)	(9)	49
Cash and equivalents, beginning of period	4,083	3,558	4,851	14,304
Cash and equivalents, end of period	4,351	3,782	4,351	3,782

Remark: Unaudited in the title of report means that this report wasn't checked by a third, independent, party (called auditor). Each company have reasons to cheat on their financial statement, and therefore a third party, auditor is introduced.

The company in the cash flow statement has OI of 8669, and OO of 4106 which yields net cash from operations of 4563 (more cash is coming in through the operating activities then comming out).

FI is 465 and FO is 5600, which yields the net cash from financing -5135 (more cash is going out).

II is 11300 and IO is 10467, which yields the net cash from investing 833 (more cash is coming in).

If you add net cash from operations, financing and investing we get net change in cash and equivalents of 261. (the company has at the end of the previous report 4083 and with 261 it has 4351. You probably noticed that 261+4083=4344, but exchange rates also has effect on cash equivalents (7).

Cash flow statement has more details about FI, FO, II, IO, OO and OI.

What is Price-Earning Ratio?

Price-Earning Ratio is calculated as (Current share price)/(Earnings per share). Price-Earnings ratio is also called price to earnings ratio (or price multiple), and we usually write P/E. P/E ratio can be calculated if we divide market capitalization with earnings after taxes for the previous 12 months. If earnings are 0 or negative then we cannot calculate P/E ratio. P/E ratio generally reflects how much the market is willing to pay for each dollar from earnings. For example, if P/E ratio is 15 then investors are willing to pay 15$ for each dollar of earnings.

P/E ratio gives us the connections between the market price and company's profit. If price is getting higher and profit is also getting higher, then P/E ratio stays the same (more or less). On the other hand, if price is getting higher and earnings stays the same (earnings change quarterly) then recent profit is not the main factor of price. That usually means that investors expect more profit in the future.

There are several aspects of P/E that should be considered when investing in a certain shares: historical P/E ratio of the company and average of P/E ratio for the industry. Also, projection of P/E for the following period is interesting. Raising P/E through recent history, for example, can show that there is increasing willingness of investors to buy shares of that company. On the other hand, if P/E is getting lower, that means that investors tend to avoid buying that company. Also, if P/E of a company is higher than average for the industry, that would mean that share is relatively expensive, and vice versa, if P/E of the company is lower then average for the industry then that share is relatively cheap. Of course, it is necessary to consider other fundamentals.

Who are brokers?

A stock broker (or just broker) is a person that buys and sells stocks on behalf of a client. That client could be another person or company. If an individual investor wants to buy or sell some stocks, he cannot do that directly on the stock exchange. The only way investor can trade stocks is through a broker.

A transaction on stock exchange must be made by between two brokers (registered members of the stock exchange). A broker charges the client a commission for completed transaction. The commission could be flat rate, or percentage based, or both.

How to find a stock broker? Every stock exchange has its listing of registered brokers. For example, on New York Stock Exchange you can find members here: http://www.nyse.com/about/members/1089312755132.html

There are basically two kinds of brokers: full service broker and discount broker. Discount brokers provide only buying and selling stocks, while full service brokers apart from buying and selling stocks provide additional consulting, research, etc. Therefore, full service broker is more expensive. Usually, there is a spectrum of services that broker can provide so a broker can position itself somewhere between discount broker and full service broker.

It should be noted that there are similar professions: investment adviser, financial adviser, Certified Financial Planner, money manager, etc.

What are mutual funds?

A mutual fund is a company that collects the money of many investors to invest in a variety of different assets. The company invests in stocks, bonds, money market securities or some combination of these. Those assets are professionally managed on behalf of the shareholders. Each investor holds a share of the portfolio and is entitled to any profits, but subject to any losses in value as well.

An individual investor has the benefit of having someone else manage its investments, taking care of record keeping, diversification over many different securities that may not be available or affordable to the investor otherwise.

Each mutual fund is a company so there is a risk of buying share of such company, but that risk is less then investing in regular company, because the work of mutual funds is heavily regulated.

A mutual fund is diversified. In addition to that, there are many different types of mutual funds with different objectives and levels of growth potential, furthering your chances to diversify. You can search for mutual funds here: http://www.mfea.com/FundSelector/default.asp. Also, a proper choice of mutual fund can help us save money on taxes (through different types of IRA).

Stock trading system

A trading system is a set of rules that tell you how to trade stocks or mutual funds. Every trading system has three parts:

1. A Market Timing Part: Something to tell you whether you should have long position, short position, or to be in cash.
2. A Selection Part: Something to tell you what to buy, when to sell, and when to buy something else.
3. Money Management Part: Something that protects you from the unrecoverable loss by telling how much cash to have, how much of each stock to have. We could call it Portfolio Management.

A trading system doesn't tell you exactly what stock to buy. It tells you whether a given stock should be bought or not. That implies that using a trading system requires ability to manipulate with a lot of informations about a lot of individual stocks. For example, there are about 3300 companies on NASDAQ stock exchange and about 2600 on New York Stock Exchange. There are a lot of trading systems offered on the Internet.

A very simplified example of a trading system could be:

1. Check if there is a growing trend in chemical sector for a week
2. Check if ABC company from chemical sector is following the trend of the sector
3. Check if it is safe to buy in order to maintain a balanced portfolio

If answer to the previous question is yes, then buy shares of the ABC company. Otherwise, check for some other company or sector.

A six must for the trading system:

1. The trading system must be "likely to be profitable."
2. The trading system must use as few rules as possible.
3. The trading system must have robust parameter values, usable over many different time periods and markets.
4. The trading system must permit trading multiple contracts, if possible.
5. The trading system must use risk control, money management, and portfolio design.
6. The trading system must be fully mechanical.

What is portfolio?

Portfolio is a collection of investments. An investment could be a stock, a real estate, bond, ... . Each investment carry a certain risk. By owning several investments risk could be reduced. If the price of stock going down it is not likely that the price of the real estate is also going down. Therefore the risk is spread over all investments in the portfolio. That spreading is usually called diversification.

For a portfolio there is usually associated some parameters: expected return, risk, what type of investments to include in the portfolio etc. Managing portfolio means that performance of the portfolio is measured and compared with the expected return. In case of difference between expected return and the current performance of portfolio, portfolio manager can decide to sell some assets and buy some other. For example, if there is decision that there should 10% of portfolio in beverage industry, say, AA Cola, and the price of AA Cola is going down, it might be a good decision to sell AA Cola and BUY BB Cola.

Risk of portfolio is usually defined as standard deviation of the expected return. Greater the deviation, greater the risk. If an investor can choose among several portfolios with the same expected return it best to choose the one with the smallest standard deviation, i.e. risk. These concepts are introduced by Harry Markowitz, in his paper Portfolio Selection (1952).

What is day trading?

Day trading is a practice of buying and selling shares during the same day. A primary idea is to avoid keeping shares over the night, because over the night there might be a substantial change in price due to new informations.

Day trading is not riskier than other trading techniques, the use of margin makes the trading risky. On the other hand, there are more expenses due to commission on frequent buying and selling.

There are several strategies in day trading.

• Trend following assumes that stocks which have been rising steadily will continue to rise, and vice versa. Therefore buy rising stock and sell on profit.
• Playing on news assumes buying on good news and short selling on bad news.
• Range trading assumes observing support and resistance and current price.
• Scalping assumes very quick buy and sell on first profit (even very small)
• many others.

Picking stocks

First of all it is recommended that an investor should have a portfolio of stocks, having no more than 3% of total capital in each asset (i.e. stock). The rationale for this is risk reduction. That means that there should be at least 30 stocks in portfolio. Also, stock should be diversified among different industries.

It is impossible to determine if price of a certain stock will rise or not. However, there are several strategies that can be used to find appropriate stocks. These strategies doesn't provide 100% success. The key stone of the each strategy is to somehow determine intrinsic value of the stock. Intrinsic value is basically calculated using fundamental parameters: Earnings per Share – EPS, Price to Earnings Ratio – P/E, Projected Earning Growth – PEG, Price to Sales – P/S, Price to Book – P/B, Dividend Payout Ratio, Dividend Yield, Book Value, Return on Equity. It is necessary to check all of these parameters and of course there are other factors such as management.

Completely different approach to picking stocks is technical analysis. Technical analysis is based on market history of a given stock. Technical analyst beleive that based on historical data they can determine if a certain stock is going up or down.

How to buy stocks?

There are several ways to acquire stocks. The main way is to contact your broker, deposit appropriate sum of money and make an order for buying a certain stock. Broker could be more or less expensive depending on the service they provide. The full service brokers charge more, but they give advice about certain stocks, while discount broker charge less and usually don't provide advice about stocks. Another way to acquire the stock is the direct buying form the company. Usually if you own stocks of the company, the company could allow you to buy more stocks directly from the them. In that case a broker is not necessary, and therefore there are no brokerage fees.

There are two basic types of orders: market order and limit order. Market order means that broker should buy stocks for you at the best price for you at that moment on the market. With limit order you instruct broker to buy stocks only at a certain price. Usually it is a bed idea to buy stocks with market order, because that means that you are willing to pay any price on the market for the stocks. If there is a low volume of the stock you are going to buy, your market order could be executed later that day or even the next day. At that moment price could be much higher than at the moment you have placed market order. Limit order will prevent buying stock at a price higher then specified.

If you don't have a broker you will have to find one. Good place to start is on the web sites of NYSE and NASDAQ and look for members. It is necessary that you feel comfortable with your broker. If you have any doubt about a broker, find another one.