Go back to Chapter 3 - Investment Types

Chapter 4 - General Investing Guidelines & Tips

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1” – Warren Buffet, famous American investor

Now that we have explored the reasons why you should invest (Chapter 1), what markets are out there and what makes them tick (Chapter 2), and which investment vehicles are available to you (Chapter 3), we are ready to look at some important guidelines and tips that will enable you to make sound investment decisions. Hopefully, the guidelines and tips discussed in this chapter will serve as a guide and will lead you on the path to investment success. I truly believe that if you follow the advice I give in this chapter, you will become a very good investor and you will be able to achieve the goals and dreams you have defined for yourself. Now let’s get on to those golden rules of investing. Some of the following guidelines are not new and have been outlined by many wise investors over the years. I have, though, added a few of my own, accompanied by some practical tips along the way. The eleven guidelines are:

Get started and keep at it
Don’t invest in what you don’t understand
Do your homework
Diversify. Diversify. Diversify.
Buy low, Sell high
Manage risk
Have an investment strategy
Follow-up on your investments
Tune-out the noise
Take some profits and cut your losses
Re-balance your portfolio

1. Get started and Keep at it

Sometimes the most difficult part of any undertaking is just getting started. You do not need to have a fortune to start investing. Even with as little as $100, you can begin investing. The idea is to take that first step and decide where you want to invest. You can begin by opening a high-interest savings account, or purchasing a GIC, CD, or Savings Bond. You can open an online brokerage account (see Chapter 7 – Do it Yourself! Online Investing) and buy stocks, mutual funds, ETFs, or other types of investments. What is really important is to get the ball rolling. You should always have your personal, financial, and investment objectives (refer back to Chapter 1) in mind when deciding where to place your money. Keep these objectives in mind throughout the investment process and not just when getting started.

Once you have started and contributed to your first investment, you need to “keep at it”. What I mean by this is simple, yet critical. Many investors simply start with a lump sum of cash in an investment account and do not regularly add cash to the investment pot. You should make a habit of making regular contributions to your investment portfolio. The frequency or the number of additional contributions is not what is critical. What is critical is that you do it. You can set aside $50 or $100 from your earnings each month or so. This may not seem like much but over the course of many years it makes a huge difference because of the magical effects of compounding, as I described in Chapter 1. Setting money aside each month or so requires personal discipline. If you are like me and lack this level of discipline, then perhaps you can ask your employer to take it from your gross pay and feed it directly into your savings, brokerage, or retirement account. Most employers or banks will gladly do this for you when processing your pay check. You can specify the amount. Just $25 per pay check could be enough and you are unlikely to ever miss it. Of course the more you can set aside each month, the better. Find the system that works best for you and stick with it. The added benefit, aside from watching your investment tree grow faster, is that it will make you feel really good about yourself and your future. You will be one step closer to achieving your goals and dreams. Brick by brick.

2. Don’t invest in what you don’t understand

This may seem a little odd but it is actually quite an important piece of advice. All the great investors, such as Warren Buffet, have stood by this very advice. It simply means that you should invest in things you understand or can relate to. Suppose you were to invest in something you know very little about, say nanotechnology. Then it will be difficult for you to have a clear understanding about the intricate workings of this particular industry. What makes the stock of nanotechnology-related companies go up or down? On what basis do these companies compete with each other? Who and where are their customers? How long will it take to get a good return on such an investment? Answering these questions is not so easy when you know nothing about the nanotechnology market. Therefore, it will be very difficult for you to evaluate the feasibility and value of investing in nanotechnology. I am not saying that it is impossible to invest in something you know little about, but it will require a lot more work as well as a higher tolerance for risk on your part. Different people know different things. Each individual is unique. I am sure that you have intimate knowledge about one particular area or industry. Use that knowledge to help guide you in your investment decisions. Regardless of what you do choose to invest in, you will have to expand your knowledge about the investment, as each one is unique and complex in its own right. Guideline #3 Do your Homework, described below, will ensure that you do just that.

Aside from knowing what to invest (or not invest) in, you should also have an understanding about the investment type itself, whether it be a stock, a bond, a mutual fund, etc. Suppose you know a lot about the retail industry and you want to invest in a retailer such as Wal-Mart. There are different investment vehicles or types from which you can choose in order to invest in the company. You might purchase shares in the company’s stock or decide to buy its corporate bonds. Perhaps you might choose to invest in a mutual fund or ETF that includes Wal-Mart as part of its holdings. Each investment type will have its own risks, returns, and timelines. Therefore, it will be important for you to understand these differences so that you can choose the best one to include in your investment portfolio. In Chapter 3 – Investment Types I covered the unique characteristics, associated risks, and possible returns of several investment types. I did this with the purpose of ensuring your understanding about the nature of these investment types. Always keep in mind the associated advantages and disadvantages of each as it will help guide you when choosing investments.

3. Do your homework

“Investing without research is like playing stud poker and never looking at the cards.” – Peter Lynch, famous American investor

A savvy investor always takes the time to thoroughly investigate all facets of a potential investment. If you are the “impulsive type” and like to make quick purchasing decisions, then I will ask you to make a small effort and change this bad habit. What you are buying here is not as trivial as a pack of gum or a bag of chips. Rather, it is the means by which you will move one step closer to realizing your goals and dreams. Think about the most significant purchase you have made in the past year or so. Did you spend time researching the product or service before making the purchase? If so, where did you get your information? Was it from the Internet, brochures, friends or others who have purchased the same product? Chances are you went through some of these steps before making the decision to purchase the item in question. This is what we call doing your homework. What you need to do now is carry that very same approach to your investment decision-making process. In life we have to make all kinds of decisions. And it is the quality of our decision-making that really determines our successes and, inherently, our level of personal satisfaction or happiness. Sometimes people make decisions either too quickly or with limited information. Another mistake is not taking the time to look at alternatives. Let me explain further with an example. Suppose you like the Coca Cola company and you want to invest in this firm. You could just go and buy shares of Coca Cola stock and the deal is sealed. But, by doing so you have failed to consider other ways (alternatives) of investing in the company such as buying its bonds, or a mutual fund or ETF that has holdings in the company. The point is that you need to ask yourself if there are other ways in which you can achieve your initial objective. That’s why it is always important to begin the decision-making process by clearly stating or defining your goals. Next you should generate or consider different alternatives that may help you achieve your goals. While doing so you should weigh the pros and cons of each alternative. Using the example from above, you may say: “If I buy Coca Cola stock it might provide a good return but be risky. If I buy Coca Cola bonds, it may be safer but provide a smaller return. If I buy Coca Cola through a fund it may be safer and may also provide returns from other companies the fund holds.” In this case, looking at the pros and cons of each different investment vehicle will permit you to make the best decision, given your own needs. In sum, you should always try to include alternatives and weigh the advantages and disadvantages of all possibilities.

Now let’s look at some specific things you need to look at when considering various investments. The first thing you need to do, other than asking yourself why you want to invest in …, is to understand the pros and cons of the investment type itself, whether it be a stock, a bond, or whatever. In the previous chapter I discussed the advantages and disadvantages of each especially in terms of possible returns, inherent risks, tax implications, etc. So feel free to revisit the chapter when needed. The next thing you need to consider are costs associated with buying, holding, and selling the investment. You need to consider all fees, commissions, and penalties that may be involved. For stocks and ETFs, you will have to pay a trading or commission fee at the time of purchase and also at the time of sale of the asset. With certain mutual funds, you may be penalized if you sell before a prescribed time period. Open-ended and closed-ended mutual funds charge a commission on the purchase or sale of the fund. Holding costs can also end up eating away at your returns. Suppose you are holding a bond that pays much lower interest than a newer bond issue. In this case you would be missing out on the higher returns of the new bond issue. Many refer to this type of cost as opportunity cost. Opportunity cost is the cost of foregoing another type of investment that would generate superior revenue than the one that is currently held. In the investment world, opportunity cost is one of the most important costs to consider. So take the time to examine all the costs that will accrue in the investment you are considering before acquiring it. Finally, you will also need to factor in brokerage costs. These are costs associated with either having a brokerage account or obtaining the services of a broker who will buy and sell securities on your behalf. In Chapter 7 - Do it Yourself! Online Investing we will take a closer look at these types of costs.

Another critical element you must consider involves the tax implications of the gains (or losses) of the investment you are considering. You need to ask yourself what type of revenue will be generated from the investment. Is it interest income, dividend income, or a capital gain? Each type of revenue is taxed at a different rate and will reduce your net investment income. Therefore, it is a good idea to take the time to consider how your gains will be taxed (and even how your losses may be tax-deductible). What is really important is the after-tax income that is generated from your investments. Of course, if you decide to invest within a sheltered retirement account then you will defer paying taxes altogether until you withdraw funds upon retirement. And the taxes you will have to pay will likely be lower by then.

Another way in which you can do your homework is to thoroughly research the investment itself. Many type of securities such as stocks, mutual funds, and ETFs are required by law to prepare a document called a prospectus that describes the investment in detail. The prospectus is available free of charge to potential investors; it can be obtained via a service called SEDAR or EDGAR (see Chapter 6 – Anatomy of a Stock under the Annual Report section), or directly from the company’s website. In the prospectus you will find a comprehensive description of the company, its products and/or services, and its management team. Furthermore, you will find financial information about the company as well as the risk factors associated with the investment. A prospectus is usually a fairly lengthy document. I am not suggesting that you read it from cover to cover. Instead, read selected parts and ask yourself: “What is so special or unique about the investment?” Another great tool that can be used to evaluate an investment is to look at the company’s website. All publicly-traded companies, as well as companies that offer funds, have an abundance of investor-related information on their websites. In addition, it is a good place to see what the company is all about. Ask yourself:

What is their mission?
What are their goals and objectives?
Are they socially responsible and environmentally friendly?
What is so special about their products or services?
On what basis do they compete?
Who are their competitors?
What share of the market do they have?
What are their future projects?

Taking some time to investigate the firm should provide you with more clarity in making your investment decisions. Also be sure to google (i.e., search for) information about the company on other websites. And try to locate magazine and news articles about the company or investment product. The Internet provides so many ways by which you can obtain information about all sorts of investments. Make use of blogs and other online discussion forums to ask questions about your potential investment. Seek opinions from others who have done what you anticipate doing. Always be vigilant and skeptical about the sources from which you get your information. Do they have a hidden agenda? Are their opinions biased in some way? The trick is to read as much as you can and then trust your instincts – they are usually right. If it sounds too good to be true, it probably is.

Finally, the last piece of advice I can give you about doing your homework is to read the fine print. You have to read carefully all the information that is provided about a particular investment (especially mutual funds) to be sure that you understand all the conditions that may apply. Be sure to ask questions when you are not sure what is meant in any literature about the investment.

In summary, doing your homework means:

Examining the nature as well as the advantages and disadvantages of the investment type itself
Calculating the related costs of buying, holding, and selling the investment
Determining the opportunity cost of holding the investment
Evaluating how the tax implications for the investment will impact your returns
Researching thoroughly the company or investment product
Reading the prospectus and fine print

4. Diversify. Diversify. Diversify.

Without any doubt whatsoever, this is the most important rule of investing. Don’t put all your eggs in one basket, they say. Any financial or investment advisor will tell you that you must diversify your investment portfolio. The reason is simple. If you do not diversify your investments, you may be risking them all. Many people have lost their entire life savings because they decided to invest in a single stock, fund, or even in their own employer. Many things can go wrong and often do. A company (or employer) can go bankrupt. Bonds can default. The stock market may crash at any time. The party that holds your investments may suddenly disappear. Things like this happen even to the best of them. It is your duty and personal obligation to make sure that you do not become a victim. The best way to preserve your investments and reduce risk is to diversify. There are many ways in which you can and should diversify. The most obvious is to diversify by asset class or type of investment. Holding different proportions of stocks, bonds, funds, and other investments such as gold, currencies, GICs, and CDs will provide you with a diversified or balanced portfolio. This is true because certain asset classes, such as stocks and bonds tend to move in opposite directions. When one asset class is performing well, another may not. Rarely do all investment types perform well (or poorly) at the same time. Remember our discussion about cycles? You can also diversify your investments geographically. Buying foreign stocks, bonds, and funds can also help to mitigate risk. If you only invest in domestic securities and your country’s economy falters or even falls into a recession you may become vulnerable. Moreover, would you be willing to wait for several years before your investment portfolio starts growing again? Probably not. While some economies are down, others are up. You must take advantage of this. You want your investment tree to grow during all seasons. Geographic diversification can help you weather different economic cycles or storms.

You should also diversify your investments across different sectors and industries. Once more, different sectors and industries tend to move in cycles. While some are lagging, others are booming. In the previous chapter, I provided you with some techniques and a list of factors that can help you spot market trends and cycles for particular industries. Use that knowledge to create a diversified set of investments that will work for you consistently. For example, you may decide to include non-cyclical stocks in your portfolio to add stability during hard economic times. So be wise, and don’t invest solely in technology, health care or one particular sector.

Another practical means of diversification that can reduce risk while preserving the value of your investment savings is to have holdings denominated in different currencies. As North Americans, we are fairly confident that our dollar (either the loonie in Canada or the greenback in the United States) is a stable currency. For the most part, it is. But what will its value be against other currencies in say twenty or thirty years? What will its purchasing power be? Many unanticipated events, such as war for example, can occur and have a great impact on the country’s currency. As a young investor you will be trying to accumulate wealth through several decades. And once you are ready to retire you will want to cash in on your investment savings. What if you decide to retire in a country other than your own? What will the exchange rate be between the country you live in and the one where you are going? All currencies have a relative value and can be used to buy more or less of a given product or service. You want to be able to extract the most value out of your savings, regardless of the currency in which it is denominated. Holding gold in your portfolio can be a means by which you can reduce risks associated with currency valuations. From our discussion on gold in the previous chapter we have learnt that many investors like to hold a portion of gold in their portfolios because it has been around for thousands of years, it has consistently followed the pace of inflation, and it is a universal store of value.

Finally, there is one more means of diversification that I want to share with you. I think it is important for you to consider diversifying with different brokers or financial institutions. I personally deal with several banks and different online brokers in order to manage my cash and investments. It is not so much because I worry that one particular financial institution may go bankrupt but more for convenience purposes. Most bank accounts in North America are insured. In Canada the Canada Deposit Insurance Corporation (CDIC)insures accounts for C$100,000. In the United States the Federal Deposit Insurance Corporation (FDIC) also insures accounts for US$100,000. And many brokerage accounts are also insured (but be sure to ask your provider if this is the case). In Canada, the Canadian Investor Protection Fund (CIPF) protects investor accounts for up to $1,000,000. The Securities Investor Protection Corporation (SIPC) covers cash and securities of U.S. investors’ investment accounts up to a ceiling of $500,000 (including a $100,000 for cash claims). Take note that the SIPC does not cover broker fraud cases.

- Canadian Investor Protection Fund (CIPF) http://www.cipf.ca
- Securities Investor Protection Corporation (SIPC) http://www.sipc.org

As I said before, for me it is a matter of convenience and service to diversify in terms of banks and brokers. If one of my banks or online brokers suddenly decides to hike fees or impose new fees (as was actually the case for me), then I can easily transfer my holdings to my other financial institution. Likewise, if one of them is providing me with poor or unsatisfactory service, then I will not feel obligated to stick with them. Also, if the website of one online broker is temporarily down, I can use the other to place an important trade. In addition, having accounts with different online brokers can be very beneficial since each provides their own investment products, level of service, market insights and research, online tools, and access to different markets. Thus, I will be able to take advantage of the best each has to offer. Get the idea?

The last thing I want to mention about diversification is that there is such a thing as overdoing it. If you diversify too much, you may be diluting or spreading your investments too thinly, negating substantial returns from individual investments.

In conclusion, repeat after me: “I will diversify. I will diversify. I will diversify.” Kidding aside, I hope that you now have a clear understanding as to why it is important for you to diversify. Since there are no guarantees in life (except death and taxes) you must do everything in your power to manage risk and preserve your wealth. So remember to diversify by:

Acquiring and holding different investment types
Investing across different geographic boundaries
Investing across different sectors and industries
Maintaining holdings in different currencies
Opening more than one investment account

5. Buy low, Sell high

“The time to buy is when there is blood on the streets.” – Baron Nathan Rothschild (1840-1915), British banker and politician

Knowing when to buy or sell a stock or another security is critical because you want to be able to get the maximum return for the period in which you held the security. For the remainder of our discussion on this topic I will mostly refer to stocks, but keep in mind that the following buying and selling principles apply to most of the other types of securities such as mutual funds and ETFs. Buying and selling decisions for new investors are especially difficult and daunting. Many new investors will buy stocks when they shouldn’t and sell them when they should hold. Most individual investors will “follow the crowd” and buy a stock when it is doing well and sell it when it is falling. This is a “newbie” mistake. Good investors usually buy stocks when others are selling and sell stocks when others are buying. This is going to sound a little strange, but the majority of individual investors usually have it wrong. They swim with the current because it feels easy, safe, and natural. Investment pros, however, go against the grain. They swim against the current. The pros will sell stocks while they are performing well and buy them at bargain prices when the majority are getting rid of them. It really does take courage to sell a stock that is performing well and to buy a stock when others are dumping it. But that is exactly how the pros do it. Think about it for a second. When a stock is performing well and is near a peak or all-time high, where is it most likely to go next? If you answered: “Down,” then you are most likely correct. What goes up must come down (most of the time). Of course there is a possibility that it can still move up for a while; but it is nearly impossible to predict the absolute high point. Contrary to popular belief, investment pros are not greedy; they are smart. They will sell a stock at profit, even though it could still generate more gains. They will use profits to buy stocks that many investors are selling. Furthermore, it is nearly impossible to predict what the absolute low point will be. So, the pros will wait for a massive sell-off of a stock and buy it then, usually at a bargain price. The pros make the correct buying and selling decisions because they have a good understanding about how markets behave in general and they can spot trends that are occurring in the stock markets. Knowing how markets behave and spotting market trends isn’t really so difficult. Market behavior can be assessed by simply looking at which phase of the cycle the market is currently in. In Chapter 2 I discussed market cycles. We know that all markets, and individual stocks for that matter, go through ups and downs. We also examined some factors that trigger market swings and we talked about bull markets, bear markets, secular markets, and corrections. So the trick here is for you to take a step back from your individual stock and look at the bigger picture. Too many investors make decisions based solely on the movement of their stock. The first thing you need to do is to look at the full market of which your stock is a part. Here we are talking about the sector or industry which your stock is a part of. For example, if you currently own company stock in an airline or big hotel chain you need to estimate in which phase of the market cycle the tourism industry is currently in. Say, for instance, the economy has been booming for the past three years and demand for flights and hotels are strong and profits are high. Then you would be in an “up” phase of the cycle. This would be a time to consider selling because eventually the economy may go back down, carrying the tourism industry and related stocks along with it. Tourism is a cyclical industry in that it follows the general state of the economy. If you anticipate a downturn in the economy due to factors such as high inflation, high unemployment, and the like, then you should sell the stock for a nice profit as it is likely to start falling. Conversely, if the economy and tourism industry have been in a slump for a while but are just starting to recover, then this would be a good time to buy, since prices would still be low. In addition to assessing how overall markets behave, investment pros are able to spot trends that are occurring in the stock market. Their tool of choice includes market indices. Since stock market indices track the greater behavior or movement in stocks on an exchange, they can tell us a lot about the direction in which stocks are headed. Just like cattle, stocks tend to move in herds. If a stock market index has been declining for several consecutive days or even weeks, it means that there is a sell-off occurring. Even if you own a good quality stock it may still not matter, since the majority of stocks, usually three out of four, will follow the market’s downward trend. Depending on how long stocks have been declining, a market correction, secular bear cycle, or bear cycle may be occurring. If you remember from our previous discussion, a correction occurs when stock prices decline by about 10% in a relatively short period of time, such as a week or two. A secular bear market cycle occurs within a bull market; it is a slight and temporary downward swing that can last for several months. A bear market is a longer period, usually a few years, in which market indices are at low levels and remain flat. These are the best periods in which investors should buy stocks. The investment pros sometimes wait for several years until a bear market comes along and then spend like crazy to buy various stocks at bargain basement prices. Try to mimic that plan. Always keep a good portion of cash in your investment portfolio so that when these opportune periods occur you will be able to capitalize on them. You have to be patient and learn to wait and buy at the right time. This is a difficult thing to do for us North Americans because when we want something we usually want it now. Investment pros are disciplined; they are patient and stick to their plan.

Another interesting tool of choice for investment pros includes the use of charts. They use charts to have a visual representation of a stock or stock market index. Charts can be used to look at the movement or direction of a given market index or individual stock over a certain period of time (even several years). There are many free charting tools available on the Internet. I will talk more about charts and provide you with some excellent links to online charting sites in Chapter 7 – Do it Yourself! Online Investing. Suffice it to say that charts are practical because they reveal two very important pieces of information. Besides prices (of a stock) or values (of an index), a chart tells us how much the stock or index has increased or decreased in value, sometimes expressed in percentage terms, over a certain period. In addition, it tells us at which rate or frequency the buying and selling of stocks has occurred. In the investment world this is referred to as trading volume. Recall that stock prices are largely determined by institutional investors such as mutual fund, pension, and insurance companies since they buy and sell them in large quantities or volume. It is they who buy and sell large numbers of shares thus pushing prices upward or downward. Charts usually indicate the volume at which stocks are traded. An unusually high volume of shares being sold, sometimes over several days, would usually indicate that institutional investors are selling the stock. As such, it may indicate a trend in which the stock will start to enter a downward phase in the cycle. Investment pros will view this as a momentum change and will often decide to sell off as well. Inexperienced investors will, unfortunately, wait longer to sell the stock. The result is that when they do decide to sell it will be at a lower price which means smaller returns for the inexperienced investor. On the flip side, when a high volume of shares are being bought over several days, it may indicate an upward trend or cycle. To confirm such a trend, investment pros will often look at several individual stocks in a given industry and see if their trading volume is also high. If so, it may confirm the trend. Specialized market indices that track particular industries can also be used to confirm a trend; and they are much more convenient, as you only need to look at the graph of the index.

Once you have taken the time to step back and look at the bigger picture, you can now focus on the stock you wish to buy or sell. Trying to determine if a particular stock is at the right price for either a buy or a sell can, once more, be difficult. There are, however, a couple of quick and easy ways by which you can determine if a price is near its high or low. The first thing you can do is look at the price history of the stock. Some investment portals (such as GlobeInvestor.com) and charting services (like BigCharts.com) let you do just that. You can also usually obtain previous prices of a company’s stock from their website under the Investor Relations or Investor Information section. If they are not posted you can always e-mail the company and ask them for previous and current prices of their stock. Try to go back as far as you can when looking at prices. If you can, get prices for the last three years or more. Then, simply look at the evolution or movement of prices over that particular timespan. Charts are helpful for this as they plot prices along a curve. What is today’s price? Is it near the highest point or peak on the curve? If so, this may indicate that the price is near a high. In other words, it may be relatively expensive or pricey to buy at this particular time. If today’s price is at a lower point on the curve, then it will be available at a relatively lower cost. You might still think that you are investing in a great company and decide to buy the stock at a relatively high price. And it may even continue to move upward. But, mathematically speaking, the odds are not in your favor. Another quick tool to gauge stock prices is the 52-Week High/Low. Stock quotes listed online as well as in daily newspapers usually include the highest and lowest prices at which the stock traded in the last fifty-two weeks (one year). Again, you can compare the current price along with the highest and lowest for the last few years to determine if it is in a relatively high or low position. As you know, there are a great number of factors that influence the price and direction of a stock, making it difficult to spot an exact high or low. We will go into more detail about that in Chapter 6 – Anatomy of a Stock. But for now, the key point I want you to remember is to consider the current pricing of the stock along with the greater market trend for which the stock is a part of. As much as possible, you should buy when:

The stock price is relatively low (looking at historical prices for the past few years)
The industry or market is near the bottom of a cycle (looking at the market index that represents the particular type of stock)

For the most part, you should sell when:

The stock is performing well
The stock price is relatively high (looking at historical prices for the past few years)
The greater market or industry is peaking or is at its highest level (looking at the respective market index)

There is at least one exception for which the approach described above may not work. If you look at the oil industry as a whole, along with individual oil-related stocks in recent years, you may find it more difficult to locate market bottoms and low prices. Shrinking oil supplies accompanied by rising demand for the commodity will make it difficult for investors to “buy low”. Although there will be many more “ups” in the oil patch in the next few years, I have difficulty seeing many, if any, significant “downs”. Therefore, if you want to invest in this industry, you will probably need to “buy high” and “sell higher”.

6. Manage risk

“Risk comes from not knowing what you’re doing.” – Warren Buffet, famous American investor

The principal goal of any investor is to accumulate wealth over time. What is imperative is that you preserve your wealth along the way. Managing risk will ensure that you do just that.

What is risk?

Risk is the chance that you can lose all or some of your investment capital. Even investment professionals lose money, sometimes in the millions of dollars. Risk is an integral part of the investment game. That is what distinguishes it from savings. There is no risk involved with savings, as your principal is guaranteed. With investing, your principal is never guaranteed (with the exception of investing solely in safe, cash investments like CDs and Treasurys). As an investor you will have to be willing to assume and take some risks. That’s what makes investing both exciting and scary. So, don’t be afraid to take risks. Just make sure you take intelligent, informed, and calculated risks.

Types of Risk

There are many types of risks associated with investing. It really depends on the nature of the asset you are investing in. Some asset classes carry little or no risk, while others can be very risky. The following types of risk may be associated with the investments you decide to choose. So, always try to understand and anticipate which risks can negatively impact your investments. In doing so, you will be in a better position to employ strategies that will help offset or diminish risk. And this will leave you in a better position to protect your wealth.

a. Market Risk

Financial markets can be volatile. The stock market in particular can be quite volatile, especially in the short term. When the stock market as a whole declines, chances are that your stocks or stock funds will lose value until the market rebounds. This is completely normal. On any given day, or even during a period of up to one year for that matter, it is reasonable to expect that the market will fluctuate. This is a natural phenomenon that occurs due to market cycles, as discussed earlier. Think of it as a ship that crosses the ocean. It will face big waves in rough times but will also coast on smooth, clear water at other times. The important thing is to arrive at the destination intact and in one piece. So if you’re investing in the stock market, hold steady and expect a bumpy ride.

b. Recession Risk

Every several years, an economy can fall into a recession. It is part of the economic cycle. Our governments take many steps to avoid this. And for the most part, their monetary and fiscal policies do a pretty good job of preventing it. Nonetheless, over the span of your investment “career” you are more than likely to experience a recession or two. During these periods you are likely to see your investments significantly drop in value or remain flat for a long time. There are two things that you should keep in mind. Firstly, over the long term, markets eventually recover. Therefore you should hold steady and weather the storm. This doesn’t mean that you should not get rid of some investments. But for the most part, you should hold back on the urge to sell your investments at a loss. The second point to remember is that you should always look for opportunities in times of recession. This is the best time to buy stocks or stock funds, as they are usually available at bargain prices.

c. Interest Rate Risk

Interest rate hikes or cuts have a direct impact on the value of bonds and stocks you may be holding in your portfolio. Hikes in interest rates pose more risk since the value of existing bonds usually declines as new bond issues become more attractive to investors. At the same time, stocks may decline in value as some investors switch to higher-paying, less risky, bonds. Cuts in interest rates usually reduce risk, as stocks usually rise because investors seek higher returns, and existing bonds with higher coupon rates will become more attractive on the secondary bond market.

Bonds are particularly vulnerable to changes in interest rates. Despite being regarded as particularly safe investments, bonds are more commonly exposed to interest rate risk than are other investment types. Both interest rate increases and decreases can hurt your bond investment depending on when it was issued and whether you decide to hold it until maturity or sell it before on the secondary bond market. In addition, when you hold bonds you are particularly exposed to inflation risk. The value of a long-term bond will always be less upon maturity due to inflation. Let me explain. Suppose you purchase a thirty-year bond with a $1,000 face value. You pay for the bond using $1,000 of your hard-earned cash. Thirty years from now, when you redeem the bond and collect your $1,000, it won’t be worth as much because things will cost a lot more by then. Think about it. Inflation in North America over the last decade or so has been around 3% per annum. That means that each year goods and services, on average, cost 3% more than they did in the previous year. Fast-forward thirty years and you will see that the purchasing power of your $1,000 will be relatively small. By all means, keep this type of risk in mind before deciding to invest in long-term bonds.

d. Currency Risk

You will be exposed to currency risks if you hold foreign securities in your investment portfolio. As with the other types of risks discussed, you have no control over currency risk. Currency fluctuations occur on a daily basis. Changes in currency values can both positively and negatively impact the value of your foreign investments. It really depends on how much the foreign currency has moved against your currency since the date of purchase of your investment. When your currency strengthens or gains value over the other currency, the return on your investment will decrease. Conversely, if your currency weakens or depreciates in value against the other currency, the return on your investment will increase in value. For example, suppose you purchased stock of a German company at one-hundred euros per share and the dollar has since increased by 5% over the euro. In this case, a share of your German stock will only be worth $95, once converted back to dollars. Should the reverse happen and the dollar weakens by 5% over the euro, a share of your stock will be worth $105. In short, the risk is that the value of your foreign investment will decrease as your currency strengthens against the foreign currency.

e. Political Risk

Both your domestic and international investments are subject to political risk. Before investing abroad, it is always a good idea to assess the political climate of the foreign country in which you want to invest. How stable is the government? Which political party is in power and what is their agenda? A good place to start to learn about the political climate of a given country is to look it up under the Central Intelligence Agency’s World Factbook.

Central Intelligence Agency’s World Factbook https://www.cia.gov/library/publications/the-world-factbook/

The Internet provides an excellent means by which one can learn about foreign political issues. Online newspapers also provide a window to foreign nations, their economies, and their markets. In brief, political instability can negatively impact your foreign investments. On the domestic front, for the most part, as North Americans we enjoy a fairly stable political climate. Nonetheless, one thing to always be on the lookout for includes changes in government regulations that may affect certain industries (or even investment types) in which we have investments. Keeping up with the daily national and financial news is a good way to keep abreast of potential changes.

Risk and Return

Different investment types carry different rates or return. Usually, the riskier the investment, the greater its potential for a substantial return. On the flip side, less risky investments provide smaller returns. The idea is to minimize risk by finding the proper balance between the two. Placing all your capital in risky investments could leave you extremely vulnerable. You could lose a big portion of your capital in a short period of time. That’s why it is much more prudent to diversify your portfolio with other less risky investment. While some of your investments may perform poorly, others will keep your head above water. So be sure to keep this in mind when selecting securities for your investment portfolio.

Risk Tolerance

Everyone has a different perception of risk. Some enjoy it while others avoid it. Your personal level of tolerance for risk depends on a number of factors including your age, family situation, and even your personality. As a young investor with a long-term view, you can, and should, afford to take more risk. Time is on your side. If your investments stumble along the way you are likely to be able to recover. But as you approach the age of retirement you should reduce your risk in order to preserve your accumulated wealth. Your family situation also affects the level of risk you will assume. If you have a spouse and dependent children that you want to send to college one day, you may play it safer than if you are single with no kids. Finally, your personality is also blended into the equation. You may be more aggressive and seek the quick gain or you may be more conservative and patient with your returns. Most people fall somewhere in between both ends of the spectrum. The idea is to assume the level of risk in which you will be comfortable with; one that won’t keep you up at night worrying about your investments.

Ways to Reduce Risk

Some of the best ways in which you can reduce risk have already been discussed: diversifying your investments across different asset classes, geographic regions, and industries. Doing your homework is also beneficial. Make a habit of doing your homework, not only before buying and investment, but also after, in order to keep track of what is happening to your investment. If you own a stock, for instance, keep track of how well the company is doing and not just its stock price. Read up on company news and see what projects and plans they have for the future. Is demand still strong for their products? Are they expanding abroad? As a shareholder, you will be sent an annual report by your online broker about the company and its operations each year; so be sure to examine the financial statements found therein. In addition, read other parts of the report to get a feel for where the company is headed. I tell you how to do all this in Chapter 6 – Anatomy of a Stock.

Be sure to avoid investing in only one or a few companies. Rather, spread the risk by investing in several companies at once through stock funds. Buying and holding Exchange-Trade Funds (ETFs) is a great way to reduce risk, since it is less likely that all stocks in the basket will perform poorly. For the young investor, ETFs that track major indices such as the S&P 500 or the S&P TSX Composite are ideal for the long haul because over a period of fifteen, twenty, or thirty years they will provide significant gains with very little risk. Even if the stock markets experience down periods you simply need to hold steady and ride them out because markets always recover and rise with time. If you are betting on particular sectors or industries, you can employ a different strategy. In this case, you may decide to sell stocks or stock funds when the associated market is hitting a peak. For example, if you invested in a real estate fund and the real estate market has been hot for several years and is beginning to cool off, you may decide to sell out and make profits before the market begins or continues to decline.

Including a small proportion of gold-related assets in your portfolio provides another means by which you can offset risk.

I’m not going to tell you which strategy to employ or what ratio of each investment type or asset class you should hold in your investment portfolio. You alone are in the best position to decide for yourself what is right for you, given your goals, age, family situation, tolerance for risk, etc.

7. Have an investment strategy

“Failing to plan is planning to fail.” – Alan Lakein, Harvard MBA and world-leading expert on personal time management

Investing without a strategy is like building a house without a blueprint. The reason why you should develop an investment plan is quite simple. An investment strategy will guide you in your choices. It will ensure that you make decisions based on sound judgment rather than on impulse and emotion. The first thing you need to do when devising an investment strategy is to revisit the financial goals and investment objectives you defined for yourself in Chapter 1. Feel free to refer back to the Have Goals section of Chapter 1 to refresh your memory about what it is you want to accomplish for yourself on the financial and investment front. If you have not completed the personal self-assessment sections in Chapter 1, I encourage you to do so now as it will be your first step towards defining your investment strategy. The first part of the self-assessment exercise asked you to write down your personal goals for the short-term (in the upcoming year), medium-term (in five years), and long-term (in ten or twenty years). Perhaps these goals included saving money for college (either for yourself or your kids), building that dream house, planning for a trip around the world, or simply saving for a comfortable and enjoyable retirement. Whatever goals you defined for yourself will probably require substantial financial backing. Now it is time for you to determine what kind of financial commitment you are ready to assume in order to reach your goals. How much money are you starting with, and how much are you willing to put aside each month in order to accumulate enough wealth to realize your objectives? Don’t worry if your goals seem unrealistic for now, as you can always make adjustments later. For now, hold on tight to your dreams because, with the right approach, attitude, and discipline, you will succeed. The next thing to do is to determine whether you will be investing inside or outside a retirement account, or both. Whatever funds you want to invest for retirement should go into a retirement account such as an RRSP (for Canadians) or a 401(k)/IRA (for Americans) due to the considerable tax savings and favorable compounding environment the account provides. For other, shorter-term, goals you may decide to open and use non-sheltered accounts that will enable you to withdraw funds without penalties. Such accounts can include high-interest savings accounts, brokerage accounts, offshore accounts, etc. These accounts will provide you with more flexibility in accessing your funds but will obviously not provide the same level of tax-sheltering as do the retirement accounts. You will also need to keep in mind the tax implications when materializing your investment returns as they will limit the net amount of cash you actually receive. It is a good idea to think about these things instead of just haphazardly opening one account for all your needs and goals.

The next step in preparing your investment strategy is the most fun part. Now, you are ready to choose which types of investments to put into your accounts. Before doing so, you must consider the time horizon or time frame in which you wish to realize your goals. In other words, you need to align your short, medium, and long-term objectives with investment types that are compatible. For example, suppose that you inherit $5,000, that you wish to invest the entire sum for retirement, and that you would like to retire in twenty years. In this case, you might invest in an index mutual fund or ETF that tracks the performance of the S&P 500 (overall U.S. market) or similar index. This would be an ideal investment, because over the long term it will more than likely provide a good return while remaining a fairly safe investment. Of course, holding this fund in a tax-sheltered retirement account would be best, as the funds would grow in a tax-free, compounding environment. I will give you another example for a short-term investment. Assume that you have $5,000 in a savings account that bears little or no interest and that you wish to buy that ultra-large flat-panel plasma television set, but it costs $5,700 (including sales taxes). And fortunately, you are a patient person who is willing to wait two years to buy it. You could decide to purchase a corporate bond that pays a 7% coupon and matures in two years. In this case, two years later, you will have made $700 in interest, giving you a total of $5,700 which is enough to purchase your TV set. In addition, you would be investing in a relatively safe investment so you would not likely lose money from the bond investment in the short term. Say instead that you would have used the $5,000 to invest in a gold-related ETF and the price of gold dropped 20% during the investment period. Here, you would have ended up with $3,950, a $1,050 loss. Notice the extra $50 missing due to trading fees ($25 to buy the ETF and $25 to sell it). Therefore, you would have been stuck buying the smaller size TV set. The idea is to choose an investment type that is in line with your investment objective, while considering its level of risk. It is important for you to consider the risks associated with all your investment choices because things will not always go your way. You have to be prepared to experience occasional setbacks as it is a normal part of investing. As discussed in the previous section, spreading or managing risk is important because you always want to preserve your wealth. For some types of investments such as CDs, GICs, and bonds, it is fairly easy to determine the level of return you will receive on your investment. You simply need to calculate the interest you will earn over time. For other types of investments such as stocks, funds, and commodities such as gold, it is more difficult to predict the rate of return as they are more volatile in nature. Nonetheless, you should still try to estimate what rate you anticipate receiving on an annual or multi-period basis. Write your estimate down on a piece of paper or an electronic spreadsheet. You can base your estimates on past performances of the security, the overall index for which the security is part of, and/or other factors that may affect both the asset class or the nature of the investment itself. Many of these factors were discussed in chapters two and three. Using this estimation method will enable you to make calculated and informed decisions. It’s just like doing your homework as I described earlier. You may find out that a particular investment is not so attractive after all and you may decide to look elsewhere. Here you will be making your investment decisions based on facts rather than on hunches. You may not always be right. But chances are that if you employ this strategy for all your investments, it will pay off for the whole. Choose a frequency or period such as every three months or every year to see if your medium and long-term investment returns are in line with your estimates. For the shorter-term investment types, don’t worry about the daily ups and downs, but rather focus on monthly, quarterly, or yearly results.

Other important elements to consider when devising your investment strategy revolve around when to buy, how long to hold, and when to sell. For example, you may choose to wait for a bear market to buy stocks at bargain prices. You may decide to hold some investments for the long term but sell others during market peaks. Another popular strategy is to set target prices for your investments. For instance, you may set a target price or percentage for which you will buy or sell a stock. Perhaps once you’ve reached a 30% profit level you will sell. If the stock drops 10%, you may also decide to sell before suffering further losses. You may even decide to compromise. For example, you may decide to sell half of a stock when it reaches 30%, and the other half when (and if) it reaches 40%. Since returns are often uncertain, always consider the possibility of selling only a portion of your holdings. Of course, if you employ this strategy, it will entail additional trading or commission fees. Find a system that you are comfortable with and make sure you have measures in place to preserve your wealth.

8. Follow-up on your Investments

“I made my money by selling too soon.” – Bernard Baruch, American financier and stock market speculator

As touched upon in the previous investment guideline, you should take some time to track the performance of your investments. Some types of investments such as CDs, GICs, and bonds require little follow-up as they are not volatile and provide steady returns. For other types of investments, you will have to keep a closer look. Always have your time-horizon in mind. If you made a short-term investment (i.e., less than one year) by buying a speculative stock, for instance, you may wish to check the price movements more frequently, perhaps on a weekly or even daily basis. There are excellent tools that you can use, not just to track the daily performance of your holdings but also to see how they are doing since you bought them. Most accounts (savings, brokerage, retirement, or otherwise) provide a monthly statement about the performance and value of your holdings. These statements usually display your account balances, including the book value and market value of your securities. The Book Value represents the market value on the day you purchased the security; it is computed by multiplying the price paid by number of shares bought. The Market Value represents the most recent or daily price at which the security was quoted; on your monthly statement it is usually the price at which the security closed on the last trading day of the month. Moreover, the market value is calculated by multiplying the current price for the security by number of shares owned. Make a habit of taking the time to compare these two values. When the market value exceeds the book value, the difference represents your profits (excluding trading commissions). If the book value exceeds the market value, then you are incurring a loss, at least on paper. However, unless you actually sell the security, you will not have materialized any losses yet. Sometimes it is best not to sell, as the asset may rise up again, depending on the security. It may be challenging for the novice investor to decide whether to sell or not. And it is exactly for this reason that I recommend that you adopt a buying, holding, and selling strategy as described in the previous section. Follow your original plan and you will make better decisions that are not based on emotions or anxiety. If a security in your portfolio has been lagging for a long time without any sign that it may bounce back, then feel free to get rid of it. This really depends on the type and nature of the investment. Most of the time it is best to hold steady and be patient. Just don’t lose more than you originally specified in your limits.

Some monthly statements also provide graphs or pie charts representing the asset mix in your portfolio. The individual assets are sometimes displayed as either a percentage or dollar amount (or both) in relation to your entire portfolio. This may provide a visual representation of how much of your portfolio you have dedicated to stocks, stock funds, bonds, cash instruments, and cash itself.

There are other useful tools that you can use to keep track of your investments. On the Internet you can find investment portals, obtain access to your own account(s) through your online broker, use free quotation services, and even use sites where you can enter your own portfolio holdings and track them for free. One very interesting feature that you can find on some of these sites is a tool called “Alerts”. Here, you simply specify a high or low range for your stock (or a stock you may wish to buy) and, when the range is reached during trading hours, it sends an alert to your e-mail, or even to your cell phone by text messaging (SMS). You can specify ranges in terms of prices and/or trading volume. Say, for example, on a given day the volume of trading for a particular stock you own reaches one million shares traded, then you will be alerted to this unusually high trading activity. You can log on to the Internet to see what is going on. Is a sell-off occurring? Are many people buying it? As another example, suppose you had set a basement price limit at which you would sell a given stock. An alert may advise you that the stock has reached your low point and you may decide to log in to your online brokerage account to sell the stock. You can even track stocks that you do not own but would like to buy if the price is right. Once more, with the alert tool you may be able to capitalize on a great buying opportunity. Most online brokerage accounts even let you automatically buy or sell stocks given your own criteria (within a specified time-frame). I will talk more about these exciting online gizmos in Chapter 7 – Do it Yourself! Online Investing. In short, you should make use of these tools to better execute your investment strategy.

Many investors like to enter their portfolio data in an electronic spreadsheet program such as Microsoft Excel. They use their monthly statements and other data to do so. The more adept users create fancy graphs and bar, line, and pie charts to get a visual representation of the performance of their investments. If you know how to use a spreadsheet application, I encourage you to do so, as you will derive two obvious benefits. First, you will be keeping a close eye on your individual investments, and secondly, you will be able to track precisely the performance of your entire portfolio. In addition, it will make it easier for you to compare the performance in relation to your investment objectives or targets previously set.

Finally, don’t be afraid to seek the opinion and advice of others about your investments. Listen to what they have to say or suggest, but always decide for yourself and trust your instincts.

9. Tune-out the noise

“Since the market tends to go in the opposite direction of what the majority of people think, I would say 95% of all these people your hear on TV shows are giving you their personal opinion. And personal opinions are almost always worthless…facts and markets are far more reliable.” – William J. O’Neil, famous American investor

As an investor you will be bombarded with advertisements for investment products, “buy” and “sell” recommendations by analysts, a sea of financial news, as well as other business happenings. You will constantly be receiving mixed signals about what you should do with the investments you may own. A stock market analyst may issue a “sell” recommendation on the stock you own. The daily news may confirm rising interest rates and report that the markets are about to fall. A journalist from a financial magazine or newspaper may paint a picture of the outlook of a particular stock, market, or industry. Don’t get caught up in the daily hoopla. One important piece of advice: Tune out the Noise! Most of it is unsubstantiated and biased. I’m not saying you should completely ignore what is being said. In fact, you should listen to what is being said. Many newscasters, stockbrokers, and market analysts have very intelligent things to say. But at times they may be biased. Therefore you need to develop a critical ear or healthy level of skepticism when listening to others. Ask yourself: “Who do they work for? Do they have a hidden agenda? Do they collect any form of compensation when making recommendations or selling investment products? Do they own the securities they are recommending? Whose interests are they protecting?” Just be vigilant. Over time you will be able to weed out the bad ones and trust the advice of those who have gained your confidence. Always listen to others, but judge for yourself; your instincts or gut feelings are usually right. Whenever I have followed “buy” recommendations from stock analysts I have lost a lot of money. Now, I always do my homework and stick to my investment strategies. With all the knowledge you will have acquired after reading this book you will have enough insight to make sound choices. But do take the time to listen and read up on the world of investing as with time you will gain additional experience that will make you an even better investor. Appendix A – Investment Resources provides you with some excellent resources by which you can expand your investment knowledge and skills.

10. Take some profits and cut your losses

“Don’t sell the bear’s skin before you’ve killed the bear.” – Anonymous

“Profits always take care of themselves but losses never do.” – Jesse L. Livermore (1877-1940), famous American investor

Many traditional books on investment have promoted a “buy-and-hold for the long term” strategy. I partly agree. But the reality is that the markets have changed. In fact, we are becoming a single, globally-integrated, market (as discussed in Chapter 2) as opposed to several domestic markets. Increased competitiveness between businesses, governments, and even investors for that matter, make it a dynamic, yet volatile, one-world market. Buying stock in a company and holding it for thirty years no longer represents a safe and feasible investment strategy. There may be a few exceptions, of course. But for the most part, our world is changing at a much faster pace than it has during the past few decades due to globalization.

You will have to decide for yourself what kind of buy, hold, and sell strategy you wish to adopt. Personally, I would advocate a “buy-and-hold for the long term” strategy for some type of investments. For example, buying an index fund or ETF (in a tax-sheltered retirement account) that holds the stocks of a major index such as the S&P 500, S&P TSX Composite, or even a foreign index, represents a safe and effective means by which one can watch investments grow in a compounding fashion. I truly believe that all young investors should adopt this approach for at least a significant portion of their investment portfolio. As for other investments, you should follow your own strategy. Do sell, either fully or partly, when you reach your target, so that you can materialize a profit. It is important to take or materialize profits once in a while because until you do so it is just a gain on a piece of paper and it may disappear or evaporate in a short period of time. Some people develop a system where they take half of their profits and invest that portion in safe investment types such as bonds or cash investments and use the other half back into the stock market. The idea is to make sure that you expand your wealth. Pick some apples from the tree while they’re nice and ripe!

Finally, you should also devise a strategy that will help you minimize your losses. During your investment life, you will inevitably own a security that will just never get out of the starting blocks. It happens to all of us. This is a very important lesson to learn for new investors. People often fall in love with a particular stock and when it starts to fumble, they will hold on to it in the hopes that it will bounce back. When it doesn’t, they may still decide to give it another chance. By the time the stock hits rock bottom it is already too late, and much wealth has disappeared into the shadows of neverneverland. Just ask all those investors who invested in Nortel Networks stock. This is why you need to have a sell-target or cut-off point for all your securities. Many experts say you should cut your losses at 8% or 10%. It really depends on which proportion of your assets you have invested in the security. You should also consider current market (or stock) cycles to make a more informed decision. Decide for yourself what the maximum amount you are willing to lose is before selling-out. Then stick to that plan. This will save you a lot of angst and grief and will permit you to sleep better at night.

11. Re-balance your portfolio

At least once a year you should take a thorough look at your investment portfolio in order to see if things are progressing as you planned or estimated. Take a close look at your real returns (i.e., once commission fees and taxes have been paid or factored in). Are the returns in line with your estimates? If not, attempt to answer why. Was it because of poor company performance, high fees or taxes, a bad economy? Always attempt to pinpoint the reasons why your holdings are either performing poorly or well. Over time, you will learn more about the factors that make your investments move.

You should also examine your portfolio in order to assess if it still corresponds to your goals and life situation. Changes in your family situation such as getting married or having kids can entice you to switch some of your portfolio holdings to safer investment types. Other life challenges such as getting divorced, losing or changing your job or career can also have an impact on your investment savings. You may need to dig into your portfolio and reallocate remaining assets. As you get closer to retirement age you may also decide to shift assets such as stocks, stock funds, or more speculative investments to safer investment vehicles such as bonds and cash instruments. Regardless of the changes you may need to make, you should always ensure that you have a portfolio that is diversified and able to accommodate risk.

There are many ways in which you can re-balance your portfolio. You may simply decide to leave it “as is”. You may add new investments and sell poor performing ones. You may even decide to sell securities that are performing well for a profit, as you might anticipate a downturn. For more difficult decisions, you may decide to partly sell a particular security. Always be sure to play devil’s advocate and try to forecast where the markets are heading. Which sectors, industries, regions, and commodities do you see peaking or falling? What is the outlook for the economy? Where are interest rates headed? How much has your currency appreciated or depreciated against others in the last year? As an investor, you need to look into the future and not rely on the past. Be a leader and not a follower.

So there you have them. If you make a strong commitment to follow religiously these eleven golden rules of investing listed at the beginning of the chapter you will undoubtedly become a very good investor. What is paramount is that you keep these guidelines in mind at all times. It is quite easy to just forget about them and invest haphazardly. So be disciplined, and revisit these rules once in a while to keep them fresh in your mind and to make sure that you stick to the plan.

Continue with Chapter 5 - Avoid Mutual Funds...Embrace Exchange-Traded Funds...