Today’s guest post comes to us from Aaron Elder of BelowYourMeans.com – Below Your Means provides articles and insight designed to help individuals enjoy a debt free life. The site focuses on living richly by spending less on what doesn’t matter and saving and investing smartly for what does.
Hello College Investor Readers, for today’s post, I considered what advice I would give a friend or family member that was in (or just graduating) college and wanted to start investing for beginners. This advice comes from the school of hard knocks and is the result of years of investing and trading. I hope it saves you a lot of money by avoiding mistakes I’ve made over the years.
Recognize if you are a Trader or an Investor
Put simply, investing involves:
o Looking for undervalued companies, assets or commodities
o Committing capital to them
o Looking to benefit from the future success of that investment.
This can be through the distribution of dividends, or the appreciation of the underlying asset or stock. With the exception of protecting your capital via stop losses, your investment timeline should be measured in years.
If your plan is to do anything other than the above, you are a trader. There isn’t anything wrong with being a trader, but you need to understand what you are and what that means.
Buy and Hold Only Works Sometimes
They don’t call it “buy low, sell high” for nothing. If you find yourself “buying high, hope to sell higher” then you are probably not setting yourself up to be the next Warren Buffet. The thing to realize about guys like Warren Buffet is that they were able to buy at or near generational lows and when they did, they bought good solid assets. Those assets were extremely undervalued, and in solid companies with good balance sheets and operating models. A smart investor doesn’t always hold, they watch the fundamentals of the assets in the portfolio. If something in those fundamentals changes for the worse; or the price people are willing to pay for those assets is more than they are worth, a smart investor will sell.
The fact of the matter is that “buy and hold” works best when you buy at or near generational lows and hold for a generation. If in January of 2000, you had bought the NASDAQ at 4700 and held for 10 years, you are still down 40%. If in December of 1989, you had bought the Japanese Nikkei at 38,900 and held for 22 years, you would be down 75%.
Don’t be a Day Trader
If “buy and hold” is one extreme, day trading is the other. During the Internet bubble, any idiot with a trading account could make money… buy any stock at random and sell it weeks later for a 10 to 100% profit. Those days are gone and may people were financially wiped out in the process.
Trading too actively can be equally (if not more) devastating to your portfolio. Being a day trader is expensive. Brokerages charge a fee to execute each trade, this typically can range from $5 to $20 per stock order and $5 to $10 per option trade plus a per option price. These fees are known as “commissions”. If a day traders making 5, 10, 50 trades a day, it is not uncommon for day traders to rack up tens of thousands of dollars in commission charges over the course of a year! If you had a $100k portfolio, and spend $20k in commissions, you have to have a 25% return just to breakeven. Think about that for a second – basically unless you are a walk-on-water trader, you are going to lose money that year. Day traders also don’t generally benefit from things like dividends and long term capital gains. A quick tip, think about how much you trade right now, calculate all the fees you spent last year in trading, figure out how that affected your performance and if maybe you are trading a bit too much.
Don’t Trade or Invest on Margin… Ever
The simple fact of the matter is you are not a professional trader and unless you are sitting at a desk on Wall Street and have access to the kind of information they do, you never will be as good, fast or informed as they are. Professional traders not only have the kind of rapid access to information, but they often work at firms that are able to buy and sell in amounts that actually move the market – meaning they have enough weight to fix their own mistakes. You are not them. Don’t risk financially destroying yourself by using borrowed money to try to prove otherwise. I can’t overemphasize this point – I would invest in lottery tickets before I traded on margin.
Don’t Invest or Trade in Things You Do Not Fully Understand
This advice sounds simple, but is actually difficult. The reason for this is that the world of investing is designed to be hard. The more confused you are about how things work, the more opportunity for those in the know to make money at your expense. I don’t mean for this to sound like a crazy conspiracy theory – it is simply how the world of investing works. The way large institutions make money in investments is by having access to resources – both money and information – that others don’t. No matter how smart you think you are, you are one of those ‘others’. And it’s not just personal investors that get in trouble here. During the subprime mortgage crisis, pension fund managers and other “professionals” got into plenty trouble with CDOs, CDSs, MBSs, and other complex instruments they didn’t fully understand. . Here is a classic example:
o United States Oil Fund (USO) – This looks and smells like an Exchange Traded Fund (ETF), but it’s actually a Limited Partnership with a stock symbol. This means that if you own it throughout the year, you will get a K-1. This shows your ownership in the partnership, and as such you have to carry the gain or loss of the partnership onto your tax return.
USO also invests in oil via futures contracts and as such suffers from having to pay a premium for the time value of the contract, this is known as cantango. To put this in perspective, since January 2009 – Crude Oil is up over 25%, while the USO fund is down about 6%. So even if you were right on the idea that oil was going to go up, using USO to make that bet would have been a very bad investment. You can read more about this here, here, and here.
There are countless other investment options that look and smell like stocks, but act very different. This includes the VIX, Options, Futures, Currencies and many more.
Avoid Inverse and Leveraged ETFs Like The Plague
Repeat after me, I will not buy 2X, 3X or 5X leveraged funds. As an investor, you should never own any inverse or leveraged ETF. Why? Because they are all going zero, just at different rates. These ETFs are designed to be traded and not held for more than a week or even a few days. The reasons for this are many, but the results speak for themselves. A prime example of this is ProShare’s UltraShort Real Estate fund (SRS), also known as “the widow maker”. Was there a housing bubble? Yes. Did it pop? Yes. Have home and real estate prices continued to drop? Yes. So in February 2007, was buying SRS a good idea? No.
Since February 2007, the Case-Shiller Home Price Index a wide gauge of the value of US residential real estate, is down more than 31%. In addition, the Moodys/REAL Commercial Property Price Index, is down almost 50%.
In the same time, the real estate inverse ETF SRS, which one might expect to be up 31% if not more 2X that since it is an “ultra” fund; instead is down an incredible 97%. (Ouch)
Many funds like this have performed so badly, that they have had to go through one or more rounds of reverse splits. Where by, for every 4 shares you own, you get one.
You can read more about this here: Long Term Investors Should Avoid Leveraged ETFs.
Options are Useful, but Do Your Homework First
There are literally hundreds of books written specifically on option contracts. Because options are leveraged contracts, the amount of money you can make or lose with them is very high. Options are complex and you have to know the Greeks if you are going to make any money with them. If you don’t know what delta, gamma, theta and vega mean to options, you are not ready to use them. Options, unlike stocks, carry a decaying time component to them, meaning their value changes not only based on price on the underlying asset, but also based on the time left in the contract and the velocity at which the price of the underlying asset is moving.
A few more points on options:
o Options allow you to get into situations with limited upside and literally unlimited downside. Know this.
o “Most people that buy options lose money” – This is a fact. The majority of option contracts are written by the big trading firms / market makers. Just realize that you have to really know what you are doing to beat the odds.
o Stay away from Weekly Expiration Option Contracts – As if the market makers didn’t need another way to make money – enter the weekly option contract. These things are volatile and decay in value very quickly. If you make bets with these, you need to be very right, right away.
o If you want to get started with options, consider writing “covered calls” – The single safest thing for new investors to dabble in options are with covered calls. This is where you actually own the underlying stock (this is why it is called “covered”) and you sell a call contract (option) to others which allows them to buy that stock from you in the future at a set price. In exchange for this, you get a premium that is yours to keep if the contract expires worthless. These have relatively limited risk, since you own the underlying stock. They also are a potential way for you to get additional “income” from the stocks you are already holding.
Before you get started though, read all about covered calls and what they mean. There are fees if your call gets “exercised” and if the stock you own drops in price and you want to sell, you will need to buy back the call contracts first.
The world of investing is wide, deep and complex all the way through. I hope the tips above will save you the trouble of having to learn them yourself the “hard way” and will help keep your portfolio sound and growing.
Cheers,
Aaron of Below Your Means
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{ 6 comments… read them below or add one }
I agree! Don’t invest in instruments and stocks that you don’t understand. The tendency is that you’ll trade according to your understanding of how the money works but not how the industry works. Sometimes though it is best to trade by day or by month. Holding on to the stock for so long is too risky but high risk also equal high returns.
It depends on the keen sense of the investor.
You highlight some really important information here – especially your warning not to invest on margin. I think this is a mistake many young investors have made and, unfortunately, been forced to pay the price. Literally. It takes time to develop the “keen sense” June mentions, and a degree in finance is no substitute. My mom always said “invest in what you buy.” That might sound redundant, but it’s always worked for me!
I’m guilty of a few of these myself! Thanks for sharing – very well written!
This article is full of sound advice with a few exceptions. First let me say that I really like the part about leveraged ETFs. Few people know about the constant leverage trap. It is important to understand how this works. Kudos for bringing it up.
My main beef is your comment on options. You are right in that it is possible to get into the situation of limited upside but unlimited downside. Yet, a few sentences later advise getting started with covered calls. Covered calls force an investor to sell a stock that is strong and keep those stocks which are weak. Tell someone owning Enron stock or WorldCom that covered calls were a good idea. No, covered calls will allow your losers to run and cut your winners short exactly the opposite of what a trader or investor should be doing.
Options Dude – Very good point, I attempted to put that warning in there. Other people had pointed this out as well, just like shorting a stock… selling options (either calls or puts) can get you into a situation with unlimited downside. But when you only BUY puts or calls, your downside is limited, but time is running against you.
Regarding Covered Calls – I personally had a good luck with covered calls when I was first starting out and was doing a lot more buy and holding. I had a few reasonable size position in solid names like MSFT and would sell out of the money front month contracts that would usually bleed down in IV and I could buy them back… making a few $ hundred at a time. If you are holding onto a few hundred shares of PCLN, GOOG, NFLX, APPL, CMG, CRM or any other of the flyers and are selling covered calls you can be in a world of hurt if you want to dump those stocks quickly.
However selling that covered call does provide you some protection! If you sell an at the money call for say $5, you are “protected” from $5 in downside risk. Of course names like NFLX, GOOG and PCLN usually make moves in $20-$50 ranges so the $5 is a small benefit.
Anyway – very good point. Reader should definately do their homework before doing anything with options. It looks like your site has some pretty good stuff on the topic.
http://www.optionsdude.com/how-to-start-selling-covered-calls.html
Ya Im in agreement with optionsdude. Also, I think many people get in trouble because they simply don’t do their homework. Any good trader knows how much money he/she can lose for any given trade and I think newbie’s only look at how much they can make, even if that means going negative on option or future margin or short selling or whatever.