An Interesting Way To Play Oil

As you empty your wallet each time that you pull up to the gas pump, there may be an alternative that can fatten your wallet instead. Put your money in a Canadian royalty trust, and you could be collecting annual dividends of as much as 20 percent!

What is a royalty trust, you may be asking? In Canada, a royalty trust is a publicly traded oil or gas production company that avoids corporate taxation by directing all of its taxable income to its investors.

A royalty trust operates like a regular corporation in that it buys and operates oil and gas wells and pays its investors a percentage of all sales of oil extracted from its lands. Thus the higher the price of oil, the greater the revenue, which results in more money ending up in the investors' pockets.

For U.S. investors in a Canadian royalty trust, payouts qualify for the 15 percent dividend rate. However, there is one pitfall to bear in mind: if energy prices should suddenly drop, the dividends could plummet as well.

If you are interested in looking further into this interesting investment area, here are a few suggestions for starters:

BP Prudhoe Bay Royalty Trust (BPT)
Enerplus Resources Fund (ERF)
ARC Energy Trust
Focus Energy Trust
Penn West Energy Trust

You may not recognize any of these names at this time, but investing in any one of them just might enable you to enjoy a regal retirement!

* * * * *

Some Thoughts About CDs

Bank CDs are much better than money market funds right now and not as risky as bond funds. One year, federally insured CDs now yield better than 2.98% on average, with some banks paying as much as 4.52%. High short-term yields result from Fed rate hikes, with another rate hike expected on November 1st.

In a rising rate environment, the best advice usually is to stay in the shortest-term investments: money market funds and Treasury bills. However, one-year CDs now give you close to a one-percentage-point pickup above money market rates without locking you in for a long time.

NOTE: one good place to go in order to check out available CD rates is BankRate.com which you can find in our listing of Links.

* * * * *

Going Way Beyond Price

Do you study the stock market? Do you puzzle over interest rates? Do you plumb the depths of modern portfolio theory? And do you diversify your holdings?

No doubt you hope to profit from all your hard work. Well, here's some rather disturbing news. Warren E. Buffett does none of these things!

Buffett has said, "As far as I am concerned, the stock market doesn't exist. And if the Federal Reserve Chairman were to whisper to me what his monetary policy was going to be over the next two years, I wouldn't change a thing." He has even said, "Lethargy bordering on sloth remains the cornerstone of our investment style."

What Buffett does with his time is look long and hard at the companies, the businesses behind the stocks. For Buffett, "the nine most important words ever written about investing," he has said, are Graham's adage: "Investing is most intelligent when it is most businesslike."

But what does that phrase mean?

In The Warren Buffett Way, author Robert G. Hagstrom, Jr. describes well how Buffett grades businesses. The highest marks, Hagstrom writes, go to managers who put shareholders first when allocating capital.

Managers with good rates of return should plow cash back into their companies to get more good returns, Buffett believes. But if returns are average or worse, reinvestment makes no sense.

Even though companies may hope that their luck will turn or that an acquisition will make the difference, he says, most underperformers should return extra cash to shareholders, who can then seek higher returns elsewhere.

Managers who do so through increased dividends or stock buybacks, tend to be low on ego and high on shareholder interests, he believes.

Berkshire Hathaway has invested in many such enterprises. A hallmark of its holdings are companies that have done stock buybacks, reducing the shares outstanding and raising their value. Some Berkshire holdings that are big on buybacks are Washington Post Co., Geico, and PNC Bank.

Buffett also likes businesses that are shielded from competition and thus can earn higher profits. And these ventures include more than just his well-known brand holdings such as Coca-Cola and Gillette Co. (now a part of Procter & Gamble).

Geico, for instance, has carved out an insurance franchise with a simple idea. It finds a group of statistically safe drivers - such as government employees - and sells them auto insurance by mail.

Using the mail cuts out agent commissions and makes low-priced policies possible, while the chosen pool of drivers keeps costly claims down. No other insurer does exactly what Geico does, and Buffett knows it. The company is his third largest holding.

Then come low costs. Berkshire, with 11 employees and no legal or press offices, keeps overhead at less than 1 percent of operating earnings. If it were 10 percent, Buffett has said, returns would drop 9 percentage points.

Buffett's holdings are equally parsimonious. Even when Geico became the nation's seventh largest insurer, its chief executive still shared a secretary with two other managers.

Buffett also asks other business questions: Can the industry's earnings grow without great outlays? Are the managers impressive? Is the stock cheap? And, is the business understandable?

Despite high regard for Microsoft, Buffett avoids its stock because the field puzzles him. Ignorance, he says, increases danger.

This belief is a departure from the common wisdom about stock diversification. Owning many different stocks - good, bad, and mediocre - depresses the returns that a more selective portfolio would achieve, he believes, and makes it impossible to fully understand all that you own. Thus in 1987, his then $2 billion portfolio had just three companies.

Buffett is not the only investor to recognize that the business behind a stock is the important factor in the long term. But he is rare in remaining deaf to the roars of Wall Street. He has no stock quote machine in his office, and he describes the market as a slough of fear and greed untethered to corporate realities.

Thus whenever Buffett invests, he sees a business. Most investors on the other hand see only a stock price.

* * * * *

A Word About Trailing Stops

We have talked about using Trailing Stops as being an excellent method for limiting your risk as an investor. Unfortunately, the use of Trailing Stops also entails some effort on the part of any investor who employs this method of monitoring his/her portfolio - the effort I speak of requires re-calculating your "exit point" as the price per share of the particular stock increases. What to do about it if you don't care to do the math yourself?

Well now there is an online service available (as a subscription) that will automatically track your trailing stops. It also tracks prices and profit thresholds. This service is called, "TradeStops" - and you can find it easily in our list of "Links."

* * * * *

Watching Warren

Warren Buffett has been so successful picking stocks that he has attracted numerous investors who seek to imitate his every buy and sell order. The problem for these followers, however, is that federal disclosure rules allow Buffett to wait 45 days after the end of the quarter before revealing the contents of the Berkshire Hathaway portfolio, and even longer for specific stocks that are in the process of being either accumulated or sold.

That should not prevent anyone from successfully following Buffett's moves, because according to a research paper by professor John Puthenpurackal of Ohio University, an investor who mimicked Buffett would have beaten the Standard & Poor's 500-stock index by an average of 11.6% a year from 1980 to 2003, even after accounting for the reporting lags.

Buffett's picks tend to jump in price when disclosed, so the researcher didn't start measuring performance until two weeks after each filing. Further, according to Gerald Martin of A&M University, who rates Buffett in the 100th percentile of all investors, "Disciples (of Buffett) can make money and beat the market."

* * * * *

This May Be A Good Bet If You're Seeking Greater Yield

There is a new Inflation Protected Security being offered by Sallie Mae, the huge student-loan lender. These notes trade on the NYSE under the symbol OSM. They mature in twelve (12) years, and currently yield around 5.7% - which makes their yield higher than that of the popular TIPS (Treasury Inflation Protected Securities). And another attractive feature of OSM is that they pay dividends monthly in an amount that is tied to the Consumer Price Index. NOTE: TIPS pay interest semi-annually, and they don't pay an inflation adjustment until the bond is sold or matures.

* * * * *

Getting Your Interest

Stocks are the rock stars of the investment world. They tend to have the eye-popping returns - both negative and positive - and are usually the featured story in the business news. Nonetheless, interest-paying investments like bonds, mortgages, certificates of deposit, annuity contracts, and bank accounts are more important quantitatively and therefore, managing the interest-bearing portion of your financial activities is just as meaningful as making wise equity investments.

Interest-bearing securities are all about borrowing and lending. If you buy a bond, make a deposit in a bank or savings institution, or hold a balance in a money market fund, you are lending. If you take out a mortgage, purchase an appliance with a credit card, or are paying off your car over 48 months, you are borrowing. Interest rates are just the price of borrowing and the return to lending. Financial intermediaries such a banks, brokers, money market funds, and bond mutual funds organize these markets and they make money by charging borrowers more than they pay lenders.

There is no such thing as "the interest rate." There are hundreds, even thousands, of interest rates. The rate of a loan depends on the creditworthiness of the borrower. It also depends on whether the loan is collateralized. And it depends on the length and size of the loan plus a number of other factors. The interest rate received by lenders depends on whether the returns are taxable or tax-exempt, the time to maturity of the loan, and whether the borrower has the ability to pay the loan off early at specific prices. If the loan contract has desirable features from the point of view of the lender - such as being short-term, tax-exempt, or non-callable - then the interest rate tends to be lower. But if on the other hand the loan has undesirable features, those will be capitalized in the market into a higher interest rate.

Interest rates compensate the lender both for the time that the money was borrowed and, under normal inflationary circumstances, for the fact that the repayment will be made with dollars of less purchasing power. Economists divide the stated or nominal interest rate into two parts - the real (inflation adjusted) interest rate and the rate of inflation. High nominal interest rates don't necessarily correspond to high real rates. A perfect example of this was the late 1970s when both nominal interest rates and inflation were high. In 1979, the average yield on 3-month Treasury bills was 10.04%. The average rate of inflation between 1978 and 1979 was 11.3%. Since prices were going up faster than the nominal rate on T-bills, the real rate of return to savers was negative.

Here are a few tips on managing your money. First, repaying money that you have borrowed is a smart investment because you are earning whatever interest rate is being charged. Second, as a lender you should recognize that very long-term loans are quite risky. If you invest in a bond mutual fund, read the prospectus to determine the maturity structure of its investments.

Third, you should keep in mind that most interest income is taxable at your full marginal tax rate. Dividends got a break in the 2003 tax bill; interest did not. If you are investing in bonds or bond mutual funds with a maturity structure of more than three or four years, you should consider municipal bonds as an alternative to taxable corporate bonds since after-tax rates seem to be higher for munis in this maturity.

Managing your lending and borrowing activity is part of a good financial plan. After all, you are looking after your own interest!

* * * * *

AAII Happenings This Week

Thursday - October 20, 2005

The regular monthly meeting of this Group takes place at DePaul University in Naperville, with our special guest, Mr. Jim Bittman from the Options Institute Council. His topic is "Covered Calls" - and the meeting starts at 7:00 PM. If you missed our regular meeting notice on this Blog, DePaul is located in Naperville at 150 West Warrenville Road. There is a $5.00 donation requested from all non-members.
------------------------------------------

Saturday - October 22, 2005

The Chicago Chapter's October Meeting takes place at the University Club, which is located in Downtown Chicago at 76 East Monroe St.. The guest speaker will be Mr. Pat Dorsey, Director of Equity Research for Morningstar, Inc.. His topic: "How To Buy Great Firms At Good Prices." Registration begins at 9:30 A.M., and the Program begins at 10:00 A.M., ending at 11:30 A.M.. Tickets at the door are $25 per person.
------------------------------------------

* * * * *

Understanding Ourselves As Investors

It wasn't too long ago that accepted economic theory held that humans are fundamentally rational and self-serving when it comes to money. Accordingly, the assumption would be that we consistently make logical financial decisions that are in our long-term best interests. Now if you're raising an eyebrow as you read this, you do so with good reason. Otherwise, why would so many Americans stash their cash in something like a savings account or a bank CD when they're losing money every day? Why would so many of us be willing to pay more for a product bought on credit rather than in cash? Why would we continue to chase past returns instead of looking to the future? And why would we fail to take complete advantage of our tax-advantaged accounts?

To answer these and other questions, a new breed of economist has been examining the ways we really behave. Here now are just a few of the insights provided by this cross between psychology and economics - commonly referred to as behavioral economics. No doubt, most of us will see just a little bit of ourselves in these examples.

If you tend to treat your hard-earned money differently from the way you treat other money - such as tax refunds or lottery winnings - then you're guilty of what the behavioral economists call "mental accounting." This concept, developed at the University of Chicago, describes our tendency to categorize and value our money according to its source or how we spend it. This tendency can be beneficial if you are safeguarding funds for college or retirement. Mental accounting can also be dangerous though - because in reality one dollar is worth just as much as the next. One hundred dollars that you get from a windfall will buy you just as much as $100 you've saved. Likewise, if you feel much freer spending money when you use a credit card than when you pay in hard cash, you are likely practicing a form of mental accounting.

If you're the type who continues to pour money into an old jalopy, you're falling victim to what the behaviorists call the "sunk-cost fallacy." If you wouldn't want to buy the car today, knowing that it needs endless repairs, why would you want to waste money continually propping it up?

Research shows that the pain we feel from losing money is often much greater than the pleasure we experience from gaining the same amount. As an investor, this means that you may resist selling your losing investments, even if your money could be better invested elsewhere. On the other side, and just as dangerous, loss aversion can cause you to sell a successful investment too soon in order to protect your current gain.

In a fascinating study, researchers set up a jam-tasting booth in an upscale grocery store to test how the number of choices affects our ability to make decisions. Half of the time the researchers offered 24 jams for tasting. The other half of the time they offered only six. The result? Customers who had only six jams from which to choose purchased a jar 30% of the time. The customers who were able to sample 24 flavors made a purchase only 3% of the time! Of course the consequences of not making a choice are much more serious for an investor than they are for someone shopping for groceries. For example, this can translate into keeping too much of your money in a savings account. Or it may mean that you don't invest your IRA properly. The irony, of course, is that by not choosing a mutual fund or a stock - and instead keeping your money in a savings account - you're still making a decision.

If you have a tendency to tune out when faced with numbers and math, you're succumbing to what is sometimes referred to as "number numbness." Clearly, this won't work to your advantage as an investor. Ironically, most of the math you deal with as an investor is simple and straightforward. But if you fail to appreciate the power of compound growth, or avoid evaluating a mutual fund on the basis of its expense ratio just because numbers are involved, your overall portfolio return will suffer.

From the famous Tulipmania in the 1600s to the dot-com bubble in 2000, history is full of examples of how blindly following trends can work against you. Or as I like to phrase it, "Whenever you follow the herd, you always run the risk of stepping into whatever the herd leaves behind!"

Although overconfidence is not the sole domain of men, a well-known study conducted by the University of California at Davis showed that overconfidence led men to trade 45% more frequently than women and earn annual risk-adjusted net returns that are 1.4% less than those earned by women. So gentlemen, the message is very clear: Don't allow your moxie to overrule your better judgment. Do your homework, diversify your holdings carefully, and never think that you can time the market.

Discussions about money are often emotionally charged, and as the behaviorists have demonstrated, we don't always make the most logical or advantageous decisions. So the next time you're facing a major financial decision, the best advice to follow is this: First of all, slow down; do the math; then weigh your options. And if you're not careful, your gut may get the better of you.

* * * * *

The "Sure-Thing" Investment

There is something you can do to make your investing more profitable. It's neither difficult nor complicated, and does not involve any increased risk. However, it does require you to take action, and for some people, that's too much to ask. But if you are a serious investor, if you are saving money for your retirement, or if you are accumulating money so you can enjoy some of life's many pleasures, then taking this simple step can indeed make a difference.

To make the value of your investment nest egg worth significantly more in the future, all you have to do is reduce your expenses. It's very important to bear in mind the fact that the expenses associated with investing play a very important role in determining the overall success of your savings and investing program over any extended period of time - not overnight nor in one year. But if you are attempting to accumulate wealth over the years with a savings program, then the importance of reducing your costs cannot be overemphasized. But before discussing specific steps you can take, let's decide if cutting expenses is really worthwhile for you.

How much difference does a slight reduction in costs make over a lifetime of savings? Let's take a look at the situation from the perspective of a mutual fund investor to see the effect of a small annual cost reduction. According to the Investment Company Institute, the average mutual fund charges 1.25 percent of your assets each year to manage your money. The most expensive exchange traded funds (ETFs) and the largest index fund, the Vanguard 500 Index Fund Investor Shares, charge only 0.18 percent - which is only 18 cents per $100 of invested capital in annual fees. So if you want to invest in mutual funds then indexing clearly is the smarter choice when you consider the expenses.

Something else to consider when it comes to expenses. However you have your savings invested, the less the return on your investments, the more important it is to reduce expenses, and mutual funds are not bashful about taking their fees, and the charge is imposed regardless of how well or how poorly the fund performs.

Let's look 15 years into the future and compare how much less your savings will be worth if you opt to own shares of a traditional mutual fund and pay 1.25 percent rather than shares of an index fund. Based on an initial investment of $10,000 over a 15-year period, you would pay more than $12,500 in fees to the team that actively manages your mutual fund. But if you owned the same number of shares in an index fund (or ETF) instead, you would pay less than $2,000 during the same period of time. And when you consider that it's likely that the mutual fund manager you select is going to underperform the market averages - and that's before management fees are deducted from your account - it makes it that much more important to consider investing your money in low-cost funds.

By investing in shares of index funds, you can cut expenses even further because index funds are managed passively. They don't spend any time or money on costly research in an attempt to beat the market. Index funds attempt to mimic the performance of a specific market segment, not beat it. Index funds seldom change their holdings, doing so only when the composition of the index they are mimicking changes. Because actively managed funds trade often and incur significant commission costs, index funds are more efficient to manage. And on average, index funds perform better than actively managed funds.

ETFs are exchange traded funds that operate like index funds with fees that, in general, are slightly lower than those of index funds. That makes them suitable investment choices for most investors. But these funds trade on an exchange, and although there are no loads, the investor must pay a brokerage commission to buy or sell shares. Thus, ETFs are suitable investment vehicles for anyone who pays very low trading commissions to a deep-discount broker.

There are more ways to cut expenses than by simply chosing a less-expensive mutual fund. The next obvious place to save money is by cutting trading expenses, and that means brokerage fees. Full-service brokers serve a purpose and are the correct choice for many investors. They provide guidance, make recommendations, and answer questions, and if those services are valuable to you then by all means maintain an account with your full-service broker. But if you make all your own investment decisions and don't need those extra services, why pay higher commissions?

All brokers are not alike. Even among the deep discounters, both commissions and the quality of service vary. So don't consider commissions as the only factor when choosing a broker. Trade execution should be your primary concern, as more dollars can be saved by quick, reliable trade execution than by getting poor execution at low rates. By all means save money on commissions, but be certain your orders are filled at good prices.

When making investment decisions for the long term, it makes sense to give yourself the best chance of success. And whenever you reduce costs, you jump-start your savings program. So if you own mutual funds, then get on board an index fund or an ETF instead.

Unless you choose to buy Treasury bonds or certificates of deposit, you never know the rate of return to expect from your investments. But by beginning with an edge - by knowing your costs have been reduced by more than one percentage point per year - you are ahead of the crowd and on a path, with an increased probability of becoming a successful investor.

* * * * *

Is The Price Right?

If you want to know if the stock market is overvalued, you should analyze the market in the context of two variables that determine value.

The first of these points out the fact that stocks ultimately derive their value from only one source: the earnings that businesses produce. And since owners get paid from future earnings, we would look to future, expected earnings. And that is one of our two fundamentals.

The other is, of course, interest rates - specifically, the rate on the 30-year government bond. That represents the risk-free return on long-term money.

To explain how this pair of market-measuring variables works, let's invent a mythical enterprise which we'll name, Durability, Inc. Now it so happens that Durability is a rather unusual firm in that it is guaranteed to earn $6 a share this year and every year, and just as assuredly, it will never earn more. But notice this - we didn't say anything about Durability's dividend policy. One year, the Board might decide to retain its earnings; the next year, it might pay a dividend.

But either way, the investor would make $6 every year on his Durability stock. So his return is simply $6, divided by whatever he paid for his share -- that is, earnings divided by price. That is known as the earnings yield. Thus if the 30-year Treasury bond was trading at 6 percent, shares of Durability ought to be trading very close to $100 per share. At that price, the earnings yield ($6 divided by $100) would match the return on the 30-year Treasury. Thus, no investor would pay more for Durability, because he'd wind up making less than he would on the bonds!

The point of this exercise is that the stock market as a whole tends to be priced pretty much like Durability. However, it should be noted that real companies are much harder to predict. They may have a tendency over time to grow; but on the other hand, they can deliver many surprises. And sometimes, investors are more attuned to the growth; other times, more wary of the risk. But on average, the market - which is a blend of stocks with varying degrees of both uncertainty and of potential growth - is more stable than you realize.

In case you think the yield on stocks can fall independently of bond yields, well it has never ever done so before. So for the overall market to make a sustained rise, one of two things must happen. Either bond yields must also fall - in which case you would be just as well off owning bonds - or earnings estimates must rise, which is a tough trick in a falling U.S. economy. And the bottom line in all of this is that what's important is not how high the market 'looks' but, fundamentally, how high it really is.

* * * * *

NEXT MEETING: Thursday - October 20, 2005

This month we observe the Tenth Anniversary of the West Suburban Sub-Group by welcoming back Mr. Jim Bittman of the Options Institute Council. The entire evening will be devoted to an in-depth discussion of Covered Calls. And as always, there will be sufficient time for questions and answers.

If you missed Mr. Bittman when he appeared here this past April, then make it a point to be sure and come to this meeting because even if you are not especially interested in options, you will enjoy Mr. Bittman's dynamic and very informative presentation style. And of course, there will be materials provided to help you expand both your knowledge as well as your comfort level regarding options.
-------------------------------------

We meet monthly at DePaul University in Naperville, Illinois - which is located at 150 West Warrenville Road (at the intersection of Herrick & Warrenville Roads). The meeting begins at 7:00 PM and ends promptly at 9:00 PM. The room number for this meeting will be posted on the easel standing next to the reception desk in the main lobby.

We meet twelve (12) times per year and our meetings are open to anyone who shares our interest in learning more about investing and investments. We do however have a modest yearly membership fee of $15.00 to cover the expenses in maintaining a group such as this, and non-members may attend for a $5.00 donation per meeting.
-------------------------------------

* * * * *

A Seven-Step Action Plan To Avoid Common Investment Mistakes

#1 - Spend some time and effort getting to know the company and its products.

When you find a company that you are considering as an investment, never hesitate to call that company directly and start seeking information. Unfortunately, investors for the most part are too trusting, and they are afraid to call a listed company's offices and start asking questions.


#2 - Check the daily trading volume of the stock you are purchasing as a general measure of the amount of buying and selling occurring for the stock.

For a small company, trading volume is a good indicator of the amount of interest in its stock. If the price of the stock suddenly moves up on low volume, there is a tight float - which means that liquidity is a problem, and getting out of the investment may be difficult for lack of buyers. Never invest in a small company that experiences spurts of heavy volume followed by days, perhaps even weeks, of light volume. The trading volume can be easily checked on a daily basis and the Wall Street Journal is still your best bet for doing that.


#3 - Find out how many market makers there are trading the stock on a frequent basis.

The more market makers there are, the better the liquidity in the stock. So never invest in any stock that has fewer than ten market makers. In a case where there are only one or two companies making a market, the market maker can artificially decide what the value of the stock should be.

For example, let's say you own 10,000 shares of stock A and you wish to sell that stock at the current market price of $5 per share. But there is only one buyer in the marketplace - the market maker - who will purchase your stock. However, when he sees that your order to sell is coming in, he will drop the price of the stock because he knows that you will have only two choices: Either you sell the stock to him, or you hold on to it.

In cases where the market maker has a buyer for your stock or is himself accumulating the stock, he will pay you the higher price. However, such cases are rare. The stock you are selling is marked by a bid price and an asked price. The bid is what a market maker is willing to pay you for a specified number of shares - but you don't know how many shares he is good for at that price. If he is only good for 500 shares at the $5 bid price, he will take the first 500 shares at that price, then lower his bid for more shares.

With more market makers bidding for the stock, you are better able to get out of your position at close to the price you are offered for your stock. In other words, there is more liquidity.


#4 - Check the spread for the issue that you are purchasing.

The spread refers to the difference between the bid price and the asked price. The spread is also the gross profit made by the trader in the transaction. In small-cap stocks, it is not uncommon to see a spread of a half-point or more. If a stock is traded at $5 bid and $5.50 asked, the spread is 50 cents. You are at a 10% plus (more with commissions) loss the minute you buy the stock, because you will be paying the asked price of $5.50, plus commissions, and, if you want to sell immediately, you will receive less than $5 net from the transactions.


#5 - Do not trust company research reports provided by brokerage firms.

These reports are nothing more than glorified sales brochures that are slanted toward selling the company. A little personal research into the company will go a long way in helping you decide if the investment is viable for you.

Treat the purchase of stock the same way you would treat having your car repaired. The local library, independent investment publications, and good judgment are your best sources for a good decision.

Collusion between companies and "pushers" of the stock, those brokerage firms who hold a large position, are also an artificial stimulus for the stock price.


#6 - Take the following steps to prevent churning.

* Set priorities that specify the type of trading in your account.

* Set profit and loss goals to be met within specific time periods. But be careful to set your profit expectations realistically.


#7 - Check the consensus before buying.

There is one source that may help you decide whether a security is overvalued or if there is a strong opinion that the company is not all the stock price makes it out to be. Check the short positions in the issue you are considering for purchase. The short list is published in the Wall Street Journal at least once a month, usually on the 15th.

If you find a company that has a short position equal to the number of shares trading in the float, this would mean that there are a lot of people who strongly believe that the company's share price was due for a fall... In the brokerage business, overvalued stocks are usually classified as "growth stocks."

* * * * *

Investment Wisdom

"You are your own greatest investment. The more you store in that mind of yours, the more you enrich your experience, the more people you meet, the more books you read, and the more places you visit, the greater is that investment in all that you are. Everything that you add to your peace of mind, and to your outlook upon life, is added capital that no one but you can dissipate."

-George Matthew Adams

* * * * *

Getting Out With A Profit

One of the most often asked questions is this: "When should I sell?"... For some strange reason, people will take 10% profits, while they'll also sit on losers in their portfolio for months, watching them continue to fall. This is called, "limited upside, unlimited downside" investing - which is an almost guaranteed recipe for failure. So let's cover how to do it right... how to end up with big profits and small losers.

There are only TWO reasons to ever sell an investment: 1) If the reason you originally invested is no longer there; or 2) If you've hit your pre-defined "point of maximum pain." Both concepts are simple, but most people don't follow either one!

Your reason for being there is gone...

If you bought a biotech stock because its wonder drug was going to be approved by the FDA, but it wasn't approved, then it's time to sell. If you bought because you liked the CEO, and he left, then it's time to sell. If you bought for no reason other than because it was super cheap, and now it's really expensive, then what are you doing still holding it?

Why did you buy? There is nearly always a MAIN reason why you got into an investment. Go back and remember what it was... and then ask yourself if it is still there. Chances are, you'll be surprised to find how many investments you're still holding that you really shouldn't be, by this rule.

Your point of maximum pain...

The biggest killer to any portfolio is a "catastrophic loss." If a stock falls 90%, it has to rise by 900% just to get you back to where you were. So you never want to find yourself in that position, and the best rule of thumb to prevent such a debacle from happening is to use a trailing stop with every stock you own.

I like to use a 20% trailing stop with most stocks although you can be selective and vary the percentage depending on the volatility of the given stock issue. But in every case, the concept of a "stop" is simple. If a stock you own falls by 20%, you get out, and "stop" your pain. The concept of a "trailing stop" is also simple: As the stock rises in price, you raise your "stop" point. If you bought a stock at $5, and it goes to $10, then your new stop is $8.00. And if it rises to $20 without falling by 20%, then your new stop is $16.

When it comes to investing, if you don't have an exit strategy, then you really have no strategy at all. And with no strategy, you'll never make any serious money in the markets because you'll always be giving back your gains!

The Reward-to-Risk Ratio...

With any investment, you need to estimate your potential reward vs. potential risk before you buy. And if you don't use a stop, that means you have 100% at risk. It is unfortunate that most people don't think about their reward-to-risk ratio like this when they trade. But they should.

Whenever you buy a stock, if you believe your upside potential is about 45%, then use a 15% trailing stop. If your upside is about 30%, then use a 10% trailing stop. It's pretty simple, and it will keep you at a 3-to-1 reward-to-risk ratio. And if you go back and check all of your current investments with the reward-to-risk ratio in mind, you'll probably be amazed to find that in many of these investments, you're risking 100% for a measly 15% expected return - which is no way to make any money!

These are all rough rules of thumb. The goal is to get you to sell when you should, instead of holding and hoping. But the real goal is to give you a defined exit strategy. That way, you'll know when to get out systematically, instead of by the seat of your pants.

If you never know when you'll get out of a stock, then you really don't have a plan. And without a plan, you'll never be able to outperform as in investor!

* * * * *