I hope you didn't reduce your 401K or other retirement account contributions over the last four to six months as stock prices and markets tumbled. Even though the value of your current 401K or retirement plan probably fell over this time, in the long term the power of dollar cost averaging and recovering/rising markets would have ensured that your portfolio will be worth more than it would have been if you stopped your contributions when things got rocky. Here's a simple example that illustrates this concept

Joe had a 401K portfolio of $100,000. Assume each stock (or fund) unit was worth $1000 in September 2007. So he had 100 stock units. He used to buy 1 unit every month when he got paid, which cost him $1000. However with the fall in share prices, the unit price dropped to $50. So Joe's portfolio is now worth $50,000. Joe is not very happy but is a long term investor. So he keeps investing the same amount every month, but now gets 2 stock units for the same price. So by June 2008, 9 months later, he has 100 + 2x9= 118 units. With a recovering stock market (just like we are seeing now), the units are back to being worth $1000 again by year end. So Joe's 401K portfolio of 118 units are now worth $118,000. By the end of the next year (2009) with the economy growing again and optimism in the markets the units are now worth $1500. So Joe's 118 units are now worth $177,000. So in the medium term, even though the stock unit price fell, the investment turned out okay as the price recovered. But what if Joe had stopped investment when things got rocky and only started back again at the end of 2009?

If he stopped investing way back in Sep 07 when the stock market tumbled, he would only have the original 100 units and they would be worth $150,000 based on the final price in the example above. So, Joe's retirement portfolio is $18,000 worse off (less $9000 for the cost of the 18 units) by not keeping up his contributions. This example is very basic and is based on assumptions like the market recovering - which I would be very confident of given historical trends. Still you get the idea and power behind dollar cost averaging. You can get more bang for your buck when markets are down and magnify the gains when markets rise.

In conclusion

Unless other circumstances prevent you from maintaining your regular retirement account contributions, don't stop investing when things get rocky. To ensure a comfortable retirement aim to commit 10% to 15% of your salary in a 401K or other retirement account. Best of all your contributions will be tax free and most likely accompanied by a company match.

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In a recent post I talked about the 5 "buy" signs for a stock. However, your portfolio should never consist of just one stock, Exchange Traded Fund (ETF) or mutual fund in the long term because of the potential exposure to loss you will have. So to manage your risk, you must diversify your portfolio. A good rule to remember is that "The more diversified you are, the less pain your portfolio will feel in the long run"

Another reason to diversify is that it is possible to have too much of a good thing. That's especially true when strong performance in a particular market sector causes one part of your investment portfolio to bulge while other parts shrink or grow only modestly. In such situations, instinct may tell you to celebrate your good fortune and leave your portfolio as is—or even to load up on the investment that's doing well. But, in most cases a smarter approach is to take a close look at your long-term investment strategy and take steps to restore your portfolio's diversification.

Protect yourself by learning from the past

Many investors don't want to worry about diversification when they're enjoying a stock market run-up, such as the one we saw in the first half of 2007. But letting one part of your holdings swell disproportionately can be risky. This would have clearly been felt with the market downturn in 2008 where financial stocks, disproportionately large in a number of investment portfolios, meant that a lot of amateur and professional investors took big losses. Conversely, if you had a well diversified portfolio, you probably held up better than most.

A key investment lesson of the last decade is that no one type of investment should have too much—or too little—weight in your portfolio. For many investors, the harm caused by the collapse of technology, financial and telecommunication stocks was compounded by a lack of portfolio diversification.

Of course, investment diversification will never eliminate your risk of loss, nor will it guarantee a profit in a declining market. But it should reduce the chance that you'll suffer disproportionate losses if one particular high-flying sector suddenly descends to earth. And owning a portfolio with exposure to all key market components should give you at least some participation in whatever sectors are performing best at a given time.

Don't lose your balance

Once you've established a diversified portfolio, you'll have to make sure you don't lose the balance you've worked to create. That will mean periodic rebalancing—shifting money from one type of investment to another—to ensure that you continue to hold the mix of stock, bond, and short-term investments that you deem appropriate for yourself.

Rebalancing will result in taking some money away from the top performer of the moment. While that can be emotionally difficult, such investment discipline will help prevent you from becoming too heavily weighted in one area. Investors, of course, want to buy low and sell high, and that is what rebalancing can help you do.

I consider having a well diversified portfolio as an integral part of my investment strategy. To enable this I track my investment performance in a simple Excel spreadsheet, where I also track what percentage (%) of my total portfolio each stock, ETF or Mutual fund makes up. Every 3 months, I evaluate my portfolio and if a particular investment makes up more than 20%, I put a plan in place to reduce it (and hopefully take some profits) to between 10 - 15%. This also enables me to convert paper profits to real profits - a good habit for successful investors.

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My brother-in-law recently decided he wanted to buy some Visa shares (V) following a discussion we had around the postive outlook for the company. However he has never bought shares before and asked me about the process. So this post is for him and others new to the stock market. It may look complex with all those charts and numbers but the good news is that in today's digital age, trading shares is simpler than ever. Just follow these two steps:

1. Find and Sign up with an online broker

For most people who just want to trade shares, the best bet is to sign up with an online broker. You can sign-up with a full service broker who provides trading advice and executes the trades for you, but they can charge a lot and you need to be investing some serious money to really warrant the use of a full service broker. To just buy and sell shares, an online broker is the best and cheapest option. There are plenty of online brokers out there and you only need to go to the Yahoo or Marketwatch finance sites to see their ads. The key thing is to select a broker with the cheapest brokerage rates (the cost of the transaction to buy or sell a share) AND one who does not have any account keeping fees. I use TD Ameritrade (no problems to date & you can contact me for a referral), but other goods ones I have heard about are E-trade, Fidelity, Scottrade, and Zecco. A detailed overview can be found here.

They all offer similar services and have transaction fees ranging from $7 to $12. Finding the right one is a matter of visiting the sites to get a feel for the user interface (most sites have free demo's). Pay attention to the fee structure and how it works with your trading style. If you are an infrequent trader, look for zero maintenance or inactivity fees. If you plan on activily trading (>10 trades a month), you will want frequent trader rates.

Another point to note is that when you sign up for an online account you will also have to have to fund your brokerage/trading account. You should do this electronically via your normal savings/checking account. Makes life much easier in the long run when moving funds for buying and selling shares.

2. Research, Order and Monitor

It should take about 30 minutes or so to complete step one based on the broker you selected and 2-3 days to get the funding and relevant paperwork finalized. Now comes the fun part - buying the stock. Here is my most important piece of advice before you do this - Research before you buy!!! Your online broker should have lots of free research available on the stock and you can do a simple web search to find out more information about it. Buying a stock takes less than one minute, research is where all the time and effort is spent. To improve your odds of becoming a succesful investor in the long term, research is key. See this post for signs on when to buy a stock.

Once you have decided which stock to buy, log in to your online brokerage account. It is through this account that your online broker will execute the share transaction process on the relevant trading exchange. America has multiple stock trading exchanges, but the biggest and most well known are the New York Stock exchange and the NASDAQ. For your purpose you don't need to worry about which stock the exchange is traded on and how your order gets routed. Your online broker will do this for you. Because stock names can be very long, each one is assigned a symbol. You will need to know this for trading it, but all the online brokers (and leading financial websites) provide an option for you to look up the stock symbol. For example, V is the stock symbol for Visa.

To actually buy a stock look for the "Buy", "Trade" or "Place a trade" option. You will be asked to enter the following :

> Stock Symbol - V;

> Quantity - number of shares you want to buy;

> Order Type - The two main options you should consider are "Market" or "At Limit". Market means buying the share at the prevailing market price. At Limit means you set a limit for the price at which you will buy the share. For volatile shares, use the at limit option to reduce your exposure to large swings;

> Expiration - This is when you want the trade to expire. My advice is set it to "Day" or "Today only". You can always reuse the order to place it again , but if you leave the expiration for too long, you may forget about the trade and inadvertently buy the shares.

Before you place the actual order, think about above and how much you want to invest. If you wanted to buy $5000 worth of Visa stock at $70 (just above their current price as I write this post), you would use the following values:- Stock Symbol = V; Quantity = 71 (5000/$70); Order Type = "At Limit"; Expiration = "Today". Once you place the trade, this order should get filled as your buying price is higher than the current price. You will get an email or mailed confirmation when your trade is successfully executed. The transaction fee will be added to your overall order once the trade is successfully executed.

You can monitor your stocks via your online broker or use Yahoo finance to set up your portfolio watch list (I do both). Make sure your monitor your stock to ensure it is heading the right way. Selling a stock is as easy as buying it, making the decision to sell is the hard part. You should also be aware of the tax implications from trading shares. I will cover these in upcoming posts.

So there you go, you now have the basic framework to complete your first trade. If you get stuck or need more help leave a comment on this post or use the "help" option your online broker provides.

Happy investing returns!

Related Posts:

Reacting to Market Volatility
Those Pesky Ratios...PE, PEG
Lessons from investing in a losing stock

Photo courtesy Stefan Schlautmann
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Here is an investing 101 post based on some of my own experiences and learning's from being an active stock investor. With the market starting to stabilize it could be a good time to get back into stocks. Here are the 5 key things you should look at to determine whether a stock is worth buying.

1. Quality of earnings and cash flows. This is the “Fundamental analysis”. Look at the historical performance and future forecasts. Based on the business conditions and market factors is this realistic? Also, a good track record normally indicates good future performance – all other factors being equal. This may go against conventional theory, but I have seen it too often too ignore.

2. Growth potential : First you need to understand where the company makes its money (revenue) – is it going to grow the revenue streams? Also, look at the costs – are these growing less than revenue. Operating margin is a good figure for this. Also, is it an industry where it can acquire other companies or be a target? Look at growth from both an international and domestic perspective. International growth is especially important with the weakening US economy and dollar.

3. Competitor Analysis – Look at the performance of the company’s competitors? You shouldn't buy if the company is not in the top 2-3 of its industry. Also if the company is dominated by one much larger rival, then this is not a good sign.

4. Quality of company management. Hard for an outsider or non-analyst to determine this. The best thing is to read the company executive profiles on their web sites or annual reports to see their background and skill sets. Also, the best way to judge management effectiveness is to look at how they have grown the company. There are also figures like return on equity (ROE) that can be used as a proxy to judge management effectiveness.

5. Macro Factors – Look at the overall economy and other political factors (this one is important if investing in developing economies). If the overall economy is doing poorly it is unlikely the companies in it are going to do well. However, if the rest of the world is doing well and the company generates most of its revenue overseas then this may be not be such a key factor. The opposite of this logic also applies.

A stock that grades well across all the five points isn't necessarily a sure thing, but it's a very good start. There is a lot of detailed analysis you can do under each point, but at least now you have the overall framework.

If you have any more factors to look at, disagree or want to elaborate on the above, feel free to comment.

Good luck investing

Related Posts:

Reacting to Market Volatility
Those Pesky Ratios...PE, PEG
Lessons from investing in a losing stock

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How are you feeling about investing nowadays? Do you own stocks that have tanked over 25% in one day? I did. On one occasion I got so worried by the fall in the stock price, that I sold it for a big loss only to see it bounce back a week later. That hurt. However I was glad to find that my reaction to a volatile stock market is line with a lot of investors. My reaction though should have been more thoughtful and I could have avoided an unnecessary loss.

Too often people panic and take drastic measures. Long term investors have to realize that the market is going to have corrections and if they panic when these corrections happen they will lose money. Here are some well known guidelines to consider for these volatile situations, that are worth revisiting:

1. Take a step back, look at the big picture and then make your decision. In the bigger scheme of things, the recently may be a 1-3 month blip and could be an excellent entry point into the market.

2. Have some cash saved up in case a great buying opportunity comes up. In a volatile market you are going to see a lot of good stocks get taken down and this is when you can make a lot of good money. Some of the blue chips look very cheap on a valuation basis. If you are not sure which blue chip to buy, get an ETF (exchange trading fund). I'll write a post on ETFs in the near future and why I think they could be a better investment for most investors rather than individual stocks.

3. A lot of people are in the same boat as you. Remember the story of the turtle and hare. Slow and steady wins the race. If none of the fundamentals of the stocks you own have changed drastically, then don't panic sell during periods of high market volatility.

4. If you are loosing sleep then do sell some stocks and take some profits of the table. A buck in hand is worth more than a buck in paper profits.

Do you have any others to suggest?

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Compounding interest is one of the fundamental concepts of investing and building wealth over the long term. Apart from the tax savings, it is also the key driver behind Retirement and 401K accounts and why all the experts tell you it is the best investment vehicle for most of us. I have been actively contributing to my companies 401K plan (about 10%) and do believe over the longer term, this will provide my retirement safety cushion. Read on to see the power of compounding and why investing over the long term is so beneficial.

When you're young, you have an asset money can't buy: TIME. Start saving now and turn pocket change into riches. Compound interest has been called the eighth wonder of the world. And with good reason. It magically turns a little bit of money, invested wisely, into a whole lot of cash. Even Albert Einstein is said to have called it one of the greatest mathematical concepts of our time.

But you don't need to be a genius to harness the power of compound interest. Even the most average of Joes can use it to make money. Trust me. This is so much easier than the theory of relativity.

Here's the gist: When you save or invest, your money earns interest, or appreciates. The next year, you earn interest on your original money and the interest from the first year. In the third year, you earn interest on your original money and the interest from the first two years. And so on. It's like a snowball -- roll it down a snowy hill and it'll build on itself to get bigger and bigger. Before you know it ... avalanche!

Harness the power

Here are three steps to help you make the power of compound interest work for you. And when I say "work FOR you," I mean it. Once you set up an account, you don't have to do much else. Just sit back and wait for the money to roll in.

1. Start young. When you're in your twenties and thirties, your best friend is TIME. Start rolling your snowball at the top of the hill and you'll have a much bigger mass at the bottom than someone who started halfway down.

Consider this example: Amy, a 22-year-old university graduate, saves $300 per month into an account earning 10% per year for six years. (That's the average annual return of the stock market over time.) Then at age 28, she starts a family and decides to stay home with the children full time. By then, Amy had kicked in $21,600 of her own money. But even if she doesn't contribute another cent ever, her money would grow to a million bucks by the time she turned 65.

Compare that to Jason, who put off saving until he was 31. He's still young enough that becoming a millionaire is within reach, but it will be tougher. Jason would have to contribute the same $300 a month for the next 34 years to earn $1 million by age 65. Although Amy invested less money out-of-pocket -- $21,600 over six years vs. Jason's $126,000 over 34 years -- her money had more time to grow, or compound. (Find out what it'll take for you to make $1 million.)

Bottom line: Getting rich is easier and more painless the earlier you start.

2. Remember that a little goes a long way. Don't think you have enough money to start investing? You can get into a good managed fund for as little as $50 a month.

Let's say a 20-year-old stashes $50 a month into a fund earning 10% annually. He'd have $528,000 by age 65. Not bad for practically starting with pocket change! A little bit can make a difference elsewhere in compounding, too. For example, if our 20-year-old earned 9% annually instead of 10%, he would amass only $373,000 in the same period of time. That seemingly small 1% difference in performance resulted in 29% less money over the long haul.

That's why, when you're young, you need to invest fairly aggressively. You should invest nearly all your money in stocks or stock mutual funds (as opposed to bonds and other conservative investments) in hopes of netting a bigger return. You'll certainly have ups and downs, but over the long-term, TIME (again, your best friend) will smooth them out for your benefit. Crunch your own numbers with our savings calculator.

3. Leave it alone. The prospect of making a lot of money without doing anything sounds good on paper. But, admittedly, in practice, it can be maddening. Every time you receive your account statement, you watch your balance s-l-o-w-l-y inch up -- or even drop. How on earth are you ever going to get rich at this pace?

Investing is a game of patience: Good things come to those who wait. You must be patient for compound interest to work its awesome power. Remember that as your money earns more interest, it'll earn even more interest. You certainly won't get rich overnight this way. But you will get rich if you start young, invest wisely and leave it alone.

Parts of this article were drawn from http://www.kiplinger.com

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From, Michael Fischer's book Saving and Investing: Financial Knowledge and Financial Literacy that Everyone Needs and Deserves to Have!, here is a simple and effective summary of the various investment classes that I reference throughout this blog.

DEBT AND BONDS (FIXED INCOME INVESTMENTS)

The first way that we as savers can interact with users of capital who are looking for funds to grow their business or to undertake a project is through debt – we can effectively lend them money. Our return depends on the ability and willingness of the other party to pay us a return, usually in the form of interest.

EQUITY AND STOCKS

The second way that we as savers can interact with users of capital is via equity (which includes stock investments), where we become owners or part owners of companies.

MUTUAL FUNDS OR UNIT TRUSTS

Funds can provide a way of investing in many investments at once, and often also involve having a professional take the investment decisions.

For many of us investing in funds where a professional takes the investment decisions probably makes sense. But there are numerous considerations to bear in mind – some funds never perform well, some funds have higher expenses than others and some funds just replicate an index.

HEDGE FUNDS

Hedge funds have been spoken about in the press a lot, and for some investors they are a very attractive alternative to mutual funds.

REAL ESTATE

Real estate can be one of greatest sources of wealth; in fact, in many countries, the government incentivises us to buy at least some real estate (for example a home).

COMMODITIES

Commodities include things like oil, metals and agricultural products and have some very interesting investment properties.

OTHER INVESTMENTS

In theory we could invest in anything. An investment becomes an investment if people buy it and make money over longer periods of time. One thing to bear in mind for some investments is that if it looks to good to be true, then it just might be.

For more detail on the above, check out the book.

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For new investors when you go to finance sites like yahoo, msn etc and hear finance programs you here about all these financial ratios. Well, below is a link that explains these ratios quite nicely.

Ratio analysis (part of fundamental analysis) should only be part of your review. However, it is a great starting point to see if you should look at stock further. My preferred ratio to look is PEG (Price earnings to Growth). Basically this is a ratio looking at the ratio between the PE (Price to Earnings) and Earnings Per Share (EPS) growth. If it is less than 1, it means that the stock is undervalued in that it's earnings are growing faster than it's PE. This is a good sign and means the stock is worth looking into further.

PEG's can be backward looking (ie based on actual reporting earnings) or you may see future PEG ratio's which are based on analyst projections of earnings growth. Future PEG's are useful but they are based on a number of assumptions that you should be aware of.

For a full list and explanation of ratio's check out Investopedia's site.

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Want to tell you a story about my trading history with Brocade Communications (BRCD). This was one the first stocks I bought after moving to the US. It had just announced good results and was trading around $10.50, There were some good articles about it and I saw some positive news stories about it. The fundamentals looked good, solid ratios, analyst buy ratings, no debt and it was in a duopolistic market - the only other major competitor was Cisco.
Yet today the stocks stands at $7. (It was down to $6 a few weeks ago and has had a run up before the earnings announcement today). So why did the stock drop so much, even though I did my homework? Well here are some reasons I think why :

- They had just been through SEC investigation for options backdating. Even though they paid a fine and had new management in place - this should have been a big red flag to me. It only takes one mistake for a company to lose it's reputation but it takes a lot of time for a company to get it back. Institutions probably didn't want to buy it until new management has a better track record.

- Their biggest competitor is Cisco- CSCO (up 5% in the last 7 months). I should have realized that Cisco is a much bigger, better established company. It has better margins and was more diversified! It was as they sat best of breed in the sector and I possibly should have bought this stock instead. I did do my research and that time felt BRCD had better relative growth prospects.

- Seasonal factors! Tech is normally weak during the summer. Brocade is a tech stock! I should have factored this in and waited to buy the stock

- Before and After the positive earnings announcement in Jan (just before I bought the stock), the share price ran up about 30% - so I bought at the peak. I should have waited and had patience.

Anyway, I am still holding the stock as I do believe in the long term it is a good company in a growth sectors (Networking and storage management). I am not selling anytime soon and hopefully their future earnings will improve. If the earnings and forecast are poor - I will probably sell and take the loss! However I will not forget the factors I should consider for my next investment,

Your comments are welcome.

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