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Eric’s Guide to Investing

Sign up with a broker.

If you want to invest, you should sign up with a broker right away. Time is money, so it is important to get started. As you will see below, it is less important to analyze stocks and make your choices than it is to act.

I suggest opening an account with TD Ameritrade or Scottrade. I screened many online brokers and tried several. Others disappointed me, and TD Ameritrade and Scottrade have been satisfactory.

When I started, I used a traditional broker who would give advice and take the time to explain the market and answer questions about investing. Traditional brokers charge a lot more than the discount online brokers, but theoretically, their advice can pay for their fees by earning you more money. I do not necessarily advise this for new investors.

If you would like to investigate a specific broker, visit the Securities and Exchange Commission’s Investment Advisor Search page.

For your first transactions, just buy and sell stocks at the market price. Use day orders, and place them while the market is open. (A day order is one which is good only until the market closes for the day. The alternative is a good-to-cancel order. You place a good-to-cancel order when you want to get a certain price, and then the order stays in the market until it is filled at the limit price you specify or until you cancel it.) Ignore limit prices and margins and options until you are comfortable with the basic orders. Your basic order will be: buy or sell, stock name or symbol, number of shares, day order at the market price.

Again, I recommend you sign up with a broker right away. But if you need more reassurance before taking the plunge, read The Only Investment Guide You’ll Ever Need by Andrew Tobias.

Taxes

Keep all your records. This is important; you must keep the buy confirmation from your broker that shows how much you paid for a stock. After you sell the stock, you will have to pay tax on the amount of the increase. If you do not have evidence, the IRS will assume you received the stock as a gift and make you pay tax on the entire sale amount.

I can only summarize the tax implications. You pay income tax on the gains in stocks you sell. You may deduct losses for stocks you sell at a loss. You can deduct more losses than gains each year, but only up to a limit, currently $3000 (in 2009). The remainders of bigger losses are carried into future years. Broker’s commissions are included in the stock prices for figuring gains and losses. By selling losing stocks and not selling gaining stocks, you can decrease current taxes and defer payment (thus keeping your money longer to earn more with it). Keep track of the dates you buy and sell stocks, because there are different tax rates for stocks held for shorter or longer periods. It is generally better to hold gaining stocks longer and sell losing stocks sooner, up to the deduction limit.

If your investments are in an IRA or other tax-deferred account, you do not have to consider the current tax implications, but you do have to plan for them eventually. One thing that is not widely publicized is that the IRS allows you to begin non-penalized withdrawals from a tax-deferred account at any age, provided you follow one of three specific formulae and continue the withdrawals until you are 59½ or five years after you started the withdrawals, whichever is later. The withdrawn money will be taxed as ordinary income.

Do not look for value.

You are smart, you have researched a company, and you know its finances and prospects are excellent. But there are thousands of professionals who are not as smart as you but who do this all day. When they place an order, it is executed within seconds. They are going to beat you to the punch, and by the time you are ready to place an order for your hot prospect, its price will have already gone up. So do not try to beat these folks at their own game.

The good news is that this works both ways. If a company is a bad deal, the professionals will figure that out, and its price will go down. On the average, the price of any stock will be about what it should be according to the best analysis everyone can make, plus some random jitter. So you will not do too badly just picking stocks at random.

Choose risk versus return.

Although opportunities to buy a stock at a discount from its true value evaporate quickly, there are high-return opportunities that remain stable and are available for you to buy if you wish.

Generally, if a company’s earning prospects get better, its stock will increase in price. Conversely, if a company’s prospects get worse, the stock will decrease. There is an exception to this general correlation, and that is risk. If you have choice between a company that would make a guaranteed income of $1,000,000 next year and a company that has a 50-50 chance of making either $2,000,000 or nothing, you obviously would not pay as much for the latter company.

The crucial idea here is that even though two companies have the same average predicted income, the safer company is worth more. How much more depends on the economy and people’s feelings. But it means that a company with a lower predicted income can be worth more than a company with a higher predicted income, if the former is safer than the latter.

What does this mean for you? It means you can choose how much money you want to make—and how much risk you are willing to take. When a company chooses a risky course, its stock price will be lower in ratio to its potential earnings. From your point of view, the ratio of earnings to stock price is higher—so you get more earnings (on average) by buying riskier stocks.

Obviously you have to be willing to take the risk. Many stocks will go up, and many will go down. Alternately, you can use this phenomenon to choose not to take risks. The cost you pay for that is lower returns on your investment.

If you are just starting to invest, select less risky stocks until you feel comfortable with your knowledge of the market. Then, if you are young and have a secure income, invest in the riskier stocks.

Value Line and Risk Indicators

How do you know which stocks are less risky and which are more risky? Go to your public library and ask at the reference or business desk if they carry Value Line. Value Line has two components: A collection of one-page summaries about thousands of stocks, and a weekly pamphlet that includes current suggestions.

There are four things in Value Line that give you clues about risk. The easiest is Value Line’s safety rating. They rate each stock from 1 to 5 for safety. As a beginning investor, pick 1s and 2s. Move to riskier stocks as soon as you are comfortable—time is money.

A second good statistic for beginniners is the price to earnings (P/E) ratio. This measures a company’s stock price to its earnings per share. A P/E of 20 means the company last year earned a twentieth of what its stock price is. If a P/E is low, it means the stock price is low compared to the company’s earnings, which is a sign that people think the company is risky—for example, they are not willing to pay a lot for the company even though it earned a lot last year. If a P/E is high, it suggests people think the company is safe. However, there some things to watch out for. The P/E is calculated from the company’s most recent past earnings report. If there is newer public information about the company’s prospects, that can throw off the P/E, because people decide whether the stock price is a good buy based on their judgment about the company’s future earnings, not its past. Also, some sources publish P/Es calculated from the company’s last annual report, and some use the most recent report, which may be quarterly. And a company that makes a loss would have a negative P/E, but that usually is not printed. A company that loses money may just be starting a new business or is certainly trying to change. (You know they do not want to keep losing money!) And, again, the stock price is based on future earnings, so a year of loss does not have the information you need to figure out next year’s profit. This illustrates that P/E is based on the idea that a stable company’s future profits are likely to continue their past trends. That means P/E does not work for companies in transition.

P/E is tricky. On one hand, a low P/E means people think a company is risky, as explained above. On the other hand, a low P/E means the company is earning a lot compared to its stock price, so how risky can it be? Even if the stock goes down, the company has lots of income to share with you in dividends. What is happening here is a balance of opposing forces. Knowledge and evaluation about the course a company is charting push opinion about risk one way, and a company’s earnings push opinion about risk the other way. When they reach a balance, that’s where the P/E settles. Personally, I prefer a P/E under 20. Above that, I have to wonder what the public is thinking. Unless there is concrete knowledge that the company is going to make more money in the future, they may be giving the company too much credit. But again, use P/E only as a very tentative indicator, because it is essentially meaningless for companies that are undergoing changes in their business.

Another statistic is called the beta, which is shown in Value Line under the Greek letter beta, β. The beta measures how much a stock fluctuates in comparison to the market average. 1 is average. 0 is something rock solid, like government bonds. So stocks with betas under 1 are less risky. Betas over 1 are more risky.

Sometimes you will see a stock with a negative beta. That means the stock tends to go up when the market average goes down and vice-versa. That can be very useful for diversifying; if you have some stocks with positive betas and some with negative betas, they will tend to cancel each other out somewhat, and you will get the average return with some of the random chance removed. However, negative betas also tend to be signs of companies that are new or that are undergoing significant changes, so be careful. One example of companies that can have negative betas even when they are stable is financial service companies. When the stock market goes down, people may move their money out of stocks and into banks and other financial services. So financial service stocks might go up when the general market goes down. It is okay for a company like this to have a negative beta. If you see another type of company with a negative beta, find out why before you invest in it. Is the negative beta just a result of recent large fluctuations in its stock price, or is the company stable?

Finally, you can judge a company’s risk by reading about it and its projects, as well as the economy generally. Value Line includes summaries that have some of this information.

(Value Line is not the only way to get most of this information. Factual data like the P/E and the beta is available from many sources. And many sources publish their own opinions about companies and their risks.)

Thinking About Money

When you invest, the way you think about money may change. When most people start their adult lives, money is harsh reality. It is solid; you must get a certain chunk of money to pay your rent or to buy groceries. Money is bricks with which you build your life. Once you have built a solid foundation and have money you can afford to invest, money changes. It is fluid. Your pour it from mutual fund to mutual fund or stock to stock. You may find this change in thinking comes naturally as you move money around in your investments, or it may come as you study a textbook in corporate finance, which I describe below.

A common misconception about investing is that when you hold a stock that has gone up or down, you have only made or lost money “on paper.” This is false, and believing it will cause an investor to make wrong decisions. After all, if you are driving around in your car and take a wrong turn and lose your way, you cannot say you are not lost because you have not gotten out of the car yet. Neither can you say you have not made or lost money if you have not sold the stock. Where you go next with a stock depends on where it is now, not how much you paid for it.

Diversify

Part of any stock’s value is random chance. Will a storm interfere with a company’s shipments? Will a storm increase a construction material company’s sales? How close are the marketing department’s projections to actual demand? Will the new CEO be an effective leader? You can reduce some of these random fluctuations by dividing your investment into several stocks. Crudely speaking, the sum of two independent random variables fluctuates about 30% less than one of the variables by itself.

However, stocks are not completely independent. Diversifying will reduce the parts of the fluctuations that are independent. But all companies do business in the same world, and they have many ties with each other. Parts of the fluctuations depend on each other, so changes that affect the whole economy will affect all of your stocks. Diversifying reduces your fluctuation but does not eliminate it.

How much stocks share with each other varies. Stocks may be in similar or related industries, or they can be in widely different industries. For your first few investments, buy very different stocks. Some stocks may tend to go up when most other stocks go down. For example, banks can do well when the stock market goes down, because people may move some of their money out of the market and into bank accounts, which helps banks make money. Investment professionals have mathematics that analyze the covariance of the stocks. If you can get access to the necessary data and algorithms, you can build a portfolio whose stocks are as independent of each other as possible.

Leverage and Corporate Finance

When you are an experienced investor, take the time to learn about corporate finance and leverage. A good textbook on corporate finance, such as Principles of Corporate Finance by Brealey, Myers, and Allen, will show you how to think about money as a tool. Stocks, bonds, and options are tools for adjusting how much risk you want to take, and how much return you make. Stocks and bonds are ways of separating investments into risky parts and safe parts. People who buy bonds are guaranteed a certain rate of return (if the company does not go completely bankrupt). People who buy stocks are not guaranteed a rate of return—but if the company does well, they get the advantages of the profit that was made with the money the bond holders paid. The bond holders got the safety, and the stock holders got the chance of extra profit. Learning how these capital structures are analyzed mathematically will prepare you for more sophisticated investments, including options trading.

© Copyright 1998 by Eric Postpischil.