Invest to Win

On Saturday afternoon, a friend of mine called me and said “You don’t have to watch the Illinois game.” I said, “They lost right.” He said, “They were up 25-7 and the quarterback had 175 yards passing in the first half. He ended up with 190 yards passing for the game because they kept running the ball to milk the clock.” I said. “They were playing not to lose.”

I think all fans hate it when teams play not to lose. Every sports fan wants their team to continue pouring it on, go for the jugular, forget the prevent defense!

Then again late night Saturday I was sitting at a No-Limit Texas Hold’em Poker tourney. I had done fairly well to become chip leader with 9 players left. I began to tighten up. I had all these chips and I didn’t want to lose them. An hour later I was the short stack. Wow! How did that happen? I was playing not to lose. I had lost my aggression and was folding almost every hand. Luckily I came back and won the tourney.

What does this have to do with investing? I hate to say this but many investors are investing not to lose. When it comes down to investing, one’s first thought is usually, “Am I willing to lose this money or can I afford to lose this money.” While these are both very responsible questions, they stem from a mindset that limits your potential.

I’ve fallen into this mode. I was very active in real estate over the past 3 years. When the market turned late last year, I sort of went into a shell. I had done so well until then that I began to fear losing my equity and net worth. That mindset was reinforced by all the media bubble-talk, and it made me sit on the sidelines the past 8 months. I am a firm believer that you can make money in any market. I had let my fears get to me.

Yesterday I was sitting and Barnes & Nobles reading the new Kiyosaki & Trump book and came across this passage (from Why We Want You to Be Rich):

One day, during a brief meeting in his office, Donald simply said, “I invest to win. Don’t you?” With that statement the defining difference appeared. He and I invest to win, while others invest not to lose.

We have talked here about the advice, “Save money, get out of debt, invest for the long term (generally mutual funds) and diversify.” Late that afternoon, Donald and I discussed how we did not focus on saving money. In fact, we are both millions of dollars in debt – but good debt. We do not diversify, at least not in the context that most people use the word diversify. And while we are both long term investors, we do not invest in mutual funds, at least as a primary vehicle. Why? Because we invest to win….
Most other financial experts are telling people to play it safe, to live below their means. They are telling people that investing is risky and that they need to save and avoid losing. The experts aren’t focused on winning. They’re focused on not losing.

This just reaffirmed what I’ve been thinking. Maybe it’s a sign. Three different situations, same result. With that, I put an offer in for that duplex in Tucson.

Averaging Down: Playing Chicken With Mr. Market

In case you doubt my membership in InvestorGeeks, I love movie trivia! What’s the highlight scene in James Dean’s 1950s cult movie, Rebel Without a Cause? You are right if your answer is the game called chicken, where Dean and his rival each drove a car towards a cliff. There are many variations of the chicken game, but in the movie, the game is won by jumping from the car later than the other player; but still in time to avert the cliff. For investors, it sometimes feels like your rival is Mr. Market daring you to jump out of your car first. The person who blinks first loses, but if you don’t blink, you might lose even more when you fly off the cliff! Sounds familiar?

I bet many investors out there have had the situation where you did all your homework before buying a stock and yet it still tanked 10%, 20% after you bought a position. It happens to the best of investors. What’s a person to do in this situation? Should you buy more? Should you get out early?

Stop-losses can certainly help, but it almost feels like you’re blinking first, letting Mr. Market win. But then again, you don’t suffer the “ultimate loss”. For most value / contrarian investors like myself, the decision to buy a position does not come easily. A lot of analysis was completed prior to pulling the trigger. What you thought was a good buffer, a good bottom with very little downside still manages to prove you wrong. It sometimes feels as if you should wait out Mr. Market to win the game. And for the average-joe investor, stop-loss may not be a common tool in their arsenal.

2 Different Schools Of Thought
Everyone can argue about what is the right answer. What if stop losses blind you from making an otherwise good decision to buy more? What if trying to out wait Mr. Market is the wrong choice?

I recently blogged a discussion between two fund managers whom I respect. They also had different thoughts on the concept of averaging down on a losing position; catching a falling knife so to speak. So the topic is not just debatable among us amateurs! Here are the 2 differing opinions:

  1. Never average down a losing position. Don’t throw good money out the window. If you’re going to do that, wait for a real wash-out. But don’t keep doing that, that’s a terrible way to invest.
  2. If we bought a stock at $10, and it goes to $8. We go back to the drawing board. And if the market is a little off-kilter, and we still think we’re right. I’ll buy more.

There Is No Right Answer Unless It Fits You!
I was tempted to write out my lists of when to average down, and when not to average down but realized that whatever answer I put up may not fit you because of one important quality – an investor’s temperament!

Whether you are a technical investor or an fundamentals investor, temperament is the single most important quality that you must possess. If you do not possess the temperament, discipline or analytical skills, consider implementing a system that you must follow (such as stop losses) to help remove the emotion from your decisions. You might blink first, but you won’t lose out!

You might have guessed that I belong to the camp where I need to re-evaluate my initial premises to see if I missed key information. I would average down if I still remain very comfortable with the re-analysis, but would probably wait for a stable entry point. And I would not hesitate to exit a position if the re-analysis showed something different. As I always say, “buy when it’s right, sell when it’s right”! I don’t like to play to lose, but I also realize that you can’t win it all!

Even though I did not write out my lists of knowing when averaging down is sane or insane, I know our InvestorGeeks readers are smart enough with their own triggers. Where do you stand on averaging down? I may be tempted to post more of my thoughts on the issue in the comments if the discussion gets good!

Singles Win Games in Baseball and Stocks

Sticking with the baseball theme, this article is going to look at the fascination with people wanting to find that ‘home run’ stock. It’s stupid. Quit doing it. It’s unnecessary and a really bad strategy.

I don’t know how many times I’ve tried to explain to people that getting rich isn’t a strike of lightning or a quick grab, it’s a slow and steady process. The tortoise always beats the hare and it’s the same with the stock market. Sure, it’s cool to say that you caught that lightning in a bottle and doubled or tripled up on one stock, but if a stock is going up that much, it’s pretty volatile and you’re probably putting yourself at extra risk.

The key to succeeding in the market is to go for singles. Singles win baseball games, not home runs. Sure, the home runs get you on Sports Center and all those other TV shows, but it’s not a good strategy at all and it puts all of your eggs in one basket.

The way I look at a stock is, if I can get a 2-3% return in a month I’m golden. That’s all I want, 2 to 3%. So, on a $20 stock I’m looking to get to $20.40 or $20.60 a share. This is easy to accomplish and if you can’t find stocks that go up 40 freakin’ cents, you shouldn’t be trading stocks, stick to index funds and ETFs.

Think about it, while the majority of people are shooting for the big bucks, I’m taking 2-3% a share, over and over, all year long. If I get just 2% a month, that’s 24% a year, totally killing the stock markets average return of 11%. (It’s actually more than 24% a year because with each sale I have more money to buy more shares the next time, so I’m compounding as well, but we’ll keep the math easy for those of you that can’t grasp this concept.)

Quit thinking you need to get 11% out of one stock a year. That’s a $2.20 gain for a $20 stock. That’s pretty difficult to pick on a consistent basis, instead, shoot for a lot of small gains throughout the year.

Even after taxes, if you made 24% gains and paid 30% in taxes (which you don’t), you’d make $3.36 cents on every share of a $20 stock. At your buy and hope 11% stock market average on the same stock you’d only make $2.20 BEFORE taxes and be 100% at risk the entire time.

That’s the other thing about TRADING stocks vs HOLDING stocks, every time I take my profit and get out, I’ve cut my risk to zero, zip, zilch, nothing.

(A little advanced lesson here for those of you who ‘get it’) Now, this isn’t to say that as soon as a stock hits 2% you automatically sell it, no no no. When a stock hits my 2 or 3% target, I put a stop loss on it for the amount I paid for it, locking in my original investment. Now, I’m only risking my gain, not my principle (not entirely, but pretty close). When the stock continues to go up, just move your stop loss with it. If it goes up to 4% gain, move your stop loss to protect your 2% gain. Keep chasing the gains and locking in the profit.

This is how you get rich in the stock market. This is how you win the game. You grab small gains, ‘singles’, over and over and then get out of risk.

– Invest in peace….

Diversification Myths

This article originally appeared on thinkingaboutmoney.com on June 20th, 2006.
One of the things I’ve learned in the past month is that diversification – the “holy grail” of investing, is not what it is cracked up to be. In fact, I’ve come to realize that one of my immediate investing goals should be to reduce the amount of diversification in my portfolio.

I realize that this statement will have many of you yelling and screaming, or immediately unsubscribing under the assumption I am a fool. But hear me out.

The idea of diversification is simple – it protects you from a serious loss in the event that a stock collapses. This is a real problem: I had a friend in college who was highly invested in a utility called “General Public Utilities”, dividends of which were helping pay for his college education. Unfortunately, this utility owned a nuclear power plant named “Three Mile Island”. Ouch! When the nuclear accident hit their stock crashed and my friend had some tough times.

The problem with diversification is equally simple. Once you are sufficiently diversified (say, through ownership of a selection of mutual funds), your portfolio will tend to reflect the overall market (typically underperforming it by a bit, if only because of the management fees). This means that when the market is good, your upside is typically limited to the overall behavior of the market, and when the market is down, your portfolio is pretty well guaranteed to lose value as the market declines.

Let me stress this: Most mutual fund based portfolios will decline when the market drops. Diversification through mutual funds provides no protection in down markets; rather, it virtually guaranteed losses.

In truth, diversification means two different things: protection from having all your eggs in one basket (so to speak), and matching the performance of the market. The former is obviously a good and necessary thing; the latter only good if you buy into the theory that the market will average a certain percentage gain over the long term and you should just buy and hold to get that return.

Let’s consider the first type of diversity. The overall market performance is based on a large set of companies, some of which rise dramatically in value, some of which become worthless, some of which hardly change in value, and many of which simply track overall market performance as investors add or remove money from the market following existing trends.

Let’s assume that by actually doing your homework – researching a company, reading their financial statement, and applying your own knowledge of the industry, that you can select stocks that can beat the overall market by 10%. That doesn’t mean they’ll always go up – just that if the market declines by 20%, you’re stocks will drop 10%. If the market goes up 20%, yours will go up 30%. Of course some of your choices may do better, and some worse, but let’s say you can average 10% better. Keep in mind that of that 10%, at least 1.5% and often more is “free” because you won’t be paying mutual fund management fees.

If your portfolio contains 15 stocks, one of them can become worthless and you will still beat the overall market.

So in truth, you don’t need multiple mutual funds containing dozens of stock to protect yourself from the collapse of one security. And if you learn to sell on time (see review of “Why Smart People Make Big Money Mistakes and How to Correct Them“), you wouldn’t even need to do that well.

Does that mean I’m recommending you go out, sell your mutual funds, and buy individual stocks?

NO – NO – NO!!!

Remember the name of this site: “Thinking About Money.” That means that you will never read simplistic advice, rules or guidelines here. The observations you read here are parts of a bigger picture intended to help me (and you) develop an overall financial strategy.

My point here is that there’s diversification as preached in the financial media, and there’s diversification in its true sense of preventing the loss of one asset from representing a financial disaster. My argument here depends on one being able to choose investments and manage them in a way that does better than the overall market. I believe this is possible, but I also believe it requires thought, discipline, research and strategy.

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports – Reviewed

This post originally appeared on ThinkingAboutMoney.com on June 15th 2006

What a treat for investors or business owners! I wish I had this book when I started my first business – it would have certainly sped up my learning process at the time. And for investors who want a good solid background on reading financial statements, it’s hard to imagine a better introduction.

Financial Statements” by Thomas Ittelson does a spectacular job of introducing the three basic types of financial statements to beginners, while providing an easy to read refresher to those who might be a bit rusty on the topic.

The book begins with an in-depth review of income statements, cash flow statements and balance sheets, showing how they relate to each other. This section also includes an introduction to the basic principles of accounting.

The strongest part of the book is the second, where the author walks you through a year in the financial life of a fictional company. A wide variety of transaction types are covered from initial raising of equity, to asset purchases, to hiring, and ultimately to manufacturing and booking income. Careful attention is paid to the process of handling inventory and dealing with cost of goods (and the entire manufacturing – sales – income cycle), including the difference between fixed and variable costs. The author even discusses several approaches for determining a business’s value for possible sale (though he does discard the discounted cash flow method as being too complex).

There is enough information here for someone starting a business to handle their own bookkeeping (with practice and perhaps a bit of hand holding by a friendly CPA at first to answer specific questions). Certainly enough to understand what the bookkeeper and accountant are doing and speak with them intelligently about the state of the business.

The third part of the book is especially important to investors, covering common ratios for evaluating the health of a company and discussing techniques that can be used to “cook the books” or otherwise bias financial reports. This part of the book is all too short. It left me convinced that there was a lot more to learn in this area.

If you are comfortable creating and reading financial statements, this is not the book for you. But for everyone else, I highly recommend it. The book is clear, well written, and breaks complex topics into simple steps that are easy to understand.

See more: “Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” by Thomas Ittelson

Share Your Chart Reading Skillz on YouTube

I found this interesting site through a link that came up on my Google Finance screen for Crystallex.

Ant & Sons Chart of the Week Video:

Ant & Sons has rolled out its updated Chart of the Week column with technical analysis video using the latest technology.

The video is hosted through YouTube and displayed on their site with YouTube’s distributed Flash player. I’ve seen a few of these video stock review sites cropping up and I think the model is tempting. I’m going to try to find some good screen capture software and a good microphone to set this up myself. Any suggestions?

I’m also going to be on the lookout for more stock review videos on YouTube. I’m starting with a simple search for “stock chart“.

p.s. Ant & Sons’ take on KRY is to watch to see if it can stay above the 50-day moving average and $3 level. The early day trading today shows KRY having trouble with that $3 resistance. I have a position in KRY, but won’t be adding to it until it trades a full day (open to close) above $3.

Reading List for the Investing Master

I have been a student of the stock market since my father and great uncle Andy sat me down in 1974 and started teaching me the beauty of investing in Exxon. This was during the oil embargo and my father’s restaurant “The Highland Diner” was situated right next to a gas station. I saw first hand the theory of supply and demand in action as cars where lined up 15-20 deep to fill up. In that year I bought my first shares of Exxon with $100 and eventually opened a dividend reinvestment plan with the company.

Working in that restaurant I also saw that every table had a Heinz ketchup bottle on it and my job at the ripe old age of ten was to manage the bottles and make sure that their were no “empties” on the tables. I saw with my own eyes the power of the trademark and invested in Heinz as well.

For the next ten years I invested most of my pay in those two companies and then went eventually big into Coca-Cola in 1984. I did this after going to college in Europe and seeing how addicted everyone was to their products.

Getting a Real Education by Reading
About every three months I would get quarterly reports from Exxon and Heinz and I would sit for hours trying to understand them. This was way before the age of personal computers and if you wanted to use a computer you needed punch cards and to work in a room the size of a cafeteria . The Internet was at least 15 years away and asking your Dad was as close as you could get to Googling an answer. In those days if you wanted to understand what “Book Value” meant in an annual report you had to go to the library and research it.

Many of you probably feel sorry for me for having to labor so and not having the technology available that everyone takes for granted today. But you should not do so, because I was forced to read in order to find out what price earnings ratio’s and return on equity meant.

While in the library I stumbled across 100’s of books on investing and read everyone I could get my hands on. By the time I was 20 years of age I knew about Benjamin Graham, Warren Buffett and Philip Fisher and was a big fan of Malcolm Forbes Sr.. I would do spreadsheets by hand and can you believe it on paper! It was not until 1990 that I converted to my first PC so I had a good 15 years of reading books in order to learn my trade.

What was I reading? Well the following list is what I consider essential reading for anyone who wants a strong foundation in investing. I will not detail each book, but just list them and provide links to Amazon so you can read the details on each one, (If they are still in print). By reading these books you will learn to not just be an observer of the markets but to become a true participant. You will never again have anyone pull the wool over your eyes and sell you some ponzi scheme or tell you that you can be a successful investor by just doing his system 15 minutes a week. Successful Investing requires hard work and a keen understanding of the terminology that is used. Without it you are flying blindfolded and will make many mistakes. The worst thing one can do in this business is to learn by trial and error. The following books contain the vast experiences of money masters and will save you thousands of dollars in mistakes. The following are the best investments you will ever make.

The Daily Regiment
First I would subscribe to the following:
The Wall Street Journal = To learn in depth stuff on companies in real time.
Investors Business Daily = A quick visual way to examine 100’s of companies a day.
The Economist = The master information source for international investing.
Forbes = A great source for in depth information on management of companies.

The Weekly Regiment
– The Library Periodical Reading Room = Despite what everyone thinks one can find 100’s of articles on companies that are not on Google, which may shed some light on a company that you are ready to invest in. You can spend a few hours at the public library and read past articles of the Wall Street Journal or trade magazines to give you a fuller picture on a company.

Value Line Investment Survey = Most public libraries have this guide available or you can subscribe if you have the money. It is the best data source for information on over 7300 companies that you will find anywhere.

== THE READING LIST ==

Books by John Train:
The Money Masters
The New Money Masters
Money Masters of our Time
Preserving Capital and Making it Grow
The Craft of Investing
The Midas Touch
Famous Financial Fiascos

Books by Benjamin Graham
The Intelligent Investor
Security Analysis -1934 edition
The Interpretation of Financial Statements
Benjamin Graham : Memoirs of the Dean of Wall Street

Books by or about Warren Buffett
The Essays of Warren Buffett
The Warren Buffett Way by Robert G Hagstrom
Buffett: The Making of an American Capitalist by Roger Lowenstein
Buffettology by Mary Buffett and David Clark
The Warren Buffett Portfolio by Robert G. Hagstrom

Books by Philip Carret
The Art of Speculation
A Money Mind at Ninety
Common Sense from an Uncommon Man

Book by Philip Fisher
Common Stocks and Uncommon Profits

Books by George Soros
The Alchemy of Finance
George Soros on Globalization
Soros on Soros: Staying Ahead of the Curve

Books by Jim Rogers
– Buying Commodities
Hot Commodities
Investment Biker
Adventure Capitalist

Books by Peter Lynch
One Up On Wall Street
Beating the Street
Learn to Earn

Miscellaneous Reading
The Wealth of Nations by Adam Smith
Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay
Margin of Safety (Out of Print) by Seth Klarman

The above is a great list to build a strong foundation as an investor. In those books you will find theories that have worked and not some “You TOO can be a great investor” books like the majority of the writings you see today.

To master the art of investing requires knowledge which must be gained on ones own. Understanding the terminology of the stock market is just as important; so spend some time and master the art so you don’t follow the crowd. Most of Wall Street acts in unison, those (like the authors above) have made their fortunes by acting independently of the lemming mentality that is found on Wall Street. Do your own homework and concentrate the limited time that you have to devote to investing by concentrating on what has worked in the past. Those above have not reinvented the wheel but have mastered the art of investing and the methods of their predecessors. They have then taken those ideas and have spent their lives trying to improve on them or make them relevant to the time they live in.

Civilization advances by passing the torch to the next generation, so grab that torch and master these writings and then innovate. That’s what makes life worth living in my book.

Earnings Guidances: Stay Or Go?

Is it possible to predict the quarterly earnings for a business, or a giant multi-billion dollar conglomerate accurately down to a single/narrow cent-per-share figure? A large number of investment analysts out there sure think so! After all, who wants to be the sucker who can only give you a broad earnings range, when “I” can give you the exact figure, so “I” must be better. So pay “me”, and hire “me”! And may god strike it down if that company misses “my” estimate by even one cent! It’s not “my” estimation error, it’s their fault! (Returning back to normal) I’m sorry, I don’t know what came over me just now!

But can you hear the analysts tooting their own horns as they predict earnings? And when did companies think it was a good idea to help these overpaid statisticans along with corporate guidances? Is it a good idea? I’d love to hear from you, but I’ll first share my perpsective!

Why We Should Scrap Earnings Guidances
1. Guidances are for the not-so-competent investors. The serious investors with the know-how would rather rely on their own valuation methods. Earnings guidances are the equivalent of financial fast-food; they’re good to grab on-the-go, without regard and question about how it came to be. What’s in your earnings hot-dog?

2. Stock price A.D.D. Investors cannot pay attention for a long time. Earnings guidances are part of the problem as the market becomes unhealthily pre-occupied with short-term success. We should remember that the market is a voting machine for the short-term, and a weighing machine for the long-term. Earnings guidances are a rally-point for short-term investors who often extremely reward or punish companies that raise or lower their guidances. By the way, who remembers how they felt about earnings guidances 2 years ago for their current holdings?

3. Companies are preceived to have “lied” to us if they missed or lowered earnings guidances. There must be something drastically wrong, right? I want to know how many investors or analysts out there have ever been tasked to run multi-billion dollar businesses? Why do they have the chutzpah to criticize how a business has operated over the last 3 months? Heck, last year we had hurricane Katrina, this year we don’t… what about next year? Likewise, you can’t always predict business conditions. The market prefers to destroy stock prices at the ticker, rather than appreciating that companies are forthcoming with their problems; assuring that they are on top of things. I’d rather judge their actions, their results from those actions, and not their announcements.

4. In a recent Forbes article, Vahan Janjigian wrote that the CFA Institute, the Business Roundtable, the Chamber of Commerce, the National Investor Relations Institute, members of Congress and Securities & Exchange Commission Chairman Christopher Cox have all sounded the alarm bell against companies providing quarterly earnings guidance to Wall Street and shareholders. But Vahan would rather focus on a study done by the National Investor Relations Institute about earnings guidances. The study does fit Vahan’s sentiments on the subject matter written years ago.

Now, I’ll admit… besides the members of Congress who possess the sophistication of comparing internet to tubes, that’s still a pretty diverse, distinguished group advocating for the abolishment of corporate guidances! My problem with “studies” is that there are so many opportunities to study the wrong thing! For example, the article cited Krispy Kreme as a “great” example of how removing corporate guidances did not help. My argument is that corporate guidances are the reason that led to the implosion of Krispy Kreme in the first place… which leads to our next point.

5. Corporate Malfeasance. At some point in their career, CFOs and CEOs forget that they were hired to run the business and start auditioning for a full-time career in PR, stock manipulation and damage control. They sign extravagant contracts to be used as exit strategies. The obsession with pleasing the stock market, the hand that feeds them, eventually leads to promising outrageous numbers. If they can’t make those numbers, they’ll inflate what they have. But you see, the market getting an inch now wants a yard! CFOs have to keep up the charade, and keep cooking the books. If you are the type that wants to take advantage of such situations, perhaps this can also be a reason FOR earnings guidances. You might be interested with my book club challenge on short selling? But I’m just trying to look out for the average joes.

6. I’ll take one last stab at Vahan’s Forbes article (from point #4). The study looked at 76 companies from 2000 through 2004. Wow, that’s a big sample size and a long time frame! My second problem with studies is their variables – what is truly representative? Ask somebody in south-east Asia about the merits of spaghetti sauce and I’m not sure how representative your data can be. The number of companies that give guidances far outstrip those who don’t. I’m sure someone can easily find 55 (not even the same number!) out of the thousands giving guidances to be used as great counter-examples.

Vahan asserts that not releasing guidances has destroyed shareholder wealth while I suggest that it’s the “stopping” of guidances that has invited backlash. What happens when you cut off a drug addict cold turkey? The bigger issue was whether the confidence to put all that money into those same stocks was justified in the first place? That confidence and irrational exuberance is mostly due to previous “favorable” guidances! It’s hard to end a vicious cycle. Maybe that’s why God had to flood the earth and only spared Noah’s Ark.

Why We Should Keep Earnings Guidances
1. Transparency. Why shouldn’t CFOs provide as much information as possible, including quarterly and annual business projections? Isn’t this to the interest of better information for investors? Isn’t this part of the “perfect information” that markets (as opposed to individual investors) are often assumed to possess? [Oops, I’ll play devil’s advocate here again! Information are already disclosed through regulatory SEC filings. Whether they are perfect is debatable. But summarizing it with a range or a single number doesn’t give more information, or make it perfect. Guidances are merely a lazy, convenient “big-picture” method to making a decision. See my fast-food example above.]

2. Guidances assure the investors that CFOs have put some thought and work into it, and know what is going on with their business through quarterly reviews. If you hold down a job, I’m sure you’d appreciate if your manager sat down to review your performance quarterly, too bad they don’t often reveal the “number” you should be getting next quarter. But this process allows CFOs to examine controls and processes so that the ship does not veer too far off course.

3. Stock price A.D.D. Why is this a reason to both scrap AND keep guidances? Truthfully, I’m torn on this subject. I believe that the correct temperament towards earnings announcements gives me the edge I need to beat the herd. Over-reactions to guidance hits and misses provide for great opportunities to transfer wealth from the emotional market to the logical, rational crowd. It sounds morbid and exploitative but it’s a valid point when everybody is investing to make money, isn’t it?

Where Do You Stand?
You might be able to guess where I stand on this issue. But I’m by no means right. I have my opinions and you have to go by what you’ll decide. I would love to hear your views on it. Nobody has all the right answers, but if we compiled enough perspectives and take an objective view of the information, we can make a better educated decision.

Getting Started with Margin Trading

I’ve been doing a little research on margin trading, because I’ve recently been using it to float purchases of stock while my sale of some mutual funds clear. So I had a bunch of questions, like “What’s buying power?” and “How much do I need to keep in my brokerage account?” Well, I was once again helped by a terrific tutorial on Margin Trading at Investopedia which answered most of my questions.

I hope you’ll head over there and read it, but let me address some potential questions for you here in case you don’t have time to check it out. (I’ll assume for brevity that you understand what margin trading is)

Buying Power is the amount of money you can currently use to purchase marginable securities. It can be simply calculated as

(Cash + Security Collateral) * 2 – Marginable Securities
— or in many cases —
Cash * 2 + Security Collateral

Security Collateral is basically any marginable security such as stocks and mutual funds. Note that it appears that Buying Power is based on the value of your security collateral before the trading day begins.

Margin is like an Overdraft Account on your checking account — at least at TD Ameritrade and according to the Investopedia article. You can’t say “I want that one stock on margin” unless you only have one security in your account. Otherwise, you can just keep buying any security until your Buying Power reaches $0.

Maintenance Margin is Cumulative. When you have a margin account there is a minimum value that you must maintain at all times. This is called the Maintenance Margin. It’s calculated by adding up all the maintenance requirements for each security in your portfolio and if your account drops below the minimum value, then you’ll have to add more cash or securities to your account.

Maintenance requirements on individual securities can change based on price or volitility and can vary from broker to broker, so it’s best to check the rules on maintenance requirements on your account.

Prime Interest Rate & Credit Interest Spreads

Almost all of us hear some variation of this from our credit card or car loan company: your interest rate is a variable rate of 14.99% based on Prime plus 6.74%. That means your current rate is 14.99% but may change at any time, so if the prime interest rate goes up or down 0.5% so will your card. Let’s look at the Prime rate closer, and I’ll share some tips to enhance your credit search.

The Prime Interest Rate, also known as the Wall Street Journal Prime Rate, is based on a survey of lenders by the WSJ. This is the rate that lenders offer to their most premium borrowers. The additional interest that your lender tacks on your loan, called the spread or margin, will decrease as your creditworthiness increases.

Better Credit; Lower Spread. Many of us start out with credit cards in college with rates running into the high teens or low twenties — analogous to a 10-12% spread. However, as you get older and build your credit, your spread will decrease. For example, I recently received an unsecured line of credit from CitiBank with a spread of 0.99%. The idea being that as your creditworthiness increases, your risk decreases, so a lower interest rate is required.

Comparison Shopping: Apples to Apples. It’s more important to find a low spread than it is to find a low interest rate. Because prime can change frequently, look for the spread on that credit card you’ve been eyeing. If you found a card with an 11.99% interest rate two months ago, and you just found another card with an 11.99% interest rate today, the new card may be more costly if interest rates fell 0.50% within the last two months. Always be sure to compare apples to apples by comparing the spread.

About Fed Rates

Just like credit card rates are based on the Prime Rate, the Prime Rate is based on the Fed Discount Rate and Fed Funds Rate.

  • The Fed Discount Rate is what the Federal Reserve loans money to banks at.
  • The Fed Funds Rate is based on the Fed Discount Rate and is the Fed’s target of what they would like banks to loan money to each other at.

Because banks and credit card companies borrow money at these rates to provide loans and credit to their customers, some if not all of the cost is passed on to the consumer through the Prime Rate. So when you hear that the Fed is raising or lowering interest rates, look for a change in your Prime Rate coming to a statement near you.

Finding Rates
You can find all the current Prime and Fed rates at BankRate.

Resources
The Federal Reserve: Monetary Policy. Investopedia.
Credit Card Management: Basics of Card Rates. AOL Money & Finance.