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An invaluable primer to the world of investing
Money Lessons from a Money Manager speaks directly to the individual who wants to manage their own investment portfolio just like a professional portfolio manager would. Written by portfolio manager William Thomason, this comprehensive guide provides professional investment advice on how to identify, research and ultimately purchase profitable investments. The book covers such subjects as fundamental analysis, understanding ...
An invaluable primer to the world of investing
Money Lessons from a Money Manager speaks directly to the individual who wants to manage their own investment portfolio just like a professional portfolio manager would. Written by portfolio manager William Thomason, this comprehensive guide provides professional investment advice on how to identify, research and ultimately purchase profitable investments. The book covers such subjects as fundamental analysis, understanding financial statements and financial ratios, when to buy and sell, portfolio construction and various investment strategies that readers can use to manage their own money just like a professional portfolio manager. Easy to read and informative, this book is a valuable resource for readers looking to take their first steps in the world of professional portfolio management for themselves.
SETTING GOALS, CHOOSING INVESTMENTS, GETTING INFORMATION
To get started as your own portfolio manager, first realize that there is no perfect way or time for you to start. And there is no perfect product for you to start investing in. The best investment choices for your portfolio are the ones you are comfortable with and the ones you have researched for yourself and understand. With that said, you can always choose better investments as you become more experienced. So once you get started as your own portfolio manager, keep practicing. The more you do it yourself, the more experience you'll gain.
As your portfolio grows, so will your knowledge of portfolio management. Start simple (with concepts you can easily understand), try your ideas on paper first, not using real money, and as you learn and your portfolio increases in value, expand and diversify the types of investments you have. There are thousands of choices that you can make but the important thing is to get started now! It really is never too late.
Before You Even Begin Investing
As an individual investor, it is paramount that you learn to manage your own money and control your own financial destiny. Drawing on my experience as a financial analyst and professional money manager (managing both institutional and individual money), I intend to teach you the skills used by professional money managers, the people responsible for investing a fund's assets, implementing its investment strategy, making the investment decisions, picking the investments in the fund, and managing the day-to-day portfolio trading.
Investing, like most other things, requires that you have a general philosophy about how to do things in order to succeed, achieve your goals, and avoid careless errors. To think like a professional money manager or portfolio manager, you need to understand the time value and compounding effect of money, determine your goals and needs, and develop an investment strategy.
THE TIME VALUE OF MONEY
The most basic concept in finance, the time value of money states that a dollar today is worth more than a dollar at some time in the future. For example, if you invest $1,000 in a 5 percent savings account today, it will be worth $1,050 in one year. Therefore, if you can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now because of its potential to grow. By saving and investing today, you make the time value of money work for you.
Let's look at the reverse of this situation, to see how the time value of money can work against you. Suppose instead of receiving $1,000, you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15 percent interest), you'd have to pay $1,150.
You should think about the time value of money before making any financial decisions.
THE COMPOUNDING EFFECT OF MONEY
A concept related to, and maybe even more important than, the time value of money is the compounding effect of money. This concept is often overlooked or underestimated by people when making financial decisions. When applied to all of your financial decisions, this effect is the key to long-term success! To illustrate the compounding effect of money, let me use some financial examples.
Suppose you have $1,000 in a 5 percent savings account today. Here's what happens to your money:
In one year, that account would be worth $1,050 [$1,000 + ($1,000 x 5%)], yielding a $50 gain. However, in year two, that same initial investment would be worth $1,102.50 [$1,000 + ($1,000 x 5%) + ($1,050 x 5%)], yielding a $52.50 gain. And in year three, the same $1,000 would be worth $1,157.63, yielding a $55.13 gain. By year ten, the initial $1,000 investment would be worth $1,629, and by year 25 it would be worth $3,386.
From this example, you can see that investing $1,000 today is much more valuable than investing $1,000 even a couple of years from now.
This second example shows how the compounding effect can work against you. Suppose you borrow $20,000 to purchase a car at a 10 percent interest rate (for five years). Your monthly payments are $424.94. Because the $20,000 loan continues to compound over the life of the loan, you actually pay $25,496.45 over the five-year period, meaning that you have in essence paid $5,496.45 because you spent the money before you had it. In fact, in your initial payments, the interest alone will account for almost 40 percent of your monthly payments. In this case, the bank or lender that gave you the loan uses the time value of money to its advantage.
Now suppose instead of making the $424.94 car payment, you invest that payment at the same rate as what your car loan was (granted it's a little high for a savings rate, but not unreasonable for other investments). Now instead of paying the bank, you are actually earning interest and compounding the benefit yourself:
After one year, you will have saved $5,340 and have earned $240 in interest. After two years, you will have saved $11,239 and have earned $1,039 in interest. By the third year, your investment will be worth almost $18,000 and you will have earned $2,457 in interest. By month 40, you will have enough money to purchase a $20,000 car in cash!
So let's weigh the differences between the two preceding scenarios. In the first case, you paid the bank $5,496 to borrow the money; in the second case, you earned $2,457 and could buy the car in cash after just 40 months (just over 3 years)! The opportunity cost of the first alternative versus the second alternative results in a net difference of $7,953 (a $2,457 gain versus a $5,496 loss). Thus, by making a simple deferral decision (buying the car in 3 years versus today), you can get ahead by almost $8,000!
To achieve the most benefit from the compounding effect of money, start young! Many investors do not start saving early enough to enjoy the extraordinary power of compound interest. Albert Einstein, when asked what was the most powerful force in the world, is said to have answered: "the power of compound interest." Table 1.1 shows you why. We assume a return of 11 percent a year on $10,000 lump-sum invested at the ages listed. The assumption doesn't take taxes into account. So unless you can find a tax-exempt or tax-deferred investment plan, be assured that taxes will greatly reduce the totals. Of course, you don't need to start off with a $10,000 lump sum. You can set aside a small amount each month in most mutual funds to get you started. The key point here is (I'll say it again), "Start saving early!" A good start would be in an individual retirement account (IRA) or other retirement plan as early as possible.
Table 1.2 illustrates how investing a fixed dollar amount ($100) each month (also known as dollar cost averaging) can build up a substantial sum over time. Note again that this chart does not include income taxes.
Table 1.3 shows how long it takes to become a millionaire based on (1) how much you can save and (2) how well you invest. Obviously, the more you invest and the more you make on your investments, the faster you reach your goals.
Table 1.3 can be used in many different ways. One way is to determine the time you have until retirement, choose your estimated investment rate of return (depending on your risk profile), and then find the monthly savings rate that matches your investment return and years until retirement. The table will show you how much you need to save each month to reach a million dollars. If you need $2 million to retire, you can multiply the monthly savings rate by 2 to find the amount you need to invest each month to reach your goal.
A second, and more obvious way, to read Table 1.3 is to find the amount of money you save or invest each month, find the estimated return you expect on your savings or investments, and then find the corresponding number of years until you reach $1 million. No matter how much you will need to retire, Table 1.3 can be useful for determining both how long it will take to reach your goal and how much you need to save to reach your goal.
To build your portfolio and accumulate wealth, you must use the time value of money and the compounding effect of money to your advantage.
YOUR GOALS AND NEEDS
While this isn't a book on financial planning, as you begin to formalize your particular investing strategy, there are some aspects of financial planning that you should consider.
Depending on what your goals are, you will utilize different investment tools and products for that particular portfolio. It's okay to have more than one portfolio. For instance, if you are saving for one or more financial goals, then prioritize them and allocate your investment strategies among the various portfolios. Most money management firms, especially mutual fund companies, have multiple investment portfolios and strategies at their firms (small-cap growth, bio tech, fixed-income, large-cap value, and so on). You should be no different.
You should have a retirement portfolio, a portfolio for short-term needs in case of emergency, a portfolio for that business you want to start or buy one day, a portfolio that will finance a future educational need, and so on. Your portfolio should have strategies as well; for example, if you are in your 20s, then your retirement portfolio should be classified as "long-term growth," possibly with a large-, mid-, and small-cap growth stock emphasis. (I discuss these portfolio strategies in the final chapter of this book.)
The following paragraphs discuss the first questions to answer as you develop your portfolio strategy according to your goals and needs.
Is your portfolio investing for the short, medium, or long term? If you are investing for the short-term (less than a year), then your best choice is probably to purchase a certificate of deposit (CD) at your local bank or park your money in a money market savings account at a brokerage firm. If you are investing for the medium-term or long-term, you'll want to open a brokerage account. Opening a brokerage account is as easy as filling out and mailing in an online form, and it can be done by almost anyone. (I discuss strategies, products, and brokerage accounts in the next section of this chapter.)
Are you investing money that you will want access to before retirement? If so, do not invest the money in a tax-deferred account.
Is your portfolio for retirement? If so, you'll want to utilize as many tax-deferred investments as possible, including any 401(k), 403(b), IRA, or Roth IRA accounts that you qualify for. The 401(k) and 403(b) plans are only available through your employer. If you are self-employed or a business owner, then consider starting an SEP-IRA for yourself and your employees (a brokerage firm can assist you in setting up one). These are the most beneficial tax-deferred plans available. If you are eligible for these plans, you should start investing in them immediately, and contribute as much as you can each paycheck and each year.
The difference between an IRA and a Roth IRA is that an IRA is tax deductible the year that you create it. Also, if you already participate in a 401(k) or 403(b) plan, you are usually unable to contribute to a traditional IRA. In a traditional IRA, your money grows at a tax-deferred rate but when you sell it you'll have to pay taxes on the full amount. With a Roth IRA you are taxed on your contribution the year you make the deposit, but you will never have to pay taxes on the money when you take money out.
Is your portfolio for your children's college education? If this is one of your specific goals, then you can invest money in a 529 plan (either a prepaid tuition plan or a savings plan) or a Coverdell IRA (formerly know as Educational IRA). See collegesavings.org to find out what plans your state offers.
Opening an Account
Once you know what type of portfolio you want to develop according to your goals and you determine your investment strategy, the next step is to open up an account to manage your portfolio. Here are the basics of each type of account:
Banks. You can buy CDs through your local bank. Discount Brokerage. The fastest, easiest, and cheapest way to open a brokerage account is to open it through a discount brokerage. Even better, open it at an online discount brokerage. My favorites are E*TRADE, Schwab.com, and Ameritrade. Ameritrade is the cheapest; E*TRADE is inexpensive but offers lots of options, Schwab.com is the most expensive but offers you additional services like advice, research reports, and other full-service options. Full-Service Brokerage. Morgan Stanley, Merrill Lynch, and Prudential Financial, to name just a few, are examples of full-service brokerages. These brokerages provide you guidance, advice, and research reports, but they are expensive and their brokers can often push you toward investments you may not be comfortable with. Instead of charging a flat fee for trades, they usually charge a commission-based fee. They also charge annual maintenance fees on your account of sometimes hundreds of dollars. Consider these accounts only if you really need the extra guidance. Your Employer. You can invest in your employer's 401(k) or 403(b) plan; these plans are offered only through your employer. Find out if your employer offers one of these plans (or any other tax-deferred, stock investment or other plan) by contacting your human resources department.
WHAT IS A BROKER?
If you are going to buy shares of stock for your portfolio, you need a stockbroker (broker) to help you with the transaction. In the same way that CompUSA or Best Buy is the middleman between you and computer manufacturers, the broker is the link between you and the stock exchange. To better understand what a broker is and how one operates, let's define the broker's role:
A stockbroker is a salesperson. Stockbrokers work for a stock brokerage firm (like Merrill Lynch). The broker's job is to carry out your transactions. At full-service brokerages, the broker can advise you about your investment decisions.
Stockbrokers get paid by salary, commissions on sales, or a mix of both. Commissions can range from as low as $5 or $10 dollars to upwards of several hundred dollars. The price difference arises when you choose between either a discount or traditional full-service broker.
To become a stockbroker, a person must pass two licensing examinations called the Series 7 and Series 63. Successfully completing these exams allows the broker to advise you, to solicit business from you, and to execute transactions on your behalf.
WHAT A BROKER IS NOT
Although a broker may do his or her own research, he or she is not a (sell-side) research analyst. He is not one of the people about whom you might read, "John Doe Smith III of XYZ Investment Bank & Associates has issued a 'strong buy' rating and raised his estimate for Bootleg and Copy Records fiscal year 2005 earnings from 19 to 35 cents per share, citing resurgence in demand for bootleg CDs and DVDs." Research analysts are other folks who work for investment banks and brokerages, and it is they who do that sort of enlightening, in-depth research of a company's business and industry.
FULL-SERVICE VERSUS DISCOUNT BROKERAGES: HOW TO CHOOSE
Investors today have the luxury of deciding whether to use a traditional full-service broker or a discount broker. Which one is right for you? It all depends on your goals and circumstances. While you ponder this important decision, think about how managing your own portfolio will benefit you versus how a live broker from a full-service firm will benefit you. After all, it's your money, and you should have it managed the way you see fit. So, the first step is to take stock (no pun intended) of what you want your investing experience to be like.
Before we get too deep into the details, I want to emphasize that the decision between using a full-service broker and a discount broker isn't necessarily exclusive; you can get the best of both worlds if you want. Many discount brokerage firms are offering the services that a traditional full-service broker provides (such as access to investment research).
Excerpted from Make Money Work For You Instead of You Working for It by William Thomason Excerpted by permission.
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Chapter 1: Getting Started: Setting Goals, Choosing Investments, Getting Information.
Chapter 2: Understanding Financial Statements: Analyze Companies Like a Financial Analyst.
Chapter 3: Calculate a Company’s Expenses, Earnings, Financial Ratios, and Profit Margins.
Chapter 4: Fundamental Analysis: Assessing the Value of Potential Investments.
Chapter 5: How the Pros Know When to Buy.
Chapter 6: Investing Strategies You Can Use to Know When to Buy.
Chapter 7: Know When to Sell.
Chapter 8: Portfolio Management 101: Putting It All Together.
More Than Just a Glossary.
About the Author.