Sep 30 2009

When it Comes to Investing, Simplicity Rules.

There was a time when only the wealthy and well connected could invest in the stock market. Then IRAs and 401(k) plans ushered in a new era of the “common man” investor. Flash forward a bit more, to the Internet age, and we have a grand democratization of the stock market.

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Not too long ago, you had to be one of the aristocracy to have access to what the power elite could dabble in: options, shorts, foreign exchange (forex), margin, commodities futures, to name a few.

But thanks to the Internet and the information age bringing investing to the masses, all that has changed. You can buy stock options through dozens of online brokerages like TD Ameritrade, Charles Schwab and ShareBuilder. Similar availability exists with foreign exchange markets, shorts and commodities futures.

When retail investors began purchasing shares in mutual funds in the 1970s, Forbes magazine was able to print the returns and expenses of every fund available. But now there are over 9,000 mutual funds on the market. When ETFs were first available in the 1990s, there were a handful and most were simple index tracking funds. Now there are over 700, many with elaborate weighting algorithms and some are straight actively managed funds.

But just because you can make use of these tools and techniques, doesn’t mean you should.

When it comes to saving for retirement, college or building your estate to pass on to future heirs, the tried and true stocks, bonds and mutual funds (and index ETFs) work just fine. The key isn’t how fancy or esoteric your investment vehicle is, but how you allocate your assets.

Take trading on margin for example. Margin is simply investing with borrowed money, usually from the brokerage. You borrow the money at a specified interest rate, and agree to pay it back with interest – hopefully once you’ve earned more from your investments than the cost to borrow. Margin amplifies returns, but it also magnifies losses, and you could end up owing more than you have. For this reason, it’s best left alone by the individual investor.

Another needlessly risky technique is shorting. Shorting is a bet that an asset will go down in value. At least in terms of individual stock, shorting puts the investor at odds with management. Knowing a particular stock is a dog, and not worth its trading price is one thing, but timing when the market will realize this is quite another.

But the real reason short selling is so risky is that you have virtually limitless amounts to lose. Consider this:

“You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold.

Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 – $10,500 = $3,000). I have ignored commissions and so on to keep the math simple.”

Sounds great, you pocket a quick and easy 3k in profit. But here’s what happens when you guess wrong:

” You short 300 shares at $35 for $13,500. However, instead of falling like all reason and logic suggests, the stock rises and rises fast.

Before you know it, the stock is at $55 per share. You get a call from your broker, who is getting nervous. Your account for short selling is a margin account and if the stock goes too high, you will have to deposit more money or cover the short by buying the stock.

You decide to cut your loses and cover the short by buying the stock at $55 per share for $16,500. Since you only have $13,500 in your account, you have to come up with another $3,000 out of your pocket to make things right. You suffer a $3,000 loss. “

But what if the stock rockets past $55 a share. A stock can only lose so much money, and most stable companies don’t go to 0. But a share price can rise a long way before it starts to turn, and that can add up to big losses when you’re short.

For these reasons and more, you’re probably better off sticking to the simpler approach of The Simple 7 or the super simple One Minute Portfolio.


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