Archive for March, 2010
Figuring out which stocks to buy is challenging enough, but somehow knowing when to sell a stock is even harder. Certainly if you hold a diversified portfolio and did your homework when you selected the stock in the first place, a drop in price alone is no reason to sell. Remember: Stock investments are generally long-term commitments; the day-to-day blips on the chart are generally not a trigger to act.
So when should you sell? In general, I use three criteria:
1. The stock’s fundamentals have changed. When deciding whether to hold or sell, analyze the stock in the same way that you did when you decided to buy it. If it no longer passes muster, this may be an indication to sell.
2. Your diversification is out of line. Suppose your target is to hold
50% large-cap stocks, 25% small-cap stocks, and 25% international stocks. But large-caps now constitute 75% of your portfolio. You should consider selling the underperforming large-caps (and buying more of the others). 3. Your personal situation has shifted. If your circumstances have changed, perhaps due to a marriage, a divorce, or a death in the family, and as a result either your time frame or your risk tolerance has shifted, you may want to reallocate your portfolio.
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After you’ve been investing for a while, you’re sure to hear someone talking about margin loans. So what are they, and are they for you?
In a nutshell, a margin loan allows you to borrow money from your brokerage company, using the securities in your account as collateral. You can use these funds for a variety of purposes, but the most common use is to buy stock ‘ion margin.” This is how it works. Let’s say you want to buy one hundred shares of stock priced at $100 per share. If you pay for the entire amount up front, that will cost you $10,000 (plus commission). If the price of the stock goes up to $150, your investment is now worth $15,000. Not bad. But instead of paying for the stock in full, a margin loan will usually allow you to borrow up to half of the purchase price. Although you will eventually have to pay back the $5,000 loan (plus interest), in the short term you’re only out of pocket $5,000 plus the commission.
While this concept is straightforward, and can certainly work in your favor, margin loans can entail a significant amount of risk. Continuing with our example, let’s say that instead of rising to $150, the stock falls to $50. With a straight purchase, the value of your initial $10,000 investment falls to $5,000. But if you had initially bought this stock on margin, paying $5,000 and borrowing the other $5,000, you would have lost your entire up-front investment. Now let’s take this scenario even further and say the stock falls to $40. In this case, the value of your shares is now $4,000, or $6,000 less than the purchase price. Now your loss exceeds your up-front investment and an additional risk is introduced—margin “calls” and margin “sellouts.” Using the example of the stock falling to $40, if this decrease in price causes your account to fall below your brokerage firm’s minimum maintenance requirement your broker will either make a “margin call,” asking you to deposit sufficient funds and/or securities to your account or sell (a “margin sellout”) some or all of the securities in your account to bring it back to the required minimum maintenance level. Be aware that your broker has the right to sell your securities without consulting you first if your minimums are not maintained in the required time frame. And once that sale goes through, you have no opportunity to recoup your loss. In essence, that’s the up- and downside of leverage. It’s great when it works in your favor, but it can get very painful, very quickly, when it doesn’t So what’s an investor to do? Following are a few questions to
ask yourself before you take out your first margin loan:
• Do you completely understand all of the rules and regulations associated with margin loans? For example, if the value of your margine stock falls below a certain level, you will be required to deposit more money or risk losing the position.
• How long have you been investing? As a general guideline, you should have at least five years of experience in the stock market before you buy on margin.
• What is your risk tolerance? If losing a large percentage of your investment would be devastating, buying on margin is not for you.
• How large is your portfolio? If you have less than $50,000 invested, a margin loan is probably not appropriate.
• How diversified is your portfolio? If you don’t own a broadly diversified mix of investment, margin debt is probably too risky.
In sum, when it comes to margin loans, a little caution goes a long way. Like any other debt margin loans can be a great tool—but only when used appropriately by a knowledgeable investor.
In very broad terms, stock research falls into two general categories: fundamental analysis, an examination of the company issuing the stock, and technical analysis, an evaluation of the performance of the stock price itself. Fundamental analysis focuses on things like the company’s products, its competition, and its management. It also takes into account the company’s financial health—whether it has consistent earnings growth, a low debt ratio, and a strong cash flow. Technical analysis, on the other hand, looks at the behavior of the stock’s price over time—but doesn’t attempt to explain the forces behind that movement.
Another way of looking at the difference between these two approaches is to think about a stock’s intrinsic value, which fundamentalists believe can vary from the stock’s market price. (If you believe that the intrinsic value is higher than the market price, you’re a buyer; if you think that the intrinsic value is lower, you’ll sell.) Technicians, on the other hand, disregard this type of evaluation and are much more likely to buy or sell on the basis of a trend or chart pattern. In general, technical analysis is most useful for active traders or other investors with a short-term horizon. If you’re a long- term investor, there is no substitute for evaluating the fundamentals. Although most investors are not likely to get involved with in-depth fundamental analysis, they can obtain a wealth of pertinent data from publicly available resources.