Stock-Picking Strategies: Value Investing

Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.

The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation. 

Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.

It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.

Value Investing at Work 
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles. (See Warren Buffett: How He Does It.)

Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.

Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.

Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.

Screening for Value Stocks 
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.

Qualitative aspects of value stocks: 

1. Where are value stocks found? - Everywhere. Value stocks can be found trading on the NYSE, Nasdaq, AMEX, over the counter, on the FTSE, Nikkei and so on.
2. a) In what industries are value stocks located? - Value stocks can be located in any industry, including energy, finance and even technology (contrary to popular belief).
   b) In what industries are value stocks most often located? - Although value stocks can be located anywhere, they are often located in industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term. For example, the auto industry's cyclical nature allows for periods of undervaluation of companies such as Ford or GM.
3. Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value. A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:

1. Share price should be no more than two-thirds of intrinsic worth.
2. Look at companies with P/E ratios at the lowest 10% of all equity securities.
3. PEG should be less than one.
4. Stock price should be no more than tangible book value.
5. There should be no more debt than equity (i.e. D/E ratio < 1).
6. Current assets should be two times current liabilities.
7. Dividend yield should be at least two-thirds of the long-term AAA bond yield.
8. Earnings growth should be at least 7% per annum compounded over the last 10 years.

The P/E and PEG Ratios 
Contrary to popular belief, value investing is not simply about investing in low P/E stocks. It's just that stocks which are undervalued will often reflect this undervaluation through a low P/E ratio, which should simply provide a way to compare companies within the same industry. For example, if the average P/E of the technology consulting industry is 20, a company trading in that industry at 15 times earnings should sound some bells in the heads of value investors.

Another popular metric for valuing a company's intrinsic value is the PEG ratio, calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.

Narrowing It Down Even Further 
One well-known and accepted method of picking value stocks is the net-net method. This method states that if a company is trading at two-thirds of its current assets, no other gauge of worth is necessary. The reasoning behind this is simple: if a company is trading at this level, the buyer is essentially getting all the permanent assets of the company (including property, equipment, etc) and the company's intangible assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading this low are few and far between.

The Margin of Safety 
A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.

This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!
Sourced from : http://www.investopedia.com

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Stock-Picking Strategies: Qualitative Analysis

Fundamental analysis has a very wide scope. Valuing a company involves not only crunching numbers and predicting cash flows but also looking at the general, more subjective qualities of a company. Here we will look at how the analysis of qualitative factors is used for picking a stock. 


Management
The backbone of any successful company is strong management. The people at the top ultimately make the strategic decisions and therefore serve as a crucial factor determining the fate of the company. To assess the strength of management, investors can simply ask the standard five Ws: who, where, what, when and why?

Who? Do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, COO and CIO are. Then you can move onto the next question.

Where? You need to find out where these people come from, specifically, their educational and employment backgrounds. Ask yourself if these backgrounds make the people suitable for directing the company in its industry. A management team consisting of people who come from completely unrelated industries should raise questions. If the CEO of a newly-formed mining company previously worked in the industry, ask yourself whether he or she has the necessary qualities to lead a mining company to success.

What and When?
What is the management philosophy? In other words, in what style do these people intend to manage the company? Some managers are more personable, promoting an open, transparent and flexible way of running the business. Other management philosophies are more rigid and less adaptable, valuing policy and established logic above all in the decision-making process. You can discern the style of management by looking at its past actions or by reading the annual report's management, discussion & analysis (MD&A) section. Ask yourself if you agree with this philosophy, and if it works for the company, given its size and the nature of its business.

Once you know the style of the managers, find out when this team took over the company. Jack Welch, for example, was CEO of General Electric for over 20 years. His long tenure is a good indication that he was a successful and profitable manager; otherwise, the shareholders and the board of directors wouldn't have kept him around. If a company is doing poorly, one of the first actions taken is management restructuring, which is a nice way of saying "a change in management due to poor results". If you see a company continually changing managers, it may be a sign to invest elsewhere.

At the same time, although restructuring is often brought on by poor management, it doesn't automatically mean the company is doomed. For example, Chrysler Corp was on the brink of bankruptcy when Lee Iacocca, the new CEO, came in and installed a new management team that renewed Chrysler's status as a major player in the auto industry. So, management restructuring may be a positive sign, showing that a struggling company is making efforts to improve its outlook and is about to see a change for the better.

Why?
A final factor to investigate is why these people have become managers. Look at the manager's employment history, and try to see if these reasons are clear. Does this person have the qualities you believe are needed to make someone a good manager for this company? Has s/he been hired because of past successes and achievements, or has s/he acquired the position through questionable means, such as self-appointment after inheriting the company? (For further reading, see: Get Tough on Management Puff and Evaluating a Company's Management.)

Know What a Company Does and How it Makes Money 
A second important factor to consider when analyzing a company's qualitative factors is its product(s) or service(s). How does this company make money? In fancy MBA parlance, the question would be "What is the company's business model?"

Knowing how a company's activities will be profitable is fundamental to determining the worth of an investment. Often, people will boast about how profitable they think their new stock will be, but when you ask them what the company does, it seems their vision for the future is a little blurry: "Well, they have this high-tech thingamabob that does something with fiber-optic cables… ." If you aren't sure how your company will make money, you can't really be sure that its stock will bring you a return.

One of the biggest lessons taught by the dotcom bust of the late '90s is that not understanding a business model can have dire consequences. Many people had no idea how the dotcom companies were making money, or why they were trading so high. In fact, these companies weren't making any money; it's just that their growth potential was thought to be enormous. This led to overzealous buying based on a herd mentality, which in turn led to a market crash. But not everyone lost money when the bubble burst: Warren Buffett didn't invest in high-tech primarily because he didn't understand it. Although he was ostracized for this during the bubble, it saved him billions of dollars in the ensuing dotcom fallout. You need a solid understanding of how a company actually generates revenue in order to evaluate whether management is making the right decisions. (For more on this, see Getting to Know Business Models.)

Industry/Competition
Aside from having a general understanding of what a company does, you should analyze the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. Of course, discerning a company's stage of growth will involve approximation, but common sense can go a long way: it's not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It's just a matter of asking yourself if the demand for the industry is growing.

Market share is another important factor. Look at how Microsoft thoroughly dominates the market for operating systems. Anyone trying to enter this market faces huge obstacles because Microsoft can take advantage of economies of scale. This does not mean that a company in a near monopoly situation is guaranteed to remain on top, but investing in a company that tries to take on the "500-pound gorilla" is a risky venture.

Barriers against entry into a market can also give a company a significant qualitative advantage. Compare, for instance, the restaurant industry to the automobile or pharmaceuticals industries. Anybody can open up a restaurant because the skill level and capital required are very low. The automobile and pharmaceuticals industries, on the other hand, have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents and so on. The harder it is for competition to enter an industry, the greater the advantage for existing firms.




Brand Name
A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in the world: Coca-Cola. Many estimate that the intangible value of Coke's brand name is in the billions of dollars! Massive corporations such as Procter & Gamble rely on hundreds of popular brand names like Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.

Keep in mind that some stock-pickers steer clear of any company that is branded around one individual. They do so because, if a company is tied too closely to one person, any bad news regarding that person may hinder the company's share performance even if the news has nothing to do with company operations. A perfect example of this is the troubles faced by Martha Stewart Omnimedia as a result of Stewart's legal problems in 2004.

Don't Overcomplicate
You don't need a PhD in finance to recognize a good company. In his book "One Up on Wall Street", Peter Lynch discusses a time when his wife drew his attention to a great product with phenomenal marketing. Hanes was test marketing a product called L'eggs: women's pantyhose packaged in colorful plastic egg shells. Instead of selling these in department or specialty stores, Hanes put the product next to the candy bars, soda and gum at the checkouts of supermarkets - a brilliant idea since  research showed that women frequented the supermarket about 12 times more often than the traditional outlets for pantyhose. The product was a huge success and became the second highest-selling consumer product of the 1970s.

Most women at the time would have easily seen the popularity of this product, and Lynch's wife was one of them. Thanks to her advice, he researched the company a little deeper and turned his investment in Hanes into a solid earner for Fidelity, while most of the male managers on Wall Street missed out. The point is that it's not only Wall Streetanalysts who are privy to information about companies; average everyday people can see such wonders too. If you see a local company expanding and doing well, dig a little deeper, ask around. Who knows, it may be the next Hanes.

Conclusion
Assessing a company from a qualitative standpoint and determining whether you should invest in it are as important as looking at sales and earnings. This strategy may be one of the simplest, but it is also one of the most effective ways to evaluate a potential investment. 
Sourced from : http://www.investopedia.com

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Stock-Picking Strategies: Fundamental Analysis

Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies. 

The Theory 

Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.

Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. (For further reading, see Understanding the Time Value of Money).

The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.

Greater Fool Theory 

One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.

This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)

Putting Theory into Practice 

The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.

Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look: 


The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts: (1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and (2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.


In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilà! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:

1. Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
2. Growth rate - The rate at which owner's earnings are expected to grow for the next five years.
3. Cash flow - The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
4. Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
5. Discount per year - The cash flow multiplied by the discount factor.
6. Cash flow in year five - The amount the company could distribute to shareholders in year five.
7. Growth rate - The growth rate from year six into perpetuity.
8. Cash flow in year six - The amount available in year six to distribute to shareholders.
9. Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
10. Value at the end of year five - The value of the company in five years.
11. Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
12. PV of residual value - The present value of the firm in year five.
13. 
    

So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.

What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same. 

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Stock-Picking Strategies: Introduction

When it comes to personal finance and the accumulation of wealth, few subjects are more talked about than stocks. It's easy to understand why: playing the stock market is thrilling. But on this financial roller-coaster ride, we all want to experience the ups without the downs. 

In this tutorial, we examine some of the most popular strategies for finding good stocks (or at least avoiding bad ones). In other words, we'll explore the art of stock-picking - selecting stocks based on a certain set of criteria, with the aim of achieving a rate of return that is greater than the market's overall average. 

Before exploring the vast world of stock-picking methodologies, we should address a few misconceptions. Many investors new to the stock-picking scene believe that there is some infallible strategy that, once followed, will guarantee success. There is no foolproof system for picking stocks! If you are reading this tutorial in search of a magic key to unlock instant wealth, we're sorry, but we know of no such key. This doesn't mean you can't expand your wealth through the stock market. It's just better to think of stock-picking as an art rather than a science. 

There are a few reasons for this: 

1. So many factors affect a company's health that it is nearly impossible to construct a formula that will predict success. It is one thing to assemble data that you can work with, but quite another to determine which numbers are relevant.

2. A lot of information is intangible and cannot be measured. The quantifiable aspects of a company, such as profits, are easy enough to find. But how do you measure the qualitative factors, such as the company's staff, its competitive advantages, its reputation and so on? This combination of tangible and intangible aspects makes picking stocks a highly subjective, even intuitive process.

3. Because of the human (often irrational) element inherent in the forces that move the stock market, stocks do not always do what you anticipate they'll do. Emotions can change quickly and unpredictably. And unfortunately, when confidence turns into fear, the stock market can be a dangerous place.

The bottom line is that there is no one way to pick stocks. Better to think of every stock strategy as nothing more than an application of a theory - a "best guess" of how to invest. And sometimes two seemingly opposed theories can be successful at the same time. Perhaps just as important as considering theory, is determining how well an investment strategy fits your personal outlook, time frame, risk tolerance and the amount of time you want to devote to investing and picking stocks. 


At this point, you may be asking yourself why stock-picking is so important. Why worry so much about it? Why spend hours doing it? The answer is simple: wealth. If you become a good stock-picker, you can increase your personal wealth exponentially. Take Microsoft, for example. Had you invested in Bill Gates' brainchild at its IPO back in 1986 and simply held that investment, your return would have been somewhere in the neighborhood of 35,000% by spring of 2004. In other words, over an 18-year period, a $10,000 investment would have turned itself into a cool $3.5 million! (In fact, had you had this foresight in the bull market of the late '90s, your return could have been even greater.) With returns like this, it's no wonder that investors continue to hunt for "the next Microsoft". 


Without further ado, let's start by delving into one of the most basic and crucial aspects of stock-picking: fundamental analysis, whose theory underlies all of the strategies we explore in this tutorial (with the exception of the last section on technical analysis). Although there are many differences between each strategy, they all come down to finding the worth of a company. Keep this in mind as we move forward.


Sourced from : http://www.investopedia.com

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Low Capital to Start Investing with?

One of the biggest problems for new investors is the amount needed to start investing.

They often want to get started investing with very little money but find out that it is hard to do this and give up.

The fact is that if you want to invest in stocks, you usually need more money to start with than you need for a mutual fund.

The reason for this is because if you invest with a small amount, a large percent would be eaten up in commissions.

On the other hand you can just keep setting aside money every once in a while until you have enough to make a larger investment.

But if you want to invest in stocks rather than a mutual fund, it is usually necessary for you to have at least around $1500 to start with.

However, if you are a long-term investor, these shouldn't be a big concern for you because your account should appreciate over time and make up for the larger commissions.

So rather than getting discouraged and giving up on investing, use your patience, grasp the opportunity and ...

Start investing in the stock market right now!

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Calculate Your Lifetime Earnings

Do you want to know how much money you will make throughout your entire career?

Determining your lifetime earnings is important as it can give you a concrete idea of just how much money you will make in your lifetime.

In many situations, you may not realize how financially healthy you are until you view this total.

Additionally, knowing your lifetime earnings calculator can help you to plan out your financial future.

Of course, knowing this sum, can also serve as a reminder of how much money you may lose if you are unable to work due to an illness or other reason.

To determine your lifetime earnings, all you have to do is input a few simple - yet key figures -into the Lifetime Earnings Calculator. For instance, you should enter your age, your present annual salary, your expected annual increase in salary as a percentage, and the expected date that you plan to retire.

After you input all of these figures, you then press the “submit” button and your lifetime earning total will appear.

Remember that if you properly manage this lifetime sum, you can maximize your profit from your lifetime earnings.

Additionally, if you find that you are constantly borderline broke, learning your lifetime earnings can serve as a reminder that you should maximize your earning power by curtailing wasteful spending practices.

In any case, learning your lifetime earning total is a helpful tool to remind you that you do make a significant amount of money throughout your life, and it is up to you to manage this money in a proper manner.

After all, you do need a significant amount of money for your retirement years – as well as to pay for present day-to-day expenses.

All in all, the Lifetime Savings Calculator is an excellent tool if you wish to learn about how much money you will make throughout your life – and it can also serve as a reminder to manage this sum of money in the best manner possible.

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Well Managed Investing Risks ... Bring Rewards!

"Risk comes from not knowing what you're doing!" Warren Buffett (1930 - )

We often listen to people who hesitate to invest in the stock market because they fear risk.

There are older people who fear that a stock crash could leave them destitute.

There are young couples who pine for a new home but worry that an investment loss could kill their chances.

For any investor, risk is a fact of life!

Whenever an opportunity opens up for you to make an investment profit, you also face the fear of the possibility of suffering an investment loss.

Even with "safe" kinds of investments, such as bank deposits, there is a risk that the rate you earn will not exceed the rate of inflation.

Often, these fears are rooted in a misunderstanding of what risk is.

Those who understand market risks -- and properly evaluate their ability to tolerate them -- can supercharge their investment portfolios by embracing a certain amount of uncertainty!

In the financial world, risk translates to uncertainty and it's measured by standard deviation from the norm.

Many individuals would say the riskier investment is the first, because their principal would be in greater jeopardy. But to professionals, the first investment is merely stupid --not risky-- because it's a sure thing to lose!

Still, what worries many is that you never know when the stock market is going to dive. What if it falls right before you need to sell?

Most individuals measure risk as their chance of loss, but we measure risk by the variability of returns!

In other words, because stocks have higher average returns, you can suffer some losses and still end up vastly ahead over the long run.

There's only one situation in which adding stocks to your portfolio doesn't make sense -- when you don't have time to let the market work for you.

In any given year, you have about a 1 in 4 chance of taking a loss in the stock market. If one year or less is as long as you plan to invest, stocks boil down to agamble.

But if your time horizon is five years or more, there's a very good chance that putting at least a portion of your money in stocks will boost the performance of your investments!

One question you have to resolve is the kind of investment risk you"re comfortable taking. The choice ranges from conservative to aggressive, with a broad middle ground between the extremes.

Conservative Investing:

Means putting money where there's little risk to principal.

Moderate Investing:

Means taking risks by putting money into growth stocks and bonds.

Aggressive or Speculative Investing:

Means taking a possible risk of losing part of your investment in exchange for the possibility of making a larger profit.

The ideal risk equalizer is that you should work for balance among the various risk categories.

One of your concerns should also be that if you invest too conservatively, you won't have enough money down the road to afford your goals even if you've been diligent in following your plan.

Another concern is that by taking too many chances you risk losing too much of your capital!

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Stock Markets and Trailing Stops

Once you bought a stock and has started moving up, you do need to get as much profit as possible. Not being able to do so will make you a losing trader in the long run!

How can you lose if you only take small profits at a time? Isn't a profit always a profit?

Well ... Not exactly!

A profit of 200 is not the same as a profit of 500. If your 200 profit is followed by two losses of 190 each, your 200 profit will become an 180 loss, while an i.e. profit of 500 will just become an 120 win. Do you get the point?

Profits are always followed by losses and if the profits are small they will not make up for the losses that will eventually and most surely follow.

However, becoming too greedy can turn a small profit into a loss.

This will make you lose money in the long run. The best solution to resolving these conflicts is to use "Trailing Stops."

As the name says, trailing stops follow the stock price that is moving up.

For example, let's say that you bought 100 shares at 50 per share. You will automatically put your stop loss at 49.5.

Then the price starts moving upwards and reaches 51. At that point you don't want to get out of this trade without a profit.

You will now move your stop loss at 50.5. This means, that if the price starts getting down, you will hit your sell order once the price hits 50.5, and at least you will still make some profit from it.

If the price continues to move in the positive direction, you will keep adjusting your stop loss accordingly. If the price hits 51.5 you will move your stop loss to 51.

Once you are more deeply "in the money" you can start using your stop loss more liberally and give the stock price more breathing space. This means that if the price hits 53, you could put the stop loss at 52.

You will be able to do this because you have already made a profit and can afford a little more risk.

You can also do this when the stock is in a clear upward trend.

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