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High Stakes Gambling?

Stock Market News

February 2001

High Stakes Gambling?

Have you ever wondered about the close resemblance between buying stocks and high stakes gambling? We have and, based on the preponderance of evidence, our conclusion is a definite maybe.

Here's why. If you are an "investor" who invests to make a short-term profit or if you are a day-trader, we would probably say you really aren¡¦t investing, you are speculating (i.e. gambling). If, however, you are purchasing stocks and holding them for long-term profit, then you aren¡¦t really gambling. Sure, you're taking a chance on losing your money, but if you have made a well reasoned decision, you are simply making an educated business decision. We all do that everyday.

How do you make solid investment decisions? That's what we're going to talk about this month. So, print this article out, grab your favorite drink, sit back and read our take on smart investment decision-making

Our philosophy can be boiled down to one sentence: "Find what works for you and stick with it."

This may sound like we're sidestepping the issue, but even with considering the numerous pundits out there touting growth stocks, value stocks, mid- and large-cap stocks or just about any other kind of stock you can think of, we still think investment makes sense. But it makes sense if and only if you really know what your choices are. And that is what this article is about, helping you know exactly what those choices are.

The first thing to remember is that you are essentially buying a business. That's what a stock is -- a piece of a business. Therefore, your primary objective is to decide how much you think the business is worth and, consequently, how much each share of stock is worth. Then you look for stocks that are selling for less than their value or stocks that you think will increase in value.

To do this, there are a number of different philosophies investors employ. We will talk about the Value, Growth, Income and Quality approaches in this article.

Investors who subscribe to the Value approach believe each company, and thus stock, has a real value and a market value. The objective is to find stocks that are, in their opinion, undervalued and purchase them. They are betting the market will eventually recognize the value of the stock and the price will increase.

Value investors generally look at stocks based on the following factors:

  • Price/earnings ratios below a certain level.
  • Dividend yields above a certain level.
  • Book value per share as it relates to the market value of the stock.
  • Sales as compared to market capitalization.

All of these tend to be more historical in nature than forward looking. They are, in essence, looking at the value of a company if it was liquidated. Growth investors, on the other hand, tend to look at the growth prospects of a company. That is, their focus is on the company as a going-concern.

Growth investors look at things like the quality of the business and the rate at which revenue has grown in the past. The products the company sells and the projected demand for those products is key. The whole idea of the growth investor is to find companies with a probability of high sales growth -- profitable growth.

The Income investor is primarily concerned with acquiring investments that produce an acceptable income stream. Many Value and Growth stocks don't pay dividends. Instead, the investor is paid off when the stock is sold. Income stocks, however, produce dividends. Stocks in this category may include real estate investment trusts and utility stocks. Some preferred stocks also produce high dividend yields. Income investors will sometimes look for and invest in stocks of companies with financial difficulties that have depressed the company's stock value to the point where the dividend yields are attractive.

Quality investors use a bit of all of the preceding approaches. Their aim is to find stocks of high quality companies at reasonable prices. What is a high quality company? It's a company that has been in business for a number of years and has demonstrated the ability to weather the good times and the bad times. Management is relatively stable in such companies and earnings are expected to increase at a relatively stable pace. Often, these investors will look at intangibles such as the competence of management and return on equity.

So which is the right approach in the current market environment? No one strategy is better than the other. It is the execution of the strategy you choose that matters. It can be likened to driving a car. Some drivers are good and some are dangerous. The good ones pay attention to what they are doing and keep their eyes on the road. The dangerous ones look at everything but the road.

Similarly, whatever strategy you choose, you must embrace it and follow it. That's where the problem comes in. How in the world do you get the data you need to implement your strategy?

In this information age, there are a number of possibilities. If you prefer the old fashioned way of getting your news, there are numerous excellent publications available such as Barron's, The Wall Street Journal and Value-Line. Money Magazine, Forbes and similar magazines are also excellent sources of information. This just to name a few possibilities and there are many other very good publications.

If you prefer to get your news electronically, there are numerous web sites and services that can help you. Sites such as Quicken.com, Investor.com and others offer varying degrees of research capabilities. Most major online brokerages also provide research services. There also paid online services to help you in your search for reliable investment data.

Wherever you get your information, always remember that making wise investment decisions requires thoughtful study and a great deal of time. If you are willing to make the time investment, you may be well on your way to properly managing your portfolio, but don't forget the easiest way to stay on top of the research -- mutual funds. There are thousands of mutual funds that follow whatever investment style makes you comfortable. These funds have professional managers who do the same thing you would do, but they do it full time. So, on average, they should outperform the average investor.

If you don't have the time to do the research properly, find several mutual funds that are compatible with your investment philosophy and invest in those.

We said earlier that you must stick with whatever investment strategy you pick. This doesn't mean you stick with a stock or mutual fund that has lost its value for solid economic reasons -- competition, product obsolescence, etc. It does mean that you don't bail out of the market at the first downturn.

The market has performed dismally in the last year. That can't be denied. However, if you have a good stock that has lost value simply because of the market roller coaster, this doesn't mean you sell everything and move to cash. Ultimately, the decision is yours, but we would suggest to you that you speak to your financial advisor before taking any drastic moves. Remember, a loss is only a paper loss until you sell and the nature of the market is to go in cycles.

As with just about everything else in life, the bottom line is to find a strategy you are comfortable with and stick with it. Consistency is key and over time, you can experience substantial returns if you take a long-term view. Don't know what strategy suits you? Drop by for a cup of coffee and we can discuss it together. We are always here for you.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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