Category Archives: Investing in Stocks

The Gordon Growth Equation

The Gordon Growth Equation is named after Myron Gordon who introduced it in the 1950s. It is a simplified model but it has turned out to be reasonably accurate over longer periods of time. The Gordon Growth Equation calculates the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate.

The Gordon Equation can be simplified in order to avoid some mathematical hurdles. Without going into the details, it is possible to rewrite the Gordon Equation as Price = Dividend / (Expected Return – Dividend Growth Rate). This can also be rewritten as Expected Return = (Dividend / Price) + Dividend Growth Rate. Which is the same as Return = Dividend Yield + Dividend Growth Rate.

Obviously, the dividend and the price of share are easy to find out. But the dividend growth rate is tougher. Also note that the Gordon Equation assumes that the dividend growth rate is constant. This is very seldom true in the real world. It is quite clear that the Gordon Equation does not work very well for growth stocks, they seldom pay any dividend at all. It works better for mature companies that have a long history of dividend payments. But it has turned out that the Gordon Equation also works well for indices, such as the S&P 500 index.

But even for indices, the markets are often very volatile. Despite that, over time, the Gordon Equation works fine for indicies. S&P has paid roughly 2.5% in dividend and the real growth of the dividend has been almost 1.5%. This gives a real return of about 4%. This is reasonably close to the real world. Note that we are talking about real returns, removing inflation makes the return less impressive.

But it is worth remembering that the dividend yield has changed a lot over the years. It was at it highest during the depression in the 1930s, reaching an amazing 14%. But few wanted or dared to buy shares during the depression. On the other hand, the yield reached an all time low towards the end of the 20th century during the Internet boom, staying just a little bit above one percent. At that time, everyone and their dog wanted to buy shares in companies with no customers, no revenue and no profits, regardless of the price.

Needless to say, the Gordon Equation has been very useful during booms and busts. During the depression, it was a very good time to buy shares. Exactly as predicted by the Gordon Equation, mainly thanks to the high dividend yield. On the other hand, it was not a good time to buy shares towards the end of the Internet hype. The Gordon Equation made this very clear as well.

Thus, don’t ignore the Gordon Equation when planning your investment strategies. Over the long run, it is amazingly accurate despite its simplicity. It can also help you make the right decisions when most others are either panicking or buying everything they can get hold of. On the other hand, if you want to invest in growth stocks, you’d better find another valuation method.

Stock Market Performance 2014

Before looking at the stock markets, it is worth pointing out that the rise of the dollar complicates the picture. For the first time since the burst of the Internet Bubble, the US dollar rose in value against all major currencies. The greenback has gained 11% against the euro, 14% against the yen and 5% against the pound. The dollar index, which weights the US currency against a basket of major trading counterparts, has risen 13% during 2014. The rise of the dollar started after mid-year and is likely to continue. Investors expect US interest rates to start to rise and are moving money into the US.

The US stock markets had a reasonable year, Dow Jones went up 7%, S&P 500 11% and Nasdaq 13%. It was not as good year as 2013 but still quite a good year for many stocks. And for investors outside the US, the strong dollar made the gains significantly larger. Most experts seem to believe that US stocks will continue their upward journey but it is prudent to remember that share prices are increasing faster than profits. According to the Shiller P/E data, US shares are 64% higher valued than the historical mean value.

The Japanese stock market went up 7% during 2014, very modest compared with plus 27% in 2012 and 52% in 2013. But if the fall of the yen is taken into account, investors counting their assets in dollars, lost about 7% on Japanese stocks. The Japanese economy is likely to continue limping along, Abenomics seems to have hit the wall. This is likely to mean that the yen will continue fall which will help many Japanese companies to increase their profits. But is questionable if the increase in share prices will be enough to offset currency losses for international investors.

Europe managed to avoid disasters, the Euro did not fall apart and the crisis in Ukraine did not spread into Europe. Unfortunately, no breakthroughs were made during 2014. ECB has still not got started on quantitative easing and hasn’t done anything else which could significantly boost growth in Euroland. The politicians seem to be unable to try expansionary fiscal policies, large government debts and Brussels insisting on austerity are the main two reasons for this.

The main stock markets in Europe moved in tandem, the German, French and Italian stock markets managed all to produce slight gains. But for investors counting their returns in dollars, the returns on all three stock markets were negative, due to the falling euro. The FTSE in the UK lost two percent during 2014. In dollars, the loss was even larger.

Looking at other markets, the Danish stock market increased 21% and Indian shares with 34%. At the other end, Russian and Greek shares have taken a severe beating lately, and both markets may very well continue further south over the next couple of weeks.

How well did the experts predict the outcome of 2014? US stocks did not manage to reach the most optimistic forecasts but many predictions were relatively close to the target. Japanese stocks did not manage to live up to the expectations but after two strong years some people had expected gains to be smaller. A year ago, many experts were bullish about European stocks but the economies in Euroland still have big problems to generate growth. This also meant that many companies are struggling which can be seen in the poor performance of many European stock markets.

Swing Trading

Buy-and-hold has not been as successful as it used to be. Is swing trading a better way of making money? It is certainly possible to make money with swing trading, even if the market is moving sideways. But before you get started, you must know that successful swing trading requires a lot of discipline and experience.

It is important to understand one significant difference between swing traders and buy-and-hold investors. Swing trading is typically based on technical analysis while buy-and-hold investors rely mainly on fundamental analysis. A swing trader tries to take advantage of the short-term price movements, both upwards and downwards movements. This means that swing traders generally hold a position for just a few days up to a couple of weeks. Buy-and-hold investors on the other hand tend to hold on to their shares for years.

If you are a buy-and-hold investor who wants to try swing trading, it is very important to understand how successful swing traders make their decisions. Apart from the two differences already mentioned, it is also important to be aware of that swing trading requires much more time than standard buy-and-hold investing. Another difference is that buy-and-hold investors generally don’t go short but for a swing trader shorting is an important way of making money in a falling market. What is very important to remember about shorting that is the potential losses from shorting are theoretically unlimited.

Although commissions have become much cheaper, it is still a significant expense for most traders. Most buy-and-hold investors don’t really need to worry much about broker commissions, they don’t make many transactions. Swing traders are much more active, meaning that commissions and fees can add up to significant amounts.

With all these potential drawbacks of swing trading, why would anyone prefer swing trading over buy-and-hold? The answer is simple, the chance of making money even if the stock market does not go upwards. In a bull market which lasts for years, buy-and-hold is an easy and comfortable way of getting rich. But if the market is going sideways or downwards, buy-and-hold investors are not making much progress and may even be losing money.

Needless to say, it is quite possible to lose money on swing trading. A lot of traders lack the discipline that is required to make trading profitable. Virtually every study shows that the majority of traders perform worse than the market average. Plenty of studies have shown that a lot of traders lose money even in a bull market. So before getting started with swing trading, it is very important to consider if it is really the right thing for you.

As mentioned earlier, swing trading requires more time than buy-and-hold investing. For most people it is best to avoid watching the price movements during the day. Instead, decide what trades you are going to do outside the trading hours. This makes swing trading much more relaxed. Studies have shown that traders who watch the market all day long generally overreact to movements and tend to do worse than traders who make their decisions outside the trading hours.

Swing trading should be treated as a business, not as a hobby. And certainly not as gambling. Needless to say, it is best to have other sources of income so if your swing trading is not producing any profits, you can still pay your bills. Desperate traders generally take a lot of risks which will sooner or later backfire badly.

Note that this article has only covered swing trading shares but you can trade almost any security. Currencies and commodities are very popular amongst traders. Whatever you do, make sure to avoid swing trading illiquid securities. Derivatives should also be avoided, you can quickly lose a lot of money due to small unexpected price movements in the underlying security.

Share Trading For Beginners

You may have noticed that the buy-and-hold strategy has not been as successful as it used to be. Trading is another way of making money on the stock markets but does it really work?

The term trading can be used for a wide range of activities, day trading and Forex trading have become very popular topics on the Internet. Nowadays, small investors can trade in almost anything. But in many ways, share trading is the safest for beginners.

Day trading has been popular for a long time but study after study have shown that most day traders lose money. This even if the market is moving upwards. Profitable day trading requires quick decisions, an extraordinary discipline and a deep understanding of how markets move. But the main problem with day trading is that the gains made on winning trades are very small. This means that day traders need a high ratio of profitable trades in order to make money. Although broker commissions have decreased, you still have to pay commissions regardless if the trade was profitable or not. The commissions are another reason why day trading is very difficult to make profitable.

A long-term investor on the other hand can often make 50% or more on a successful investment. As long as such a investor makes sure to cut his losses, it is possible to make handsome money even the investor picks a winner less than every second time. Also a trader improves his chances of success by holding on to his winners as long as possible. In other words, cut your losses and let your profits run. The longer time horizon has another advantage, you can make your trades once a day, in the morning before the stock market opens or in the evening after it has closed. This way you don’t need to worry about the daily volatile and don’t need to watch the prices all day long as a day trader has to.

But even with a longer time horizon, profitable trading is far from easy. If you are a beginner, it is highly recommended that you start with paper trading, meaning that you are not investing any real money. It may not be very exciting but it is very important to learn how the markets move. Once you have worked out a strategy which is profitable, you can start trading with real money. But note that it is important that your strategy is profitable over a longer period of time, not just a few weeks. Trading is not a fast way to riches, you should at least paper trade for six months before you start trading with your own money. Note that you must include the broker commissions also when paper trading. You are not paying any commissions of course but you will once you do real trading.

During the paper trade time, you should also make sure that you have the best tools you need for successful trading. You don’t really need much, just one program which keeps track of your profits and losses as well as trading software. Be careful with magic trading software that is supposed to automatically pick winners for you. Such programs don’t exist. All you need is a program that automatically downloads the market data and displays the data in a way you like.

As a trader, you should always use a discount broker. Even if you are not a day trader, you need to minimize your broker commissions. Trading requires frequent buying and selling so low commissions are essential. One last thing to remember is that it is impossible to always make money on the stock markets. If your trading is going badly, take a break and reconsider your strategy before you start trading again.

Technical Analysis versus Fundamental Analysis

Technical analysis and fundamental analysis are the two main methods for selecting shares. Which one is the better method is often hotly discussed. Technical analysis forecasts future price movements based on past price movements. Fundamental analysis on the other hand, looks at the financial figures, not just of the individual companies but also of the competitors, the customers and the whole economy. The goal is to find companies that are valued below their intrinsic value. A technical analyst on the other hand studies charts, trying to find buy or sell signals.

As can been seen already from the short introduction, the two methods don’t have much in common. The technical analyst is looking at historic prices, without even worrying about the underlying company. Actually, technical analysis can be used for anything that is traded, for example commodities and currencies, not just shares. Fundamental analysis is performed on historical and present data, as well as trying to estimate future figures.

Both methods have plenty of devoted followers, and hot debates are common about which school is the best. Especially some of the technical analysts defend their methods aggressively. This may have to do with that some people are looking down of technical analysis and ridicule it and its followers.

Technical analysis has become much easier thanks to cheap computers and Internet. With suitable software, it is possible to automatically download the latest information and display graphs on the screen. It is even possible to let the program do the buying and selling decisions automatically. In the good old days, technical analysts spent a lot of time collecting data and drawing graphs.

But does technical analysis (TA) work? There are plenty of stories about the efficiency of TA, both negative and positive. But it is difficult to find any studies that confirm that TA can be used to produce better returns than the market average. Every now and then a report pops about a new TA method that can be used to make money. But generally it turns out that someone has gone through an enormous amount of data, looking for patterns and found a way that would have produced a handsome profit. The problem is just that there is no guarantee that the specific pattern will repeat itself. By going through a lot of a data, looking at it from different angles, it is always possible to find some interesting patterns. This is true regardless if the data examined is just randomly generated or historic share prices.

Maybe the biggest concern about TA comes the fact that it is very difficult to find rich technical analysts. Given that thanks to computers and Internet, TA is very simple, shouldn’t plenty of people be making big profits? Apart from times when stock markets are going only upwards or downwards, it looks like technical analysts have trouble making money.

But wait a minute! Don’t hedge funds use technical analysis for some of their short term trading? Yes, hedge funds and other financial institutions often use TA for their short term trading. But they typically place huge money on relatively safe bets. The profit margins are extremely small, but with big money, even trades with razor thin profit margins add up to significant amounts after a while. Very few individual traders have such amounts of money and the trading fees are higher for individuals than for financial institutions. Even small fees will quickly wipe out any such small profits. Not to mention that hedge funds have invested enormous amounts of money to get the most efficient trading systems. A laptop with trading software for $100 is unlikely to outsmart such competition.

In theory, fundamental analysis seems to be almost foolproof. You buy something below its real value and wait until the market realizes the true value. Unfortunately, while TA is very simple thanks to computers, fundamental analysis is far from easy. First, there are a lot of different ways to estimate the intrinsic value of a company. Additionally, a number of forecasts about the future is necessary. Furthermore, a fundamental analyst must be able not only to read financial reports but also to understand what the figures are really saying. Even worse, a good understanding of the market is also necessary, as well as be able to judge the strength of competitors. In other words, in order to become a good fundamental analyst a lot of experience is necessary.

Does fundamental analysis work? Difficult question! There are certainly plenty of successful fundamental analysts. Unfortunately, since fundamental analysis can be done in many different ways and it requires a lot of training, it is far from guaranteed that fundamental analysts will be successful.

If you are going to become a trader, TA is the easiest method. But be careful, most traders seem to be losing money. For long term investments, thorough fundamental analysis is the best solution. Unfortunately, while TA just requires a computer with relatively cheap trading software and an Internet connection, fundamental analysis requires much more of the investor. Maybe cheap index funds are not that bad after all!

Stock Market Outlook 2014

People have always been interested in trying to predict the future. Trying to guess where the stock market is heading is no exception. This despite that most people know that it is impossible to know the answer. We are not going to try to guess how much shares will go up or down during 2014, just looking at how things look like at the moment.

2013 became a good for many stock markets around the world, much better than had been predicted. The US stock markets had a splendid year, S&P hit new all-time high and gained more than 26%. Much more than virtually all experts and gurus had predicted at the beginning of the year. Now almost all gurus believe that the S&P Index will go up again, not as much as 2013 but still more than ten percent.

Unfortunately, the economy has not grown as quickly as share prices. At the moment, the Schiller P/E ratio is at 25.38, the highest since the end of 2007. Some analysts who think that share prices will continue their upward journey are replacing the Schiller P/E ratio, so that the stock market does not look too overvalued. You can learn more about Schiller P/E ratio here and get both current and historic values.

Although the US shares look expensive, it is quite clear that the Federal Reserve does not want asset prices to go down. Most of the experienced professionals are convinced that quantitative easing will continue, any reduction is most likely to be just symbolic. At the same time, the Fed will keep interest rates low. So unless any major setbacks happens, it is quite possible that the S&P index will reach new all time highs during 2014. But it can prudent to remember that US shares are expensive, any setback can cause major drops.

The Nikkei index had a fantastic year, up more than 55%, the best year since 1972. One reason is that the Yen has dropped about 20% against the dollar. Add to that the massive economic stimulus programme and it is less surprising that the Nikkei index had such a good year. The question is if Abenomics will work. If it does, the Nikkei index will continue to rise. If Abenomics stalls, so will the Nikkei index.

London’s FTSE 100 increased 14% while the broader FTSE 225 did much better, up more than 25%. Almost all experts think that the FTSE 100 will break its old all-time high from 1999 during 2014. Many of the stock markets in Europe posted impressive gains. The German DAX hit new all-time high and is set to continue its upward journey in 2014. A lot of financial experts believe European shares will have a strong year. After several poor years, many of them look cheap. But it is all dependent on that the Euro gets through the year without any crisis. The weaker economies in Euroland still have a long way to go and even small issues could rock the boat.

Most so-called experts are very confident that 2014 will be a good year for shares, not as good as 2013 but still a good year. They certainly have strong allies, the major central banks will most likely be doing whatever they can to keep asset prices up. But it is also good to remember that the economic recovery since the global financial crisis is still painfully slow and there are plenty of potential problems that could stall the recovery. 2013 turned out to be a calm year, no significant setbacks happened. Will the same be true for 2014?

Penny Stock Advantages and Disadvantages

Penny stocks attract plenty of investors. If you buy the right penny stocks, you can get handsome returns. Unfortunately, it is also easy to lose money on penny stocks. Here is an overview of penny stock advantages and disadvantages.

For many people penny stocks are shares that trade at low prices, typically less than two dollars. In the US, the SEC defines a penny stock a share that sells for less than $5. The SEC also requires that the share is not listed on a national stock exchange plus some additional criteria. In the UK, shares that trade for less than £1 called penny shares.

So why are penny stocks attractive as investment? The two main reasons are that penny stocks are often very volatile, the movements in percent can often be large, and most penny stocks are micro cap stocks which means that successful companies can grow a lot.

Despite the fact that penny stocks are cheap, penny stocks can still go down in value. The big price changes, measured in percent, can go in both directions. Unfortunately, the spread for many penny stocks can be big. This means you may need a relatively big gain before you are making a profit.

Studies has shown that over longer periods of time, small caps perform better than large caps. Cap refers to market capitalization, which is the total value of all outstanding shares. The share prices of large caps, that is companies with large market capitalization, are typically less volatile than for small caps. But that does of course not mean that all small caps perform better than large caps. Indeed, most small caps stay small. But a few successful companies managed to grow tenfold, yes even hundredfold or more. If you can find such winners, you can make a lot of money.

But there are also a number of disadvantages with penny stocks. As mentioned earlier, the spread (the difference between the bid and ask price) can be fairly large. One reason for this is that many penny stocks are illiquid, meaning that the number of transactions is low. This also means that it can be difficult to quickly buy or sell specific penny stocks.

The main drawback with penny stocks in the US is the lack of regulations. This means that the risk of price manipulation is much greater than for shares traded on for example the NYSE. The fact that many penny stocks are thinly traded also makes it easier to manipulate the price.

One thing to remember about small companies is that while large companies once were small companies, not all small companies managed to become large. On the contrary, a lot of small companies remain small or go bankrupt. Sometimes you hear the argument that all large companies started as small companies so by investing in penny stocks you get the chance to invest early in the next Walmart, Microsoft or Cisco. But that has not much with reality to do, most of the large companies were already far beyond the micro cap level when they went public. And the share price when they went public was not just a few dollars.

Another thing well worth remembering is that there is generally a good reason for why the share price is low. Typically, the share price has been much higher but the company got into trouble and the share price plummeted. A successful penny stock investor must be able to judge how likely it is that the company can solve its problem.

So is it worth investing in penny stocks? Yes, it can be but beware that it is probably more about speculation than investing. Often it can be difficult to value a penny stock, there is simple not much reliable information. Even worse, hot penny stocks are often very highly valued. But yes, as long as you are aware of the risks with penny stocks, it is nothing wrong having some penny stocks in your portfolio. After all, if you get it right, you can make good money. Just remember that penny stocks are not as safe investment as large caps.

ETF Overview for Beginners

ETFs, Exchange Traded Funds, can be used in a number different ways to safeguard your investment portfolio or to increase your wealth. ETFs are a relatively new financial instrument. They have a number of advantages over traditional mutual funds. But you still need to know what you are doing if you are going to invest in ETFs. Here is an ETF overview for beginners, explaining the basics.

ETF stands for Exchange Traded Fund and is simple a collection of securities that you can buy and sell over a stock exchange. As an ETF investor you are simply buying an interest in a pool of securities and other assets. In essence, an ETF is similar to a mutual fund but it is traded like individual stocks, through a brokerage firm on a stock exchange. While the price of a mutual fund is the same the whole day, the price of an ETF changes all time, exactly as share prices.

Already in 1989, shares that tracked the S&P Index were sold. But it became a short-lived experiment after a lawsuit stopped the sale of the shares in the US. The first Exchange Traded Funds was launched in 1993. The first few years not much happened but after a couple of years, ETFs in all possible shapes and forms started to appear. The main types of ETFs are tracking either stocks, bonds, commodities or currencies. Leveraged ETF are more volatile than standard ETFs which will increase your profits and losses. ETFs are typically passively managed but lately actively managed ETFs have been launched.

Note that the market value of an ETF is not the same as the net asset value, NAV. NAV is the underlying value which is the total value of the assets and the cash in the fund. The price of an ETF on the other hand is decided by supply and demand. This can be confusing since the performance of an ETF is typically based on the NAV. That said, the difference between the market price and the NAV is generally very small.

The main advantage of ETFs is that you can build a diversified portfolio yourself, even if you have limited assets. ETFs cover virtually all industries and countries. But ETFs are not limited to just shares, they cover all major assets classes including bonds, commodities and currencies. Lower cost is often mentioned as another big advantage. But in practice the savings can be very small compared with cheap mutual funds. ETFs don’t have any client related service expenses. If you questions about an ETF, you talk to your stock broker not to the company which is responsible for the ETF. Unlike mutual funds, ETFs don’t issue any quarterly reports. On the other hand, like mutual funds, ETFs also have operating expenses. ETFs have some tax advantages, generally you will pay less capital gains tax and it is only payable when you sell the ETF.

Note that ETFs allow you to place special orders such as limit orders, stop-loss order and buy on margin. You can also trade in ETF options and short selling.

ETFs give you a lot of flexibility but you need to beware of potential drawbacks as well. First, far from all ETFs are low cost funds. Over time, the expense ratio has increased. Some ETFs are charging more than one percent in fees. That is significantly more than cheap index funds. Trading costs can be high, especially if you trade often or use an expensive broker. The spread, the difference between the buy and sell price, can also be large for some ETFs. Another thing to be aware of is the tracking error. ETFs are supposed to track an index. Unfortunately it is impossible to track an index perfectly. In many cases, the tracking error is very small but there are plenty of exceptions.

Thanks to the huge number of ETFs and the flexibility of ETFs, they can be used in many ways. ETF investment strategies include everything from just investing in the S&P Index to creating your own hedge fund. Here you can read more about popular ETF strategies.

Is Buy and Hold the Right Strategy

A lot of people have got rich by investing in shares and simply holding on to them for a long period of time. Buy and hold is a passive strategy, a very easy and comfortable way of investing in shares. But the last couple of years, buy and hold investors have not made any progress. Is buy and hold still the right strategy for investing in shares?

Buy and hold worked very well on the stock markets in the 80s and 90s. As long as shares go up, on average, at least 10% per year, the compound interest will create small fortunes even out of modest amounts. Buy and hold is a very simple strategy and it requires very little ongoing work.

You may already know that compound interest over time works wonders. But this requires that the annual growth is reasonably high. It must be at least a few percent higher than the inflation, otherwise you are not building any real wealth.

What becomes of $2400 invested each year, at different growth rates

Year Amount 4% 6% 8% 10% 12% 14%
1 2,400 2,496 2,544 2,592 2,640 2,688 2,736
2 4,800 5,092 5,241 5,391 5,544 5,699 5,855
3 7,200 7,792 8,099 8,415 8,738 9,070 9,411
4 9,600 10,599 11,129 11,680 12,252 12,847 13,464
5 12,000 13,519 14,341 15,206 16,117 17,076 18,085
6 14,400 16,556 17,745 19,015 20,369 21,814 23,353
7 16,800 19,714 21,354 23,128 25,046 27,119 29,359
8 19,200 22,999 25,179 27,570 30,191 33,062 36,205
9 21,600 26,415 29,234 32,368 35,850 39,717 44,010
10 24,000 29,967 33,532 37,549 42,075 47,171 52,907
11 26,400 33,662 38,088 43,145 48,922 55,520 63,050
12 28,800 37,504 42,917 49,189 56,455 64,870 74,613
13 31,200 41,501 48,036 55,716 64,740 75,342 87,795
14 33,600 45,657 53,462 62,765 73,854 87,071 102,822
15 36,000 49,979 59,214 70,378 83,879 100,208 119,953
16 38,400 54,474 65,311 78,601 94,907 114,921 139,482
17 40,800 59,149 71,774 87,481 107,038 131,399 161,746
18 43,200 64,011 78,624 97,071 120,382 149,855 187,126
19 45,600 69,067 85,885 107,429 135,060 170,526 216,060
20 48,000 74,326 93,583 118,615 151,206 193,677 249,044
21 50,400 79,795 101,741 130,696 168,967 219,606 286,646
22 52,800 85,483 110,390 143,744 188,503 248,647 329,513
23 55,200 91,398 119,557 157,835 209,994 281,173 378,381
24 57,600 97,550 129,275 173,054 233,633 317,601 434,090
25 60,000 103,948 139,575 189,491 259,636 358,401 497,599
26 62,400 110,602 150,494 207,242 288,240 404,098 569,998
27 64,800 117,522 162,067 226,413 319,704 455,277 652,534
28 67,200 124,719 174,336 247,118 354,314 512,599 746,625
29 69,600 132,204 187,340 269,480 392,386 576,798 853,888
30 72,000 139,988 201,124 293,630 434,264 648,702 976,169

As can be seen in the table above, over time even small amounts become huge over time. But you need a reasonable annual growth rate, otherwise it will take far too long. At 4%, your money does not grow much. It gets better at 6% but you still have to wait at least 30 years before the compound interest really starts to work. You really want at least 8% annual growth in order to start enjoying the magic of compound interest. But look at the difference between 8% and 10%, after about 25 years the difference of only 2% in annual growth starts to explode. At 12% growth, your money doubles every six years. As can be seen in the table, at this growth rate, even small amounts become huge within a reasonable timeframe. Of course, at 14% the magic of compound interest kicks in early. But it is far from easy to achieve 14% over 20 years or more.

Cheap index funds are the best solution for most people who want to invest using the buy and hold strategy. It has turned out that very few active managed mutual funds manage to beat cheap index funds over longer periods of time. When looking at performance over ten years or longer, cheap index funds are only beaten by about ten percent of the actively managed funds. And extremely few mutual funds manage to beat index funds with any significant amount. Also note that in reality index funds are even performing better than the statistics show. The actively managed funds only include the funds that have survived for ten years or more. Funds that have been closed or merged into other funds are not included. In almost every case the funds that have disappeared have been underperformers. Thus, the chance of selecting an actively managed fund which can significantly beat a cheap index fund is extremely small. Just selecting a fund that can match an index fund over longer periods of time is very difficult.

But some people insist on that individual investors can beat index over time. Most mutual funds are simply too large to be able to just select the few shares which they really believe in. A small investor on the other hand can invest in just a few companies. But if you want to beat index, you have to be prepared to take bigger risks and also to sell underperformers, which is not what a buy and hold investor would do.

In the 1980s and 1990s it was relatively easy to find shares that performed better than index for a very long time. Those who bought shares that increased ten or twenty fold got wealthy by just hanging on to their shares. You can still find such shares but it has become much more difficult. Needless to say, holding on to underperforming shares is not the fast way to riches.

So is buy and hold still a viable strategy on the stock markets? It certainly is the easiest strategy for most people. Unfortunately, it may not work as well as earlier, due to the fact that the last couple of years many stock markets have performed poorly. But unless you are prepared to learn about the stock markets and analyze shares, investing in cheap index funds and holding on to the investments is the best option. Despite the relatively poor performance of many stock markets, it is still advisable to have a large portion of your wealth in shares. But it can be worth looking at shares outside Europe. The US stock market may recover but it looks like many European stock markets will underperform for quite some time.

Investing in Stocks

A lot of financial advisors recommend investing in stocks. The 1980s and the 1990s were excellent years for most stock markets. But lately, most stock markets have been struggling. Is it still a good idea to invest in stocks and how should it be done? Here is an introduction to investing in stocks.

Investing in shares is easy and convenient, especially compared to investing in real estate. Nowadays, you can invest in shares using your computer. It has also become much cheaper to buy and sell shares.

You can invest in several different ways in stocks. You can buy shares of individual companies or buy mutual funds. So called derivatives make it possible to make a lot of money with little money but it is also possible to lose a lot of money. Here we are going to focus on investing in individual companies and mutual funds, the most popular ways of investing in stocks.

Mutual funds have become very popular. You give your money to a fund manager who selects what shares to buy. It is very easy but you don’t have any control how your money is being invested. Mutual funds used to be expensive, annual management fees could be several percent. Thanks to index funds, which can be run by computers, you can invest in mutual funds without paying much. It has turned out that funds with high management fees extremely seldom perform better than funds with low fees. Actually, over longer periods of time, like ten years, extremely few fund managers managed to beat cheap index funds.

If you are going to invest in mutual funds, pay attention to the fees. Most funds tend to perform like the index over longer periods of time, before the fees are deducted. This means that expensive funds seldom manage to make up for their higher fees. Nowadays, you should never pay any entry or exit fees. Not long ago, many funds had entry fees as high as 4%. Often part of it was paid as commission to the seller or advisor who got the client to invest in the fund. But funds with entry fees did extremely seldom perform better than funds without entry fees. In most cases, the investor wasted  money by paying such fees. If you are going to invest in mutual funds, we recommend cheap index funds.

If you are going to buy shares on your own, you need to do some research. That said, often so called experts have trouble beating portfolios selected by random. There are two main ways of selecting stocks, fundamental analysis and technical analysis.

Technical analysis looks at a stock’s previous performance, typically looking at price and volume. What the company does, how competitive it is, its profits or any other way of trying to estimate a fair price is not of any interest. Instead technical analysts are looking for specific pattern in past price movements, sometimes combined with the volume of traded shares. Specific patterns are identified as sell or buy signals.

Nowadays, technical analysis is easy to do. Computers can quickly process the latest data and suggest what shares to buy. Technical analysis has plenty of supporters but it is very difficult to find rich technical analysts. Many models work for a while but one day they just don’t generate any more profits. You can buy a lot of training and computer programs if you want to try technical analysis. But to us it looks like it is mostly the people selling those products that who are telling you that technical analysis can make you rich.

Fundamental analysis means that you are investigating a company and trying to estimate what the company is really worth. This includes looking at revenue, earnings, assets, liabilities and other figures but also includes judging how good the management is and how tough the competition is. It is a question of finding companies that represent good value, buying them and wait until the price goes up.

Fundamental analysis is far from easy but most successful investors belong to this category. Two terms that are often used are growth investing and value investing. Growth stocks are stocks of companies that are growing quickly, typically the P/E is high while the dividend is very low or non-existing. But as long as the company keeps on growing, the share price generally keeps on increasing. Value investing on the other hand is looking for undervalued companies.