Passive Investing: A Lucrative Alternative to Active Portfolio Management

Not everybody has the time for managing an equity portfolio. Understand and researching the financial markets for fruitful stocks to purchase is not only time-consuming, but requires experience and patience. For many Americans, it is simply not feasible to actively manage an investment portfolio. However, everyone wants to grow their money as the economy grows, right? Passive investing allows anyone to grow their wealth as the market grows over long periods of time. Rather than actively seeking worthwhile investments, one can buy index or mutual funds in their 401(k) or investment portfolio. Holding such funds long-term will yield great profits as the broader economy grows.

What is passive investing?

Passive investing is when an investor buys a market-basket index, such as the SPY index fund that tracks the S&P 500 index. This index will be highly diversified among industries, and will have a portfolio makeup that resembles major stock market indexes (Dow Jones, NASDAQ, S&P 500).

Passive investing is incredibly easy to do. All one needs is a brokerage account, with any major brokerage such as Charles Schwab or Fidelity. Then, one must purchase an index fund, such as the SPY S&P 500 fund or the VFINX Vanguard 500 index fund. There are a variety of funds, with varying levels of risk. It is very easy to do research on funds.

The main justification for passive investing is the “Efficient Market Hypothesis.” This theory effectively states that stocks are priced fairly, as they must reflect all the knowledge about each company that is available. Therefore, there is no point in trading stocks in the short-term to try to outperform the overall market. Only in the long-term, with new products and growth opportunities, will stocks grow.

Why invest this way?

Passive investing is excellent for individuals who lack the time to find their own investments, or lack experience in the stock market. Such investors can turn to index funds, where they can park their money and realize long-term growth as the economy prospers. The everyday American, with no knowledge of the stock market, can contribute a portion of their paycheck to their investment portfolio in index funds, and could have the potential to retire many years earlier than if they hadn’t invested.

Index funds are safe to invest in, as they are highly diversified to resemble market indexes, and nearly always get returns that match overall market returns within a small deviation. Index funds are low-cost too. Often, there is only a small fee. For the SPY index fund, the gross expense ratio is a mere 0.0945%. As long as you buy a fund from a trusted managing company, such as State Street SPDR or Vanguard, your money will be safe and reflect broader market returns. There is low-cost, low-risk, and good returns. The prospect of making 10% a year without doing any active management is exciting and one that anyone should consider.

What alternatives are there?

The drawback to passive investing is that there is not the potential for short-term profitability. A fund manager is usually required to minimize risk and match a market-basket of stocks to an index, while keeping buying and selling at a minimum to prevent large costs. Instead, one can choose to invest in hedge funds, though this is difficult according to Sean Ross from Investopedia as it requires the investor to be “accredited,” meaning they have “a net worth of more than $1 million and a sophisticated understanding of personal finance, investing and trading.” Hedge funds are typically Long/Short, meaning they can profit in both bull and bear markets.

One could also choose to be an independent “active investor.” Such investors don’t believe in this efficient markets theory, instead choosing to believe that there are small amounts of arbitrage in stock prices that can be profitable. Thus, one could attempt to make many trades a day, in order to generate small profits on each trade in the short-term.

The alternative that I would recommend, assuming someone has a baseline knowledge of investing, would be to follow the financial markets for a few hours a week. A few hours of research have the potential to yield excellent value stocks, or stocks of companies that have good management teams and sustainable future plans. These stocks have been beaten down into oversold range, but they are set to recover. They also tend to pay nice dividends of more than two percent. If you have the time and knowledge to assemble a minimally-managed portfolio of 10-20 stocks, there is potential to beat the market and grow even more wealth. Warren Buffett’s “Buy and Hold” strategy is one that truly pays dividends in the long-run.

Final Thoughts

Lacking time or energy to research and find stocks to purchase is one justification for not investing, but this can be easily fixed. Investing in index funds through a passive strategy can yield great returns, and also ensures that you don’t lose out on economic growth in the long-run. By effectively contributing a portion of your monthly paycheck to index funds, you can expect to see great returns in the long-term. Index funds are an excellent place to park your money, as they are cheap, low-maintenance, and yield returns that nearly always match the broader market.

Long vs. Short Positions

Quite simply, you can either be long or short in the stock market. If you are long, you are bullish, meaning you expect the market to go up. If you are short, you are bearish, meaning you expect the market to go down.

Long the Market

If you are long in the market, you typically purchase stocks. You own those stocks, and you believe the stocks will go up. If the stock goes up, you make money, and if the stock goes down, you lose money.

You can also be long in the stock market through derivatives, primarily options. If you purchase call options on the open market for a premium, you are effectively betting that a stock will hit at or above a predetermined strike price. You can also sell puts, such that you insure someone against a loss, and receive a premium on each put contract you sell on the open market. (Note that options are complicated, but will be covered later)

Short the Market

If you are short the market, you typically short-sell stocks. To short-sell a stock, one must first borrow a stock or another security (usually from their stock broker, such as Charles Schwab, Fidelity, etc.), then sell it.

One can also be short the market through options. One can sell call options on the open market, and receive a premium for each. Thus, the investor is betting that the stock on which he sold call options will not reach the strike price, and the options will expire worthless. One can also buy put options as a safeguard against any loss. The investor will pay a premium to have their losses insured.

Inherent Risk in Long vs. Short Trades

If you examine more closely, the potential for loss is much greater with a short position. The maximum you can lose with a long position is the price of the stock at the time you buy it. However, this is not true with short positions.

Suppose I purchase stock A for $20. If the stock drops to $0, I’ve lost the maximum amount possible, $20 per share that I’ve purchased. Now suppose, I short stock B when it is at $20. Now, suppose stock B turns bullish, and it goes up to $100. I’ve now lost $80 per share, as I lose on the stock if it goes above the price I shorted it at. Imagine if the stock went up to $1,000. That would be a loss of $980. Theoretically, the loss potential for a short position is infinite.

Additionally, as I described before, you must borrow shares from an entity such as your broker to short a stock. This involves using a margin account, and you will most often have to pay interest on the stock. Thus, when you short, you must be nearly certain that the stock will go down, especially if you are taking a large short position.

Hedging Against Risk

The short position is not completely useless, however. A risk-averse investor tends to use portfolios called “Long/Short Portfolios.” This means that they are protected from risk. They have a certain amount of their portfolio that is bullish, through long positions. Then, they have another portion of their portfolio that is bearish, through short positions.

Now, the split between long and short positions does not have to be 50%-50%. If the investor believes that the stocks have a higher probability of going up, then they could have 70% of their portfolio dedicated to long positions, and 30% dedicated to short positions. Thus, their risk is controlled. However, this also stifles their maximum profits, as if the market does end up going up, then they will lose some money on the 30% of their portfolio that is short.

Final Thoughts

It is always best to be long in the market, and take long term bullish positions. Short-selling stocks is risky, and something that institutional traders do. Finding a solid portfolio of 10-20 stocks is much better than trying to maximize profits through short-selling. In the long term, you should be safe with bullish investments.

Finding Value Stocks Through the P/B Ratio

One of the most important technical indicators to value investors is the P/B ratio, or the Price to Book ratio. This ratio effectively describes the fundamental value of a company relative to their balance sheet. This strategy has been largely pioneered by the most famous value investors of all, Benjamin Graham and Warren Buffet. The P/B ratio, used in conjunction with other metrics and evaluations, can lead to the discovery of a solid value stock to add to your portfolio.

What is the P/B ratio?

The P/B ratio, quite simply, is the price of the stock, divided by the stock’s book value. The book value is the balance sheet valuation of the company divided by the number of shares of the company’s stock in the stock market, otherwise known as Assets – Liabilities/Number of Shares. The book value basically tells an investor what the company’s assets are worth (but doesn’t include intangible assets such as patents). The book value is important because it gives an indicator as to what the stock should be fairly priced at.

Buffett’s Strategy

According to Richard J. Parsons in Seeking Alpha, “Berkshire’s price-to-book value has reset to a 1.32 average.” Berkshire, of course, is referring to Berkshire Hathaway, Warren Buffett’s enormous conglomerate holding firm. Warren Buffett, the greatest value investor of this century, now tends to buy stocks with a P/B ratio of around 1.3.

For example, if company A is priced at $500, but its book value is $25, then its P/B ratio would be 20.00. Thus, the stock price is double the book value. Ignoring growth or other factors, this stock could not be characterized as a value investment. It is overbought, meaning the share price is much higher than what it should be. This is reflected in the very high P/B ratio. Warren Buffet would not buy this stock.

If company B is priced at $30, and its book value is $30, then its P/B ratio would be 1.00. Thus, the stock price is equal to the book value. As long as the company has a good future outlook, and a sustainable business plan, for example, then this would qualify as a value investment. The P/B ratio indicates a fairly priced stock.

Finding stocks with fair P/B ratios

Currently, the stock market is overbought, meaning that P/B ratios will be inflated above their normal levels as stock prices are much higher than the book values, which will not be inflated in overbought market conditions. However, there are still excellent value investments that can be made, and Warren Buffet is taking advantage of some of them right now.

Bank of America Corporation (BAC) – P/B ratio of 1.14

Micron (MU) – P/B ratio of 1.28

Chevron (CVX) – P/B ratio of 1.50

All of these companies have stocks with total market capitalizations of above $50 billion. These are blue chip stocks, that, for whatever reason, have been beaten down lately. In the case of Bank of America, a weakened financial sector has kept banks’ stock prices near their book values. Micron has seen some weakened demand for semiconductors lately. Chevron has experienced a bear oil market, with weakened demand and large supply. However, these companies are all worth investing in. They are run by excellent management teams, and command large shares of their respective markets. Most importantly, to the value investor, is that they are fairly priced based on their P/B ratios.

Special Cases

An example of a stock with a high, yet justified P/B ratio would be Amazon (AMZN). With a P/B ratio of 18.27, this is unlikely to be a company that Warren Buffett invests in. You may be thinking, this is clearly an overbought, overpriced stock! Here is what you have to consider – Amazon has had quarterly revenue growth of about 20% for many years, and continues to expand its operations. This is something that value stocks with beat down P/B ratios lack – they are not high growth. Thus, many stocks have justifiably high P/B ratios when they have growth, or when they have high profit margins. Many of the FAANG stocks will have large P/B ratios, but this should not discourage you from investing in these companies.

Google (GOOG), for example, has a P/B ratio of 4.47. Thus, it is not necessarily a Buffett stock, but it surely is cheap for a technology stock. As an investor, I know Google will continue to expand. With profit margins and quarterly revenue growth both above 20%, I may consider purchasing Google at these valuations. Perhaps the strict value investor may not, but the P/B ratio can still give you information about stocks that don’t qualify as traditional value stocks.

Final Thoughts

The P/B ratio cannot be the only indicator used to find value stocks. Is there a reason as to why the stock’s price is matching its book value? Perhaps the product or service offered by the company is no longer competitive. In this case, the stock would be a good purchase. The P/B ratio should be used to confirm the intrinsic value of a company, which, like any other trustworthy company, has good management principles, and a forward-thinking expansion strategy. It is one of the most important fundamentals used by the value investor, and one anyone should pay attention to.

Statistics from:

finance.yahoo.com

The Difference Between Investing and Trading

Investing and trading are two different types of stock market strategies. Generally, the investor seeks to create slow and steady returns through investing in companies’ business plans and balance sheets. The trader, on the other hand, seeks to make risky short-term plays in market equities, often entering and exiting a stock position in seconds. Both have benefits and risks. It is important to understand each strategy when seeking to buy and sell stocks in the stock market.

Investing

When you invest in a stock, you are picking the stock for a variety of reasons, and typically plan to hold the stock for a long period of time. When you buy a company’s stock, you buy into the company’s values, management team, and fundamentals. Does the company have a trustworthy, experienced executive board? Can the stock continue its high revenue growth for the next 10 years? Is the company’s product or service a sustainable one? Will the company maintain a dominant industry presence? These are questions that the investor must answer.

Investing will generate slow, but consistent returns. Each year, you can hope to gain anywhere from 5-10%. It must be stressed, however, that the investor will not tend to care about these numbers. As long as their portfolio features a diversified basket of stocks, each of which has good potential in the long run, the portfolio will trend upwards with the market.

You may think that a 5-10% return is not very good. However, assuming you reinvest your returns, you can make quite a bit in the stock market over long periods of time. Suppose you make a consistent 7% return each year in an investment portfolio, and continue to reinvest your returns. On an initial $10,000, you would end up with $38,696.84, or nearly four times your initial investment. Suppose you continually add a portion of your income to your investment portfolio, these returns would be magnified even more.

Trading

You have likely heard of the “day trader.” The day trader often sits in front of multiple computer monitors, screening multiple stocks, options, and other equities, and making up to thousands of trades in one day. You may have heard of something called “technical analysis.” This is the main strategy employed by the day trader, where 1-day charts are analyzed for patterns. Technical signals such as the SMA (simple moving average), MACD (moving average convergence/divergence), and RSI (relative strength index) are just a few of the indicators used to trade stocks.

A technical analysis of a stock

Day traders are able to make small returns by entering and exiting positions quickly throughout a day, hence the name “day trader.” A day trader favors market volatility, which brings about wild price swings in equities. The day trader is able to use this volatility to make greater returns in stocks.

Day trading is generally unprofitable, especially for the everyday day trader. The overwhelming majority of retail investors who try to day trade will lose money. In the long term, day trading is not a profitable strategy, unless you have the tools and expertise to do it properly. Many investment banks, such as Goldman Sachs and Morgan Stanley, have trading desks, where proprietary traders (prop traders) use algorithms and high frequency orders to make small returns in fractions of fractions of a second. The same goes for hedge funds. However, these trading divisions at banks and hedge funds are becoming less profitable. If the big corporation is struggling to make day trading profitable, then surely the day trader will be having an even more difficult time.

Bottom Line

The investor seeks to find valuable companies to invest in the long run, while the trader seeks to take positions in stocks for short periods of time, hoping for price swings and market volatility.

In the long term, investing will make you generous returns. By doing research, and ensuring you are loosely following the markets and your portfolio, you can make excellent profits through good companies that have solid business strategies. Day trading requires work, and often requires the right skills to make it profitable.

Value Investing: How to Build Wealth

With a net worth of over $80 billion, Warren Buffett has already cemented himself into the annals of stock market history. Buffett’s conglomerate Berkshire Hathaway has grown its assets to the hundreds of billions, and currently has major stakes in dozens of large market capitalization companies. However, although Buffett’s success may instill awe in the average retail investor, it is how “The Oracle of Omaha” got to this point that is truly important: value investing. In this article, I will explain what value investing is, how it gained popularity, and why it is a sustainable strategy for the retail investor.

Buffett’s Mentor

Benjamin Graham, a legendary Wall Street mogul, pioneered the idea of value investing. He mentored Warren Buffett on various concepts of value investing, including diversification and fundamental and technical analysis. Graham wrote the book The Intelligent Investor in 1949, detailing the ideals of value investing, the goals of a successful stock-picker, and how to build true wealth by investing in companies. The Intelligent Investor is the most popular investment book in the world, and has been reprinted in multiple editions for the past 70 years.

Benjamin Graham, legendary value investor

I would highly recommend anyone looking for information on how to invest and build wealth to read The Intelligent Investor. It is the Bible of the stock market.

Buffett’s Philosophy

At its core, Buffett’s philosophy prioritizes buying a company when purchasing a stock, rather than following any technical chart or aiming for a quick buy and sell transaction. It is part of the reason Buffett has grown his holdings of The Coca-Cola Co (KO) or Kraft Heinz Co (KHC) to over $10 billion each. Buffett continues to add shares of Apple Inc. (AAPL) because, in the words of Benjamin Graham, the tech giant “promises safety of principal and an adequate return.”

Buffett’s investment strategy mainly plays along buying companies that were once solid – or are still excellent companies – but have been deeply oversold, to the point where their price is unjustifiably low. To this end, Buffett’s purchases would likely be along the lines of having a low P/B ratio, indicating a stock’s price has tumbled, as well as high yields on dividends, indicating that companies respect shareholders and intend on delivering tangible results.

Coca-Cola (KO), a widely acclaimed Buffet stock

That being said, Buffett would not solely focus on fundamental analysis of stocks. There can be a variety of red flags in companies, such as a low market capitalization, high debt combined with low free cash flows, and an unsustainable management strategy. Although Buffett prioritizes what is called an “intrinsic value” of stocks in its fundamentals, the entire picture must be taken into consideration.

In today’s market, Buffett would likely reference Bank of America Corp (BAC) as a good value pick. With a price-to-book ratio of 1.18, a price down from highs of $53.85, and an excellent management team led by Brian Moynihan, Bank of America would be a trustworthy stock that Buffett would advise to buy and hold for decades to come. That is exactly why BAC is one of Buffett’s top holdings in his portfolio.

Alternative Strategies

A high frequency trader sits and monitors stocks

As Graham eloquently put it in The Intelligent Investor, “investing is a unique kind of casino—one where you cannot lose in the end, so long as you play only by the rules that put the odds squarely in your favor.” Other stock traders, primarily hedge funds and HFTs (high frequency traders) attempt to trade securities with high volatility, high risk, but potentially high return. They will quickly buy and sell stocks in fractions of a second, to make quick returns. They are not analyzing the value of a company – the management principles, the innovation over the past decade, or the room for growth – but rather technical charts and patterns that a computer can analyze. These types of strategies are anathema to Buffett’s careful, pragmatic philosophy.

Final Thoughts

Whether you support Buffett’s conservative approach to investing or not, there is something to be learned from value investing. Even if you choose to invest in high volatility ETFs, or trade options with a high IV (implied volatility), the main tenets of value investing such as safety margins and risk limitation should be paid attention to and adapted to risky strategies.

Value investing is an important concept to learn for the retail investor. It is important to realize that in order to build true wealth, it is best to invest in the broader market. One such way is to invest in value stocks, which legends Benjamin Graham and Warren Buffett have been able to prove can deliver excellent returns.

Robinhood: How to Start Trading and Investing Real Money

According to Robinhood, “Getting started with a small amount of money is better than not investing at all.” This statement greatly reflects why you should begin your investing career in Robinhood. Offering free trades, an easily understandable platform, and the ability to easily buy and sell equities, Robinhood is quickly becoming the top choice for those entering the stock market.

Practice First, Apply the Skills Later

It is important to note however, that in order to dabble in the stock market, you should have some practice. It is incredibly easy to gain applicable investing skills through something called “paper trading,” or using a stock market simulator and fake money to buy and sell stocks. There are many great resources for paper trading practice, but I would highly recommend Investopedia’s “Stock Market Game” simulator here. The idea of using fake money and a simulator should not deter you from paper trading. These simulators model a real trading portfolio very well, and are nearly always accurate in delivering stock prices. That being said, this article is meant to inform you on investing with real money.

You have been paper trading for a year now. You’ve won some trades, and you’ve lost some, but you’re ready to invest your own money. Now what? You have to find an online stock broker to trade from. Here’s why you should start with Robinhood.

Expenses

Trading is expensive. The average cost of online stock trading can be nearly $9 per trade, an incredibly expensive fee. If you have $1000 in your account, one trade would cost you nearly 1% of your entire portfolio. Especially since you are just beginning to invest, you shouldn’t use a large amount of money to trade. There are also account management fees that you have to be cognizant of. So, a cheaper alternative has to be found.

Various stock brokerages that are available to use

Robinhood is precisely that alternative. Offering free trades, and no extra fees, your trades will be easily executable and you won’t have to worry about large, expensive commissions.

You’ll Need to Understand What You’re Doing

If you are new to the stock market and trading real money, you’ll want to be able to understand what is going on inside of your portfolio. The screen should be easy to manage and understand, and trades should be easy to execute. Robinhood offers exactly those things.

Inside of your portfolio, you will be able to easily see your stock holdings, account value, where to get trading ideas, and your watchlist.

A look at the Robinhood trading platform

When you want to trade a stock, Robinhood makes it incredibly easy. Just click on the stock that you want to buy or sell, and you will be quickly prompted with options. Then, you can input how many shares you want to trade, and even the order type (we will cover these later). You will be presented with the estimated cost of your transaction.

Drawbacks

Robinhood is an excellent brokerage platform for some, but it is not without its drawbacks. Firstly, you are not able to short-sell stocks and other equities. You are still allowed to buy “inverse ETFs” and other financial products that are bearish on certain indexes, but you cannot short-sell stocks. Many traders are driven away from using Robinhood’s platform for this reason. Understandably, Robinhood wants to keep their platform free, and allowing short-selling would open up a wide variety of potential issues, such as margin accounts, requiring more work and risk on their end.

Robinhood also doesn’t allow for many other financial products to be traded, including mutual funds and options. Until recently, Robinhood had also not provided for foreign investments, but now there are many ADR (American Depository Receipts) that you can purchase. Larger brokerages such as Charles Schwab and Fidelity offer more asset classes, such as mutual funds. Fidelity, a large brokerage has a FundsNetwork that provides for different funds.

Placing an order in Robinhood

Final Thoughts

In conclusion, Robinhood offers the perfect inexpensive, understandable trading platform for the beginner. Although you cannot short-sell equities (we’ll cover this later), and there may be day trading restrictions, Robinhood is a great place for the new investor to grow wealth and gain experience in the stock market.