How to Profit on Declining Stocks

Most investors purchase a stock with the expectation that the stock price will rise. If all goes according to plan, the investor would eventually sell the stock and realize a profit. But have you ever felt certain that a stock price would fall? What if there was a way you could profit from that situation? There is! It’s called short selling.

Short selling is rather simple, but many investors struggle to understand the mechanics of the process. This technique also has some different risks to consider.

What is Short Selling?

In simple terms, short selling is the selling of a stock that is owned by someone else. Even though someone else owns it, you’ve made a promise to deliver it. When you short sell a stock, the broker lends the stock to you.

The shares are sold, and the money is credited to your account. Then, you finish the transaction by purchasing the same number of shares to replace those you were ‘given’ by the broker.

If the price has dropped, you can buy the shares back for less than the original price and you make money. However, if the stock goes up, you’ll lose money.

The following steps show the mechanics for making a short sale:

1. Set up a margin account with your broker. Any broker will offer margin accounts. This type of account allows you to borrow money from the brokerage company. Your investments are used as collateral.

2. Place your order. You can either call your broker or complete the sale online. There will be a box on the website marked, “Short Sale.”

3. The broker will borrow the shares. The shares may be owned by the brokerage firm, another brokerage firm, or another investor.

4. The broker then sells those shares and puts the proceeds in your margin account. If the price falls, you can buy back the shares you sold at a lower price and keep the difference. If the price rises, you’ll be forced to cover the difference.

The Risks of Short Selling

Short selling is risky. Over time, stocks have a general upward drift. Look at the value of the stock market now compared to 50 years ago.

The downside is greater than the upside. Remember that the lower the price falls, the more money you’ll make and that the price can’t fall below zero. But, in theory, there’s no limit to how high the price can rise.

You’re also borrowing money. If the stock price rises too much, you’ll have to put more money toward the investment. If you can’t pay more, your brokerage firm will be more than happy to sell some of your other investments to cover it.

You can be totally on track, but have poor timing. The stock might be overpriced, but it can take some time for the stock price to adjust. During this waiting period, you’re potentially on the hook for interest and margin calls.

Conclusion

Short selling is another investing technique for your toolbox. There is more risk involved with short selling, but there can be a considerable upside. You won’t need to invest much money to control a lot of stock, since you’re leveraging your other investments.

While short selling isn’t for everyone, it provides a big opportunity for those with the risk tolerance. Consider short selling when you’re very confident that a stock value will decline.

The Secret to Smart Investing Decisions

Nearly everything you do on a regular basis is accomplished by following a process. You follow a certain sequence of steps to accomplish your objectives, like when you bake a cake or get ready to go to work in the morning.

Your level of success in any activity is largely dependent on the quality of your process and your ability to follow it accurately. Likewise, smart investment decisions require a solid decision-making process.

Try this sequence of steps before making your next investment decision:

1. Figure out if it’s the best use of your money. Paying off a credit card with a 22% interest rate is likely to result in a better return than any other financial investment.

* In most cases, investing is a smart move, but not always.

2. Consider whether the investment is congruent with your investing timeline. All investment goals should have a timeline. Does this potential investment match the deadline of your investment goal?

* It doesn’t make a lot of sense to invest in ultra-conservative short-term investments to achieve a goal that’s 20 years into the future.

3. Evaluate the level of risk. Is the risk level appropriate for your timeline and your comfort level?

4. Ensure you understand the investment. Some investments are extremely challenging for even financial professionals to fully grasp. Avoid being lured into investments that are beyond your current level of expertise.

* Albert Einstein once said that you may not truly understand something if you can’t explain it to your grandmother. Could you explain your investment to your grandmother and make her understand?

* It’s not easy to be successful with something you don’t understand. Seek advice from a financial expert and then try explaining your investment to someone with less financial sophistication than yourself to show you fully understand it.

* Do you know everything you need to know? Some investors have a habit of knowing 90% of what they need to know and then decide that’s ‘good enough’ because things get too tedious.

5. Ask yourself why you’re enamored with this investment. Warren Buffet once implied that if people were limited to ten investments, they would make their choices more carefully and end up extremely wealthy. Would you make this particular investment if you were limited to only ten?

* Are your investment choices based on valid reasons?
* Did your research verify your decision?
* Would you feel confident recommending this investment to a friend or family member?
* Are you guilty of any behavioral finance biases?

6. Assess what level of monitoring the investment will require. Some investments require little monitoring. However, many require constant attention.

* Are you prepared to do the necessary work and do you know how?
* Create a schedule for follow-up that’s appropriate for your investment.

7. Know when to get out of the investment. Every investor is well served by knowing when and how to get out of an investment. Know your exit strategy and the signs that it’s time to get out of an investment.

* What signs will you look for as a signal that it’s time to sell?
* Is your investment sensitive to interest rates?
* Will a change in technology render your company’s primary product or service obsolete?

Many people view investments like lottery tickets and they spend more time investigating a vacation spot than they do researching where their money is going.

Give your investments and your future the respect they deserve. Try this process before making your next investment decision. Using a good decision-making process will always give you better results.

Best Time to Buy a Mutual Fund

In an ideal world, we would all have the time and expertise to pick our own investments. Unfortunately, most of us don’t have an MBA from Harvard and our other responsibilities keep us from having the time to worry about our investments.

For many individuals, getting a financial advisor can make a lot of sense. One way to indirectly hire a financial advisor is through the purchase of mutual fund shares. The fund advisor will make a lot of your investing decisions for you.

When should you invest in a fund?

These times are opportune:

1. After you’ve determined that the fund manager’s track record is based on skill, rather than luck. Investors are notorious for looking at a fund’s short-term results. Don’t fall into the trap of believing a fund’s manager has the Midas touch based on a couple of quarters of good performance. A market cycle of 3-5 years is a good start.

* Spectacular short-term results are rarely repeated.

2. After you’ve completed your due diligence. While you won’t have to spend time analyzing individual securities, it’s wise to spend some time researching a profitable mutual fund to purchase.

* Consider the track record of the fund manager. Also consider the fund’s reputation and any turnover in the management team.

* Keep in mind that certain types of funds tend to do well in certain types of markets. Remember to consider the fees associated with the fund.

* The most important thing, and the most difficult, is to attempt to project the fund’s likely success in the future. Unfortunately, most fund ratings and metrics can only look at the past.

3. If the fund is an index fund. Index funds are difficult to beat. While it might seem that active managers should be able to beat the market, more often than not, they do not.

* Most fund managers cannot provide a large enough return to overcome the fees they charge and still beat an index fund. Index funds are great for defensive investors.

* Many investors scoff at the idea of investing in an index fund. But try not to jump to conclusions. Look at the returns over the long haul. You might be very surprised.

4. When you have no other options. Many 401(k) and 403(b) plans don’t offer any options besides mutual funds. The question isn’t whether or not to purchase a fund. It’s a question of figuring out the best fund from the available offerings.

* Realize that your retirement plan sponsors cannot provide advice. You’ll have to pick a fund on your own.

5. When there’s no other reasonable way to invest. If you’re interested in foreign or emerging markets, it might not be reasonable to attempt to invest in these markets on your own.

* For example, many European markets are neither very liquid nor friendly to individual investors. In this type of situation, a mutual fund is a smarter move.

* Mutual funds provide a great way to have diversification in many different asset classes. It’s not easy to become an expert on precious metals, foreign currency, and auto manufacturing. Sometimes it’s more effective to just hire experts.

When buying a mutual fund, it’s your responsibility to do the necessary research and homework. While the amount research required is likely to be less than the research required for individual stocks, there are some differences in the type of information you need to examine.

One of the greatest benefits of investing in a mutual fund is that your account is managed by a registered investment advisor. Be wise when choosing how to invest your money. There are many times when a mutual fund can be the best choice.

Investing Traps To Avoid For A Greater Returns

Whenever there is money involved, there are always traps you’ll want to avoid. Knowing about these traps beforehand can make them much easier to recognize. The traps in this article are all psychological in nature, so they apply to everyone.

Avoid the following traps and you’ll be a much more successful investor:

1. The sunk cost trap is primarily caused by pride. With this trap, the investor is attempting to protect his previous decision. For investments, there is more at stake than just pride, however. Sometimes it’s necessary to just take the loss and move on.

* If your investment turns out to be a real dud or is dropping quickly, the sooner you can get out, the better.

* Some stocks can take a decade to recover. Some never recover. Move on when the time comes.

2. Another trap is confirming a poor investment with the person who provided the initial advice. If you’re questioning the quality of an investment, the worst person to get reassurance from is the person who first suggested the stock.

* Don’t fall into a codependent investing relationship. There’s no value in mutually confirming a bad decision to each other.

* Misery loves company, but you don’t have to fall into this trap.

* Seek out an objective source of information to make a wise decision.

3. Avoid letting friends and family lead you astray. Limit the amount of influence your friends and family have over your investment decisions.

* Your brother doesn’t necessarily know anything about the stock market or municipal bonds simply because he’s your brother.

* Only allow others to influence your decisions to the extent they have proven their expertise in this area. It can be challenging to handle friends and family when it comes to money. Be smart.

4. Freezing is a bad thing. You’ve probably heard that there are 2 basic responses a human can have when threatened: fight or flight. But there is actually a third: freezing.

* Do you find it difficult to take action when things are going badly? When there is a challenge, it’s best to make a thoughtful decision and act on it. Don’t wait until it’s too late.

5. Be flexible. Many people believe the first thing they hear without letting their opinion evolve.
* For example, consider the lowly egg. Most of us were brought up to believe that whole eggs are unhealthy. However, even though there is now research to support that eggs are extremely healthy, you’re probably still hesitant to eat too many eggs.

* The first thing you hear isn’t necessarily the most accurate. Be open to all information that’s available. If they were wrong about eggs, consider how many other things you believe that might also be inaccurate.

6. Avoid overestimating your investment acumen. Many individuals want to believe they can out-think the experts.

* The truth is that many self-proclaimed “experts” are nothing more than people who have done a great job of marketing themselves. So you might be able to do better than these people, but it’s wiser to do your research and seek out true experts.

* A good financial advisor is a true expert that spends all day looking at investments and frequently has access to information that the average investor does not.

* Many investors have piddled away a fortune because they were certain they knew better than everyone else. Maybe you’re a financial genius, but can you afford to risk it if you’re not?

Human psychology is a tricky thing. It’s easy to fall into these traps and watch your investment portfolio take a serious hit. When the situation becomes heated, you’re much more likely to fall victim to yourself.

The solution is to be open-minded and honest with yourself regarding your investments and seek the advice of experts.