The downsides of going short are obvious. In general, the stock market goes up. If you think a particular stock goes down, and you are wrong, you are liable to lose an unlimited amount of money if that stock keeps on going up forever. Of course, practically speaking, if you short $5,000 of a stock, it is unlikely that the stock will increase 100X anytime soon, but the dangers are pretty clear.

A major reason investors to choose short a stock if they think that company has become grossly overvalued. For example, during tech boom, many tech companies that had few revenues and negative earnings were valued in the billions. Investors kept buying these stocks on the hope that they would somehow, magically have future profitability. Those that shorted these stocks often made a fortune.

Shorting a stock and betting that it is a bubble is a nice way to make some money. It also lowers your overall exposure to the stock market (assuming you have a significant amount of money in stocks). Stock bubbles can be broad-based, such as the late 90’s tech bubble, or individual stocks. For example, Crocs (CROX) zoomed up from its IPO price in the teens up to $80 a share and then quickly cratered back to its IPO price. Those that bet that its shoes were nothing more than a one-trick-pony fad were right. Here are some tips if you hope to short bubbles:

1. The news and commentary about the stock should be almost universally optimistic. There should be a lot of talk of pie-in-the-sky growth, without clear indications how the company will ever be able to realistically achieve that growth.

2. It is very important that you understand the company and its sector in question. The way you have an edge in the market, in general, is by understanding a company better than the market does. If you are going to bet against a stock, you better be able to justify to yourself why you are making that bet.

3. Just because a stock has a high PE does not mean it is overvalued. Its last year’s earnings may have been artificially depressed or there may be extremely good reason to believe that its earnings will significantly expand soon.

4. Often, the dumb, hot money will chase bubbles. You know the type of guy that always bets on the hot sports team or was sure that Amazon and Yahoo could only go higher in 1999? If you see the type of dumb money chasing a certain stock or sector, it may be time to short them.

I was attracted to Apple because of its brand. Right now, Apple is hot. It’s iPhone is the coolest phone the market. Mac sales are soaring (because Mac is cool). Ipod sales are slowing, but that’s because everyone already owns an iPod. Pretty much anything Apple sells, there’s going to be a demand for the product.

Apple is now trading just shy of $170. It was previously trading at $200 during its October highs, and it may get back up there. With Apple being the hottest brand on the market, who knows how much it will beat Wall Street estimates. Why did I sell then?

Well, quite frankly, it’s because Apple’s brand is hot right now doesn’t mean its brand will continue to be hot in a few years. Right now, everyone needs an iPhone. People who have absolutely no practical reason to shell out $400 for an iPhone are buying them. I use an Iphone and love it. But I run an Internet business, so I have a reason to check my email every 5 minutes. My little sister in college wants an iPhone or at least a blackberry (she was whining at my parents to buy her one). I told them, under no uncertain terms, should they shell out the money for one since she simply does not need it.

Apple had a great quarter because Mac sells soared. Apple’s brand and image led people to want to buy more Macs (my sister in fact begged my parents to buy her a mac). I have a Mac laptop, and it’s ok. But I chose a PC for a dekstop since, pound for pound, PCs are a far better value for the dollar right now (and shit, I’m rich!) People are buying Macs right now because they are cool, not out of any need.

Apple could leverage its brand into more fields and could continue to grow at a rapid pace. Apple TVs? Apple microwaves? Apple cars even!? Who knows. A hot brand sells. But, a hot brand can also cool off. In my opinion, unless Apple expands its product line even more, it’s going to run into growth issues.

Apple’s moat is its brand. A brand can be a great moat, but who knows how long a ‘hot’ brand will stay ‘hot.’ After all, the appeal of Apple’s products is a sort of quality/elitist sense. If everyone has an iPhone, I’m going to want to buy some sort of souped up Blackberry instead.

Disclaimer: Author is a former Apple shareholder at the time of his posting.

* Don’t hold on to stocks that are making losses. People do this in the hope that there will be a turn around in the price and then they can exit at the buying price.

* Not diversifying sufficiently. Diversification is the basic rule to observe if you desire success, at least desire to minimize risks associated with the stock market investment.

* Investing without studying the stock. You must study every aspect of the company that you wish to “buy” on the stock market. Details of the company’s financial aspects are available everywhere, but still it is found that people just rush in to buying a stock without proper investigation.

* Don’t get attached to the stock. Often people have “favorite” stocks and they hold that stock forever even when it is either not moving, or is going down! Review your portfolio regularly and take actions, even sell it, if a stock is showing negative trends or losses. Emotional investment is not a part of the successful stock market investor.

* Ignoring risks. Don’t ignore the risk factors in the investment.

* Using tips from friends and other sources without doing appropriate research and analysis.
Investing and finding the right stock is never an easy job. To become successful investor, you must do research and analysis of every stock that interests you. Even if you trust the friend, you must still do further analysis before buying the stock.

* Following the crowd. You should avoid crowd mentality in stock market investing. To quote Warren Buffet,” You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” He echoed the same thoughts while warning the investors against following the crowds. “Be fearful when others are greedy and greedy only when others are fearful,” he said.

*Frequent trading.

* Not listing your mistakes and failures. Even the great Warren Buffett, one of the richest man in the world who made his billions on the stock market, lists his mistakes and failures. He then vows not to repeat them. So, knowing your mistakes will make you cautious and will force you to take the right actions the next time a similar situation occurs.

* Focusing on earnings per share and not on return on equity. Earnings per share is a smokescreen, because usually the company retains earnings to increase their equity base.

* Buying a stock and not the business! Warren Buffett has advised investors to buy the business and not just its stock! He has good reasons to say so.

To quote Warren Buffett:
“An investor should only buy shares in a company which he would be willing to purchase outright if he had sufficient capital. From this perspective, an investor should look for a company with business operations that are understood, has favorable long-term prospects, is operated by honest and competent people and is available at an attractive price.

The decision to buy a business is based on:
Business tennets
Management tennets
Financial tennets
Market tenets.”

‘‘The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.’’

– Warren Buffett

What exactly is a good mutual fund. I’d define one as a mutual fund that outperforms its peers over a significant period of time. For example, a mutual fund that tends to invest broadly in large cap stocks is a good mutual fund if it beats the S&P 500. A good small cap fund would be one that consistently beats the Russell 2000 index. Remember, its relative performance, not absolute performance, that is the method to judge a mutual fund.

Finding a good mutual fund is the same as finding a good stock in the sense that it takes research and patience. Here are some things to look for when researching a good mutual fund:

1. Keep the fees low. Any fees you pay is less money in your pocket. Any good mutual fund should have a maintenence fee of 1.5% or less, 1% or less is preferable. Under no circumstances should you pay a load (upfront fee) to invest in a mutual fund.

2. Check out the asset base. Often, mutual funds become so bloated with investors money that they cannot invest as effectively. It is much easier for a fund to invest $1 billion in assets than $100 billion. As the fund gets larger, it has to invest in more and more stocks, and take larger positions in companies (which will often move the price of the stock).

3. Remember the sector the fund invests in. Just because the fund had a hot year last year doesn’t necessarily mean its a good fund to invest in. The sector that the fund focuses on may have just happened to have done well, so the fund got lucky.

4. Check out the fund manager. At the heart of mutual fund investing is the fund’s manager. This is the man or woman you are trusting with your money and believe will make the best investment decisions for you.

In this article, I’ll detail what I view as the five most common signs of a stock scam:

1. A ‘get rich quick’ mentality. Most investing scams will act as if you can turn a few thousand dollars into millions in the market. This is practically impossible. Even a yearly 20% return will take decades before you can turn a few thousand into millions. Most of these ‘get rich quick’ scams will actually try to claim they aren’t a ‘get rich quick’ scheme! Don’t fall for it. If you are led to believe you will be a millionaire with a few thousand bucks in a few years, run.

2. They talk about individual trades rather than yearly returns. Most stock scams aim to dupe the newbie investor. They know that knowledgeable investors won’t fall for the scam, so they try to keep it simple. Most people are impressed at the idea of making $5000 or more in one day due to one trade. Of course, that means nothing. If you have a million dollars, $5000 is only a .5% return, which could be an average daily move. Also, an impressive investor is measured as someone who beats the market over time, not one who makes a few lucky trades.

3. They talk about 100% or more returns in months. Achieving this is virtually impossible without taking a lot of risk and getting very lucky. Even the best hedge fund managers struggle to make much more than 30% a year, and anyone who consistently makes 20% or more a year is amazing. Do you really think some class can teach your average shmo how to make 100% or more in a year?

4. They utilize options. Options are a complicated, risky instrument that should only be used by experienced traders. Most scams use options since they allow for amazing returns when you get lucky. Of course, the flip side is that you can easily lose your entire investment in any option. Newbie investors should never trade stock options.

5. They utilize penny stocks. Like options, penny stocks involve a lot of risk. There can also be a lot of fraud involved in these stocks. There is less SEC oversight for these types of stocks, and they are sometimes used as part of pump-and-dump schemes.

What do I mean by this exactly? Well, look at it this way. There are always two sides to a trade. If you are buying a stock, then someone is selling the stock. You each are essentially making bets about the future of the security. The seller thinks it’s good for him to get out, while you think it’s time to pick up shares of the stock. Time will only tell who is right.

It’s difficult to beat the market by investing in large and mega-cap stocks like GE and Microsoft. Sure, these companies are generally safe investments for the long run. But it’s difficult for an average investor to tell which of these companies will have above-average returns. These companies have many analysts covering them, and the major institutions that invest in them do significant amount of research to know when it’s best to buy or sell these types of companies.

For an average investor to beat the market over the long term, he or she often needs to invest in under-followed companies, which are generally small caps. Since fewer analysts and professional investors focus on these companies, the chance for finding good bargains is higher. Of course, the chance for finding total duds is higher too, so small cap investing can be riskier.

How do you find good small caps? Well, generally, it’s best to start off with companies you know well. These companies may be locally-based or they may be in a field that you understand well. If you are in the web industry, then you may have a better understanding of web-focused companies and their prospects and risked, so you may be in a better position to make a calculated judgment about the future of a stock compared to most people in the market.

If you want to beat the market, then view your stock investments as bets. When you buy, do so because you think you know something or understand something that the seller doesn’t. The best way to do this is by investing in companies that you know well.

2. Selling scared.Sometimes, it’s time to face the music and sell a stock that’s been a loser. However, you shouldn’t sell just because you’re scared. You should sell if you think it makes rational, logical sense to close a position. Many times, people sell stocks because the market had a bad day and they’re afraid it will go lower or the stock itself had a bad day. This later turns out to be a bad decision when the stock shoots back up. In many ways, selling stocks is like selling a property or mortgage. You wouldn’t sell a property lower than its mortgages value just to get it out of the way, in the same manner you shouldn’t move stocks just for the sake of getting rid of them.

3. Not keeping any cash on the side.I have to credit Jim Cramer with this tip. This was one of the biggest newbie mistakes he talked about on his Mad Money show. When you are fully invested and have no cash, you can’t take advantage of the market when it has a bad day. You are also more prone to panic selling and making other fear-related decisions. He recommends keeping at least 10% of your portfolio in cash, which I think is a pretty good tip.

4. Buying fad stocks. Sometimes, popular “cool” stocks do well. Examples from 2007 would be Chipotle and Apple, both of which more than doubled (in full disclosure, I own shares of Chipotle). These companies are solid companies with excellent growth, so the gains are justified. Often times though, people buy shares in a stock just because other people are buying shares. The obvious example is the tech bubble, when people were paying exorbitant prices for companies that weren’t even close to turning a profit. The psychology behind people’s willingness to buy these stocks was largely because other people were buying them, so they figured people would continue to buy them. That’s not a good reason to invest in a company (in fact, it’s a horrible one for long-term investing). When investing for the long-term, always make sure the fundamentals are good.

5. Investing in too many stocks. This is another tip I’m borrowing from Jim Cramer. Too many of us buy too many stocks and can’t follow-up with the companies. We often barely know what we’re investing in and have no gameplan in regards to the stock. I know I make this mistake often. If we want to diversify, it’s easy enough to just buy an index fund or ETF. If we end up investing in 50-100 individual stocks, we effectively become our own mutual fund, but without the resources to adequately monitor the companies we are invested in.

Some investors look to these drops as opportunities. When a stock drops, a lot of the stock’s investors simply panic and begin selling, pushing the price far too low. This recently happened with E-trade (ETFC). A report circulated about E-trade’s bad, almost toxic mortgage portfolio, and the possibility of bankruptcy surfaced. Due to the company’s small, though not totally insignificant chance of bankruptcy, many hypothesized that e-trade’s customers would move all of their assets out of the company, a sort of run on the bank. The stock dropped 59% in one day.

The next day, the stock shot up by 41%. Obviously, it didn’t recover all of its losses, but investors realized that people had way overreacted. There was almost no chance of E-trade going bankrupt, another company would simply swallow it up and take over its customer base. Those who had bought the company on the huge dip the day before were rewarded and those that sold proved to be huge losers.

When a stock drops a lot, it presents a buying opportunity. But, it may also just be a signal of more drops to come. You need to evaluate how detrimental the news is really for the company. The market will often overreact to news, but sometimes, a drop is warranted and buying the stock is just an attempt to catch a falling knife.

Its math is quite involved with communication and information theory, mostly dealing with probabilities. However, behind all the maths, there lies an astonishing result: by placing bet amounts according to Kelly Criterion (originally applied to horse-race gambling), one can maximize the returns in the long term. Here is the betting formula which has been tailored to stock trading:

K% = ( (b+1) * p – 1) / b = ( b*p – (1-p) ) / b Win probability (p): The probability that any given trade you make will return a positive amount.

Win/loss ratio (b) or odds: The total positive trade amounts divided by the total negative trade amounts.

If you think of b as the odds of b-to-1, payout of b when betting 1 unit of money, the numerator is simply the mean value of expected payout, or the so-called “edge”. Therefore, K% can be expressed as edge/odd. For obvious reason, you don’t want to bet in any game where the expected payout is 0 or negative.

If Kelly Criterion is so great, why is that this is not heard or used very often in the investing world. There are a couple of reasons that prevent it to be used practically:

1. The volatility of strictly using Kelly Criterion is quite big. Despite that in the long term, probabilistically speaking your portfolio will have the maximum return possible, the ups and downs are too big to be digested by most people. Therefore, people talk about using “half Kelly” or half of the bet amount calculated from Kelly Criterion in attempt to reduce the portfolio volatility.
2. To use Kelly Criterion, it requires knowing how good you trade stocks (in terms of p & b). Obviously, if you don’t know exactly how much your “edge” is, the Kelly betting amount will probably be off from the correct amount. Estimating and knowing your edge will be a much harder task than calculating the Kelly betting amount.

Despite the mathematical correctness of Kelly Criterion, it is much harder to invest such in practice. Aren’t there anything that we can walk away from such a terrific investing formula? Indeed, there is. Here is what I personally learned after investing stocks for almost 10 years now. The riskier the stock/or entry point is, the less amount that you should put in; the safer the stock/or entry point is, the more amount that you should put in. This is exactly the spirit of Kelly Criterion that bet should be proportional to your edge or your supposed advantage. I have been burned by stupid bets so many times that I finally learned to carefully size each of my stock transaction. In fact, sizing of your transaction is equally important if not more than what stocks you pick. While most of the investment world talks about what to buy, much less attention is spent on how much one should buy. But for every transaction, it always consists of the following elements: what (stock) to buy/sell, when to buy/sell, and how much to buy/sell. For successful investing, all three elements must be carefully chosen. And Kelly Criterion helps you on deciding the last element: how much. For more related articles, one can check out the article from investopedia. Tom Weideman also has an excellent article using simple calculus for deriving Kelly Criterion with less math from information theory. You can find the original Kelly’s paper here.

About the Author:
Please visit http://www.1stMillionAt33.com for more money tips. Check out my 2006 online tax calculator. All copyrights reserved, with EzineArticles reprint policy.
Tag: Kelly

[tag]Kelly,Kelly Criterion,gamblling,gamble,stock trading,transaction size,risk control[/tag]

Recently the SEC (Securities and Exchange Commission) called them on the carpet for not correcting an error within a reasonable time (whatever that is according to the SEC). Everyone makes errors and this was no big deal.

It seems that when you went to their site and drew up a chart or asked for statistics on Rock Canyon Top Flight mutual fund it failed to notify the potential buyer that the fund had issued a very large dividend of approximately 25% and the NAV (Net Asset Value) dropped from $15 to $11 to reflect the $4.00 dividend.

When you ask for a chart of this fund on MarketWatch, Yahoo, TheStreet or Bloomberg they only post the NAV and do not make any adjustment for the dividend or capital gains distributions. Looking at the chart it appears the fund fell out of bed. Because I look at so many charts I knew immediately that this was a distribution and not some calamity. It is best to call the fund to verify this.

Most funds that make dividend and capital gains distributions usually do so in December, some in November and very few at other times during the year.

Some nitpicker called the SEC and made a complaint about Morningstar. Not that I am a big fan of them (in fact I think their reports are worthless) they get their price information from other sources such as the above. If you are not familiar with the requirement of mutual funds to disburse their profit before year end you might be fooled when you see the price suddenly drop.

This is important for potential investors. I caution everyone to get a chart on the Internet of at least a one year performance of any mutual fund before buying. It is better to go back to year 2000 to see if the fund manager was able to keep from losing money during the last 4 years. Almost none of them could so they bamboozle about how they did better than the S&P500 Index which had a huge loss of 50% and remains down 25% from those highs at this time. Don’t fall for that one.

Once again I caution that any purchase should have an exit plan. One of the basic rules of investing is never to lose a lot if you are wrong. Small losses will not ruin your portfolio, but big losses can ruin your retirement. Set your loss limit (5%, 10% or ?) and stick with it.

Charts can help you with buying/selling decisions, but check out their accuracy as charting is not an exact science.

About the Author:
Al Thomas’ book, “If It Doesn’t Go Up, Don’t Buy It!” has helped thousands of people make money and keep their profits with his simple 2-step method. Read the first chapter at http://www.mutualfundmagic.com and discover why he’s the man that Wall Street does not want you to know.
Tag: investment

[tag]investment, charts, brokers, portfolio, trading, stocks, money, financial planners, mutual funds[/tag]