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CHAPTER ONE: THE STOCK MARKET CAN WE WIN AT THIS GAME?

Edward Winslow Berrett-Koehler Publishers ePub

The investor’s chief problem—and even his worst enemy— is likely to be himself.

BENJAMIN GRAHAM, FATHER OF VALUE INVESTING,
SECURITY ANALYSIS, 1934

MANY MODERN-DAY investors have become like crazed gamblers, risking their nest eggs and retirement money on visions of a chance at 20 percent-plus returns on their investment portfolios. Most of them don’t even take the time to read a financial statement, yet they scamper to brokerage firms and mutual funds, surrendering every spare cent they can on a stock market system few of them understand. Greed, advertising, and peer pressure have lured them into a terrifying real-life game with sky-high stakes of fortune or poverty.

That’s gambling.

Have investors forgotten that stocks do not exist just to give us a lottery ticket to future riches? Stocks finance the agendas of business and their corporate executives. It’s a system run by professionals who spend a lifetime mining riches, at times contrary to the letter of the law. In the end, when the vein is dry, the gold is in their account; the fool’s gold is what’s left in our portfolios.

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APPENDIX A: USING OPTIONS TO REDUCE RISK

Edward Winslow Berrett-Koehler Publishers ePub

Options are derivative contracts that have no value on their own. They derive their worth from the value of some other asset. They are used to reduce risk and are the most sophisticated, intricate, and arcane of the financial instruments.

If used improperly, options can be among the riskiest of investments. In the early 1990s some institutions that obviously lacked a full understanding of the risks and consequences of the inappropriate application of derivatives became high-profile casualties of improper usage. An electric saw can be a valuable tool in skilled hands or a dangerous one in the hands of a careless individual. Orange County lost an estimated $2 billion and Long Term Capital, $4 billion from the bungled use of derivatives. The accompanying negative publicity gave these tools of risk management a tainted reputation.1

The call option is an agreement that gives the investor the right but not the obligation to purchase a security at a specified price within a specified period of time. Conversely, a put option gives the investor the right to sell a security at a specified price for a specified time.

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CHAPTER EIGHT: THE MATCHING GAME INVESTING IN THE INDEXES

Edward Winslow Berrett-Koehler Publishers ePub

There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know.

WILLIAM BERNSTEIN, THE INTELLIGENT ASSET

ALLOCATOR (NEW YORK: MCGRAW-HILL, 2001)

CONVENTIONAL investment managers have an interesting view of risk. They are more concerned with the variation between the actual return on the money they manage and the overall performance of the market than they are with preserving the client’s capital. Most use specific benchmarks, such as a particular stock index, to evaluate their performance. If the benchmark stock index is up 20 percent and the managed funds do better, the manager is deemed to have a successful period. If the market is down 20 percent, the fund is deemed a success if it is down anything less than 20 percent. Success is defined as beating the market, not preserving the capital.

Endless combinations of stocks have been grouped together to form unique indexes. An index is initially based on the total value of a group of stocks. It provides a convenient measure for 130evaluating the stock price movement of the particular group of companies.

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CHAPTER FOUR: FAITH IN PROFESSIONAL ADVICE CONFLICTS OF INTEREST

Edward Winslow Berrett-Koehler Publishers ePub

Well, the broker made money and the firm made money— and two out of three ain’t bad.

ANONYMOUS

IT’S A DIFFICULT JOB, at best, to evaluate the merits of a corporation as a potential investment. Interpreting the accounting, understanding how the business operates, and factoring in a host of other issues, including current investor psychology, can make the task pretty intimidating for even the most seasoned professional. But the decision as to whether a stock should be bought, held, or sold is made easier for most employees of the brokerage and investment banking industry because as a group they think it’s always a great time to jump in and buy.

Investment analysts are researchers whose responsibilities include reporting on a particular company, following that company, and making recommendations on whether to buy, hold, or sell stock. With the emergence of CNBC and other investment-related media, analysts are continually in demand for interviews and their “educated” comments and recommendations. Their comments and stock ratings have become like gospel for certain investors. A new report on a company by these media analysts can have a dramatic effect on the stock price. In other words, they are influential figures in the investment world.

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APPENDIX B: CREDIT RATINGS

Edward Winslow Berrett-Koehler Publishers ePub

Credit ratings assist in evaluating the level of credit risk involved when investing in equity-linked notes, annuities, and insurance. Each rating organization uses a slightly different system. The highest four ratings encompass what is referred to as “investment grade bonds.” All ratings below the four highest are in the “junk” category. Moody’s and Standard & Poor’s publicize ratings on corporations and each has its own unique grading system.

See Table

As of the date of this writing, the more frequent issuers of equity-linked notes had investment grade ratings as follows:

See Table

Additional modifiers indicate whether the rating is at the top, middle, or bottom for each category. S&P uses plusses and minuses, and Moody’s uses 1, 2, 3, with 1 being the highest. Source: Moodys.com and Bloomberg Financial.

Ratings are fluid and can be changed at any time by the rating companies. Insurance companies have their own unique ratings. A. M. Best ratings are as follows:

See Table

Anything below a B+ should not even be considered. A. M. Best rates the leading companies that offer equity-index annuities as Superior. Weiss Ratings uses a different methodology for measuring the financial strength of insurance companies. The ratings are as follows:

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