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APPENDIX A: USING OPTIONS TO REDUCE RISK

Winslow, Edward 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 ELEVEN: REFORMING THE SYSTEM

Winslow, Edward Berrett-Koehler Publishers ePub

Creative thinking may simply mean the realization that there is no particular virtue in doing things the way they have always been done.

RUDOLPH FLESCH, PHILOSOPHER AND EDUCATOR,

WWW.LINEZINE.COM

WE HAVE SEEN the tremendous conflicts of interest that plague corporations and their CEOs, the accounting industry, the brokerage industry, and even our federal government. These conflicts contributed to the shocking evaporation of wealth that investors endured in the early 2000s when the market bubble finally burst.

The solution to these problems isn’t easy. It will take a concerted effort by all concerned to re-create a fair and equitable capital system in which the investor gets a reasonable return that is proportionate to the risk assumed when purchasing equities. The markets will eventually provide such a solution, either through decreased share prices or meaningful change at all levels. If reformation doesn’t occur, further harm to stock portfolios is inevitable.

Investors who employ strategies for protecting principal are prepared for any scenario. The major overhaul required to win back investor faith and confidence is a huge and complex undertaking. Conflicts of interest still exist, which make the task a strenuous challenge. 190

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CHAPTER FIVE: THE REAL WINNERS OF THE STOCK MARKET GAME

Winslow, Edward Berrett-Koehler Publishers ePub

An infectious greed seemed to grip much of our business community. It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously.

ALAN GREENSPAN, TESTIMONY TO THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, U.S. SENATE, WASHINGTON, D.C., JULY 16, 2002

THE INVESTORS who put their hard-earned dollars into the market take on the majority of the risk but receive only the crumbs of a market advance. The real winners are the executives, the brokerage industry, and the corporations. The potential rewards are so great that the behavior of these beneficiaries of market advances can range from unethical transgressions to outright fraud.

The primary argument in favor of large stock option grants to executives is that they give incentive to focus on earnings growth since management benefits if the stock price increases. If the stock price goes up, current stockholders should be happy to reward management for a job well done. There are some major flaws with this line of reasoning due to the inherent conflicts of interest and shortsightedness created by stock option compensation.

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CHAPTER EIGHT: THE MATCHING GAME INVESTING IN THE INDEXES

Winslow, Edward 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 THREE: FAITH IN CORPORATIONS TRICKS OF THE TRADE

Winslow, Edward Berrett-Koehler Publishers ePub

The greatest management sin today is not to report a loss, but to report a loss not expected by Wall Street.

DAN BERNHARDT, ECONOMIST,

UNIVERSITY OF ILLINOIS

STOCK PICKERS love to compare companies by analyzing easily obtainable financial statistics. One of the most popular measures is a simple ratio. It is calculated by dividing the current price of a stock by its last twelve months’ earnings per share, and is commonly referred to as the price to earnings (P/E) ratio.

Corporations with similar growth prospects usually have similar P/E ratios. The organizations that show the best earnings within the group are going to have the highest stock price.

The market price for a share of a growth company is rarely based on assets such as cash, land, and equipment but rather on current earnings and expectations of future earnings. Management fully realizes this and sees it as their mission to maximize earnings. Unfortunately there is a lot of leeway in determining how earnings are calculated. Some companies maintain strict and conservative accounting policies, while others stretch the rules to the limit and beyond.

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