Derivatives, shorting against the box, ascending trend channels, 50-day moving averages, Bollinger bands ... ohmigosh! Yes, there are a heck of a lot of high-level, complicated topics in investing. Fortunately for you, most of them are basically nonsense.
You can let out a big sigh of relief, because in this step we won't be covering or going into excruciating detail about many of these "advanced" topics. Instead, we'll highlight a few market complexities -- one that's worth running away from (day trading), one that provides a useful chuckle (technical analysis), and a couple that you might consider learning more about and perhaps using (margin and shorting).
Day trading
We think the best way to accumulate wealth is to buy stock in great businesses with the intent to hold them for as long as they remain great. But this is easier said than done. When the stock market is surging or plunging, or when you learn of one exciting company after another, it can be hard to refrain from actively buying or selling.
Our business-centric message is further challenged by the likes of "day traders," who believe they can wring extra profit by following the stock market by the hour. You've probably seen segments on day traders on your nightly news. It became a fad, as more and more people gave up regular 9-to-5 jobs and spent that time with their eyes glued to computer monitors (and we all know how painful that can be), buying thousands of dollars of stock at a time, holding it for a few hours (or minutes!), and then selling. Sheesh.
People "investing" like this aren't really investing. They're gambling. They're not holding on to pieces of strong companies, accumulating wealth as the companies grow. They're making bets that they can out-think others. They aren't participating in the growth of the American economy -- they're betting that they're better guessers than the next guy.
They aren't. If you've been around investing for a while, you've noticed that there are significantly fewer advertisements for day trading in 2008 than there were at the heights of the market in 1999. Know why? Because most day traders managed to set their money on fire in the interim.
Technical analysis
Technical analysis dwells on charts of stock price movements and trading volume. Fundamental analysis, on the other hand, focuses on the value of companies, studying things such as a company's business, earnings, and competition. While investors from the fundamental school (Fools!) want to understand a business from the inside out, technicians mostly remain on the outside, observing how the stock behaves in the market.
Investors who use technical analysis focus on the psychology of the market, scrutinizing investor behavior. They try to determine where the big institutional money is going so they can put their cash in the same places. It's amazing to us to think that anyone might study a stock chart, see a particular pattern, determine that the stock is "breaking resistance," and then commit actual money to that proposition.
It's a shortcut to actual analysis. We're sure that there are folks out there who have some aptitude at seeing things in the squiggles. For most people, though, it's just a way to trade more often, and umpteen scholarly studies show the same thing: The segment of individual investors who trade the most tend to do the poorest.
Simply put, leave technical analysis alone.
Margin
Buying on margin means you're borrowing money from your brokerage firm and using it to buy stocks. It's attractive because you can turn a profit using money that you don't even have. For that privilege, you're paying interest to the brokerage, just as with any other loan. (Actually, it's a lot easier to open a margin account than to apply for a bank loan.) If the market turns against you, you either sell for a loss -- plus interest costs -- or hold on until the market picks up, paying interest all the while.
Investing with margin isn't an automatic no-no, in our opinion. It should just be used with extreme moderation and caution. Some people, however, will max out on margin, borrowing 50% of the value of their portfolio. We think that's far too risky, and something any investor should avoid.
If you already have been investing for a few years and decide to use margin, we suggest you limit yourself to borrowing no more than 20% of your portfolio's value. If you do so and you have $20,000 in your portfolio, you'll be borrowing $4,000 and putting $24,000 to work for you. That's called leverage. A little of it can be useful and not too risky.
However, think very carefully before you use margin. If you're borrowing on margin and paying 9% interest, you should be pretty sure your stocks will appreciate more than 9%. If your margined securities fall below a certain level, you'll receive a "margin call," requiring an infusion of additional cash.
Only experienced investors should use margin. Indeed, many experienced investors steer clear of it and do very well without it. However, there is one reason why, even if you're not interested in buying stocks on borrowed money, you still might want to open a margin account ...
Shorting
If you've ever swaggered up to a craps table, cleared away the necessary elbow room, and slapped down a few candy-colored chips on the Pass Line, you were doing what most of the people at a craps table do. You were betting with the crowd.
Adjacent to the Pass Line, however, is a cheaper strip of real estate (usually a vacant lot) known as the "Don't Pass." It's virtually the opposite bet; you win when the Pass Line crowd loses, and lose when it wins. Because you're betting against the roller and most of the rest of the table, betting Don't Pass is considered bad form. The craps jargon for you is "wrong bettor." Many other bettors will actually dislike you for doing it, a feeling that will be reinforced whenever you smile at dice rolls that make them frown.
If you read our discussion boards for very long, you'll notice that short-sellers aren't generally the most beloved of contributors to this forum. Doesn't matter -- they play a valuable role both here and in the public markets.
When you short a stock, you are banking on that stock's price going down. You initiate the process of shorting a stock by first borrowing shares from a current shareholder. This may sound difficult, but it isn't. Your discount broker does this for you automatically. You then sell these borrowed shares at the current market price. Then you sit and wait, rooting for the stock to spiral downward. While you wait, you have to pay dividends to the person who actually owns the stock you borrowed (if the stock pays a dividend) and, in some cases, you can also be subject to paying margin interest to the brokerage, just as if you had borrowed money.
When you're ready to cash out of your investment, whether for profit or for loss, you close out the position by buying the stock back at the market price so you can return your borrowed shares to the lender -- another thing your broker does for you automatically. That's it.
Shorting can offer a couple of potential benefits for your portfolio. First, shorting stock is a "hedge" -- you're taking compensatory measures to counterbalance a potentially plummeting stock market. Outside of its status as a hedge, however, selling stocks short is also a great way to make money. Indeed, if you make the right choices, you can make money both ways -- as the stocks you own rise and as the stocks you have shorted wither. It's tremendous fun! In fact, before we turned Foolish enough to short stocks, we didn't know just how much fun we were missing.
Second, and more important, the shorting of stocks is vastly underpracticed by the investment community at large. From a purely Foolish point of view, this makes shorting stock even more compelling. That's because Fools relish a good swim against the tide. When most investors are trying to figure out how many more half-point gains they can squeeze out of their equities, we're looking the other way. We're regarding these same securities from the top down, assessing how far each might fall. The seldom-taken contrary view can be lucrative.
A final note: Once in a blue moon, your broker may be forced to return your shorted shares to the anonymous lender, usually because he or she wants to sell them. Forced into doing so, you'll have to buy back the shares prematurely -- whether you've made money or not. This happens only with very small companies that have few shares outstanding, and is usually just a minor nuisance. Put the money somewhere else.
When calculating returns, keep in mind that all the normal steps of buying and selling a stock are still present -- just reversed. Both transactions still have a cost basis and a sales price. But, for stocks sold short, the chronological order has been reversed.
Shorting stock is one approach that separates the sophisticated investor from the novice. Believing that selling shares short is difficult and highly dangerous, some people pay oodles of money to enter "hedge funds," mutual fund partnerships whose managers short stock and go on margin. Having read this far, you already know most of what these "pros" know, and can do it yourself.
Finally, remember that when your "Pass Line" friends find out you're shorting stocks, they may start to regard you as Darth Vader. So, wear dark clothes, a low visor, breathe loud, and milk it.
You're almost home-free, Fool. Now, on to the last step to investing Foolishly.
To see the rest of the 13 Steps, follow the links at the bottom of this article.
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