Individual Stocks versus Mutual Funds

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A mutual fund is a diverse holding of stocks that are managed on behalf of the investors that buy into the fund. A mutual fund allows an investor to take advantage of a diversified portfolio without having to invest a large sum of money.

What is the advantage of a diversified portfolio? It offers protection against rapid market losses of any one particular stock. If a portfolio is spread across 20 stocks, if any one of those stocks quickly loses value the effect is less than if the portfolio consisted of that one stock by itself.

When investing it is always a good idea to diversify. The problem for small investors is that they often don’t have the funds to buy a variety of stocks. Mutual funds allow small investors to benefit from diversification with a small amount of money.

Besides stocks, mutual funds can be made up of a variety of holdings including bonds and money market instruments. A mutual fund is actually a company and investors that buy into a fund are buying shares of that company. Shares in a mutual fund are bought directly from the fund itself or brokers acting on behalf of the fund. Shares can be redeemed by selling them back to the fund.

Some funds are managed by investment professionals who decide which securities to include in the fund. Non-managed funds are also available. They are usually based on an index such as the Dow Jones Industrial Average. The fund simply duplicates the holdings of the index it is based on so that if the Dow Jones (for example) rises by 5% the mutual fund based on that index also rises by the same amount. Non-managed funds often perform very well – sometimes better than managed funds.

There are downsides to mutual funds. There are usually fees that must be paid no matter how the fund performs, and the individual investor has no say in which securities can be included in the fund. Also, the actual value of a mutual fund share is not known with the same precision as stocks on the stock market.

Mutual funds are often a better choice for the small investor than either stocks or bonds. They offer the diversity that provides cushion against sudden stock market movements and usually provide a greater return than bonds. Of course, mutual funds can also lose value, especially in the short term, so short term investors may be better off with bonds which offer a set rate of return.

There are three main types of mutual funds: money market funds, bond funds and stock funds. Money market funds offer the lowest risk – they consist solely of high quality investments such as those issued by the US government and blue chip corporations. Money market funds have rarely lost money, but they pay a low rate of return.

Bond funds aim to produce higher yields than money market funds and therefore carry a correspondingly higher risk. All the risks that are associated with bonds – company bankruptcy, falling interest rates – also apply to bond funds.

Stock funds usually have the greatest potential for profitable investment but also carry the greatest risk. The risk is more for short-term holders of mutual funds – stocks have traditionally outperformed other investment instruments in the long run.

There are different types of stock funds including ‘growth funds’ that attempt to maximize capital gain and ‘income funds’ that concentrate on stocks that pay regular dividends.

Mutual funds are an ideal investment for those with limited funds or investment experience. Choosing the right fund is a decision on how much risk you are willing to take against your expected return on your investment.

Chasing Bulls

MORE disciplined behavior among US investors has perked up returns accruing to individuals, a US study has found. But long term returns remain meager when seen against a simple buy-and-hold strategy on the S&P 500 index. The annual study by US research company Dalbar, the 'Quantitative Analysis of Investor Behavior delves into mutual fund flows to produce a picture of investor behavior. It covers 20 years of real investor returns for equity, fixed income and asset allocation funds between 1987 and 2007.

Dalbar sets out to make some points on investor behavior that are worth taking to heart here in Singapore as well. Foremost is that timing the market does not work.

Over one year, the average equity fund investor enjoyed a return of 14.7 per cent compared to the S&P 500's 15.8 per cent, and beat inflation of 2 per cent by a wide margin. Over three and five-year periods, the average investor actually beat the S&P500. Dalbar attributes this relative success to longer retention or holding periods.

But over 20 years, the average individual return was only 4.3 per cent, against the 11.8 per cent return on the S&P using a buy-and-hold strategy. The long term inflation rate is 3 per cent.

Returns for investors in bonds and other fixed-income securities were worse. While the individual beat the long term government bond index over one year - 2 per cent against the index's 1.2 per cent - the 20-year return was dismal. The individual's return was only 1.7 per cent against the index's 8.6 per cent.

As for asset allocation or balanced funds, the individual's return paled against the equity-only S&P500. Dalbar, however, says such funds encourage longer holding periods which translates into 'investors making more money'.

Dalbar says: 'Whether the mutual fund industry is enjoying rapid expansion in times of economic boom, or is being battered by the bears, the key findings uncovered in (the) first study from 1994 remains true: Investor return is far more dependent on investor behaviour than fund performance. Mutual fund investors who hold their investments are more successful than those who time the market.'

In Singapore, fund flows are tracked by research company Lipper on a quarterly basis. CPF also gives a snapshot of investors' profits and losses on an aggregate basis. But it is difficult to glean individual holding periods from the data, and returns are typically reported on the basis that a fund is held for the relevant period.

Dalbar says: 'While mathematically useful, there are virtually no investors that exhibit this behavior, making published returns applicable to no one ... Investors are motivated by greed and fear and not by sound investment practice.' Tracking the dollars going into and out of a given month, compared to market performance, proves the correlation, it says. As markets rise, cash flows swell. As markets fall, cash flows deflate.

The data posits two broad types of investors. One is the 'average' investor, which assumes that a $10,000 investment is made in a pattern similar to average investor behavior. This is inferred from fund sales, redemptions and exchanges as provided by the US-based Investment Company Institute. There is also the 'systematic' investor where a $10,000 investment is evenly distributed across each month.

Of guesses and gains

The 'guess right' ratio reflects the frequency with which investors make a short term gain. A point is awarded for every month that an investor sees net inflows and the S&P 500 rises the following month. A point is also scored when there is a net outflow and the market declines the following month.

The 'guess right' ratio is strongest in rising markets (1992, 1995, 1996-97, 2003-2006). But the most mistakes are made during downturns. 'These mistakes occur because investors are driven by the fear that markets will not recover ... If you don't know when to get out, it is better to stay in,' it says. The overall 'guess right' ratio over 20 years is 61 per cent.

Comparing 'average' behavior to systematic investing, Dalbar found that $10,000 invested systematically using dollar-cost averaging yielded 40 per cent greater returns. 'It is clear from this analysis that behavior drives the returns that investors actually receive. Good investment behaviors compensate for major nonperformance,' it says.

It tested this by comparing a systematic approach with just 75 per cent of S&P 500's return against the 'average' behavior: the disciplined approach still outperformed.

Loss aversion - people's tendency to prefer avoiding loss than making a gain - is the greatest influence on behavior, says Dalbar. This is the main cause of loss among mutual fund investors. 'The imprudent response to risk is very often based on the fear of catastrophic loss.'

Concern about risk is greatest in three instances - when an investment decision is required; after a loss and after news of a loss by others. These events present the best opportunities for risk education, says Dalbar. 'Risk education must first correct the fear of catastrophic loss by providing anchors to establish risk as being relative, and then include explanations of how risk is controlled ... The biggest risk is getting out before the upturn.'

The average holding period among equity investors is 4.3 years. This has been so from 2002 to 2006. Before that the holding period ranged from 1.7 years in the late 1980s to about three years between 1992 and 1996. Retention is critical, says Dalbar, as one cannot benefit if one is not in the market. 'While it is highly profitable to avoid market downturns, very few investors do so successfully ... After all, the market moved up 60 per cent of the time and down only 40 per cent for each month of the last 20 years.'

How investors find reasons to buy - or sell

IT'S always interesting to see how investors are always able to find a reason to buy or sell in earnest when it suits them. If you like, it all depends on whether you prefer to view the glass as being half empty or half full. The determining factor? Momentum. If prices rise for no apparent good reason, the tendency is for market players to convince themselves that they have either missed something or that their previous assumptions were wrong.

Last June, for example, when the US Federal Reserve raised its short-term interest rates for the 17th consecutive time in the current cycle by 25 basis points to 5.25 per cent, analysts confidently declared that it was the end of the tightening cycle and that the next move would be a cut, perhaps coming as early as the end of 2006. As a result, stocks soared, ending a steep, two-month long down-cycle that had been triggered by interest-rate fears.

In January this year, when oil crossed US$60 per barrel and US Q4 GDP growth of 3.4 per cent surprised on the upside and stocks fell, the tone changed because everyone suddenly expected the Fed to keep rates steady at its March meeting. Noticeably silent were the experts who had a few months earlier urged their clients to buy because rates were to be cut.

In March, people rushed to buy stocks because it was claimed that the minutes of the Fed's meeting hinted at an impending rate cut and the language supposedly demonstrated a move away from a hawkish stance. The US Treasury market duly priced in a 50 basis-point cut before year- end and stocks hit all-time highs.

As pointed out in this column on April 6 ('What exactly did the Fed say?') the markets got it wrong. The language used by the Fed was nowhere as accommodating as experts would have everyone believe and if anything, suggested that core inflation was still a concern and that rates might have to be raised or at least be kept steady for the rest of the year.

Following the conclusion of last week's Federal Open Market Committee (FOMC) meeting, this view has now been proven true. The Fed did not lower rates and Wall Street is now convinced that there will be no loosening for the rest of the year. Oil is close to US$70 a barrel (a 10-month high), the 10-year Treasury yield is above 5 per cent but perhaps worst of all, the US economy is stalling - last week's Q1 GDP figure showed the slowest expansion in four years. Stagflation, anyone?

Still, as stated earlier, it's always possible to find reasons to buy (or sell) depending on prevailing momentum. To see this, look no further than the penny sector, where syndicates and manipulators - no doubt with the aid of major shareholders - have managed to generate considerable momentum in 'junk' stocks, thus inducing retail punters to find reasons to buy.

A popular inducement to buy has been the laggard theme, the idea being that if something - a stock or a country - hasn't risen as much as others, then it has to eventually become attractive, hopefully sooner rather than later.

Today's market is replete with the laggard argument - Citigroup's 'sell Singapore, buy Taiwan' last week for example, was founded on the argument that Taiwan has lagged everybody else. Second line activity is founded primarily on laggard reasoning - if a sector leader for example, has been ramped up to a particular level, then analysts use that lofty valuation to justify recommending a buy on others in that sector.

The upshot of all this is that currently, the market wants to continue to find reasons to keep buying, though it knows at the back of its collective mind that it might be prudent to take a little money off the table considering - other reasons aside - that the third quarter is traditionally a quiet period. Still, much depends on the prevailing momentum and, of course, how convincing the laggard argument proves to be.

Why Day Trading?

"Because it's there!" What has come to be known as day trading is new, and many are lured by it. Of course, day trading is as old as the first market, but it has generally been the preserve of professionals. Now one finds traders of all degrees of experience at innumerable trading houses hunched over computers, buying and selling in seconds or minutes, hundreds of trades a day.

Uncountable trading rooms in cyberspace connect thousands of traders all over the world, responding instantly to "calls" made by head traders to buy or sell. And in countless chatrooms, this or that stock is touted or rumored into buying or selling frenzies by traders acting on this information alone.

Four factors converging in the last few years of the twentieth century have made this possible:

   1. The computer
   2. The Internet
   3. Discount brokerage fees
   4. and an unprecedented Bull Market

These, combined with the ever-present lust for quick fortune, have produced a new market dynamic:

A massive degree of public participation in short-term trading.

Volatility in some markets is obviously a direct result of day trading activity. Whether this amounts to more than day traders buying and selling to one another is not yet clear. What is clear is that trading is not investing. If trading is "take the money and run," investing is "plant the money and let it grow." Trading is always short term in its orientation, whether for 6 seconds, 6 hours, or 6 days. Investment is always intended to be long term.

Trading aspires to the growth of capital; investment to growth in ownership. The wealth of a trader is measured in units of currency; that of an investor in units of equity. The trader always seeks cash in pocket; the investor certificates of ownership (shares). Investment is long term because it generally takes a long time to accumulate a sizable degree of ownership.

Unless an investment goes sour (e.g., a company fails), there is often no incentive to divest — even when there are large "profits" in the value of an investor's position. The trader, however, seeks something quite different. The trader seeks gains now. The trader in effect attempts to reduce the time element to near zero. While a 15 percent return in a year's time would be considered satisfying to the investor, the trader wants this in a day!

Why invest in stock market

Investing is making your money work for you by getting your money to generate more money.  Investing in stocks has consistently proven to be one of the most profitable forms of investment available.

The benefits include:

•  Immediate Buy/Sell so you can sell part of your investment any time.
  
•  Very low transaction cost.
  
•  The freedom to work at your own place, at your pace in your own time.
  
•  Easy monitoring — log in to the market from anywhere in the world.
  
•  Being able to maximize returns whilst spreading your risk.
  
•  A predictable form of investment if you know what you're doing.
  
•  Putting you in control and freeing you of fund management fees.
  
•  Considerable tax advantages.
  

Things to watch out for:

• The market can be a volatile place.
  
• You must acquire knowledge of what you are doing.
  
• You must monitor your investments.
  
• You must learn the discipline to enter and exit the market on entry and exit signals.
  

Understanding the stock market

Raising Capital on the Stock Market

The Stock Market was created by companies wishing to raise capital for their business. When someone says they have a listed company they mean listed on Bursa Malaysia. All companies need cash to take advantage of growth opportunities. Many start-up companies however find themselves short of capital to fund expansion.  

One way to acquire this cash is to publicly float the company. This involves selling part of the company to private individual and institutional investors who are then able to freely exchange these stocks on an open market. Purchasing stocks in a company that is listed on the stock market is done through an Initial Public Offering or IPO.

Once an IPO has been issued, you can contact the company (phone, fax or email) for a copy of the Prospectus and complete the application to apply for an allocation of shares. Or you can wait until the company is floated and buy shares on the open market.  Besides Bursa Malaysia, stock brokers will also have information regarding Initial Public Offerings.

Companies that are already listed can also raise additional money on the stock market by offering existing stockholders the opportunity to buy more stocks in the company.  For example, a listed company wanting to raise additional capital might issue one new share at 5sen each for every three shares an existing investor owns.

When you buy shares, you are buying a share in that company and so you own a percentage of that company. When the company makes a profit, you share in that profit in the form of a dividend. Typically, the number of shares that have been issued multiplied by the share price gives us how much a company is worth.

The role of broker

To buy or sell shares on Bursa Malaysia, you need to use a registered broker who is a member of Bursa Malaysia.  You cannot deal directly with Bursa Malaysia as only brokers have direct access to the market.

• A broker acts as your agent—much like a real estate agent that sells your house.
  
• He/she earns a commission on the value of shares you trade – just like a real estate agent earns commission on buying and selling houses for people.
  
• A broker can also be involved in the listing of a new company by underwriting the float and marketing the float to their group of clients.
  

Getting stock price

The stock price is the market price of a stock. Using the Bursa Malaysia website you can view the price for any listed stock.

Getting A Price

It's good practice to explore the market news wherever you can find it. Many of the terms will be alien to you at this stage but familiarizing yourself is all part of the learning process.

There are many places you can find market news, for example:

1. The financial section of the daily newspapers
   
2. Bursa Malaysia Website. Click here for Market News
   
3. Your broker website may have an up-to-date list of stock prices
   
4. Your telephone company may be able to send you market updates via your mobile phone
   

It is best to explore your options and find services that best suit you.

Type Of Stock

What types of stocks are there?

Ordinary Stocks: When purchasing an ordinary stock, you own a share of the company. This entitles you to receive profits from the operations of the company in the form of dividends. At the annual general meeting (also referred to as an AGM), you have voting rights. Ordinary stocks are what you will start to trade in and most traders never venture beyond this.

There are, however, other types of securities and these are:

Preferential Stocks: A preference stock is different from an ordinary stock. Preference stockholders receive dividends before dividends on ordinary stocks are announced. If the company is wound up, preference stockholders rank above ordinary stockholders in the distribution of assets. Preference stocks can often have a fixed dividend rate.

Contributing Stocks: A contributing stock is one that is not fully paid for and requires the holder to make payments at a future date.

Bonus Issue: This is a free issue of stocks to the stockholders based on the number of stocks already owned.

Rights Issue: A rights issue can be granted to stockholders to buy stocks in the company, often below market price.

Derivatives: There are also securities you can trade on the market that derive their price from the parent stocks. There are two types – Options and Warrants – and these are collectively known as Derivatives.

Option: An option can best be described as a contract between two parties giving the taker (buyer) the right to buy or sell a parcel of stocks at a predetermined price on or before a predetermined date.

There are two parties involved in an options contract, the writer or seller and the taker or buyer. The writer writes the option and has the obligation of accepting or delivering the stocks. The takers have the right, but not the obligation, to buy or sell the stocks.

There are two types of options – Calls and Puts.

Call: A call option gives the buyer the option to buy stocks from the option writer.You are 'calling' stocks away from the owner.

Put: A put option gives the buyer the option to sell stocks to the option writer.You are 'putting' stocks to the writer.

There are many advantages of options trading, the least of which is leverage. An option can be bought and sold for a fraction of the stock price, giving an effective higher return (or loss) on investment for a stock price move.

Warrants: Warrants, like options, derive their price from the parent security. Warrants though are issued by banks and other financial institutions and are classified based on whether they have an investment or trading purpose.

Warrants may be issued over securities, a portfolio of securities, a stock price index, currency or commodities.

Buying and selling stocks

The thought of buying and selling stocks can seem daunting for a beginner but it is quite simple and will grow on you quite quickly once you have some practice. One essential thing to know is that you must go through a broker to buy and sell stocks, only a licensed broker can deal directly with the stock market.

Engaging A Broker
Aside from making the purchases, a broker can also advise you on your purchases. However, you should not depend on them for market knowledge, you must do your own research to succeed in the market.

Buying And Selling Online
Online brokers generally take less commission than other brokers, making online trading a more profitable alternative. Online trading does not come with expert advice but does normally come with live market updates so you can keep track of your purchases online and become an expert yourself.

When To Buy And Sell

One of the benefits of investing in the stock market is that you can do it after hours. Bursa Malaysia is open from 9am to 12.30pm, then again from 2.30pm to 5pm but you can do research and place orders outside these hours.

So, let's say you go to work all day and only have the evenings and weekends free. In the evenings you will review what happened to the market that day and decide how to trade the next day. If you miss a few nights during the week, you can do your analysis on the weekend.

There are two ways to place a buy or sell order:

At Market Orders
You can only make 'at market' orders during trading hours. If you do your research after trading hours then you would put an order through with your broker as soon as the market opens the next day. The purchase will then be made 'At Market' price, which may be different from the price you found during your research the night before.

At Limit Orders
The advantage of 'At Limit' orders is that you set the maximum price you will buy or the minimum price you will sell the share for. So, if you have done your research that evening and decided that the most you want to pay for the share is RM 1.20 then you place an 'At Limit' order for 100 shares at RM1.20. If your broker can get the shares for RM1.20 they will buy them for you. If not, they won't make the trade.

This practice is quite good if you want to control the amount you are investing. The other advantage of buying 'At Limit' is that you can place a buy/sell order outside market hours. Therefore, your share trading business needs do not interfere with your daytime job.