Showing posts with label stock market. Show all posts
Showing posts with label stock market. Show all posts

HOW STOCK MARKET AFFECT THE PRICE OF SHARES AND SITUATIONS

By virtue of being a public company, the company is now liable to disclose all information related to the company to the public. The shares of a public limited company are traded on the stock exchanges on a daily basis.

There are few reasons why market participants trade stocks. We will explore these reasons in this chapter.

What really is the stock market?


The stock market is an electronic market place. Buyers and sellers meet and trade their point of view.

For example, consider the situation of Infosys.  Infosys is facing a succession issue, and most of its senior level management personnel are quitting the company for internal reasons. It seems like the leadership vacuum is weighing down the company’s reputation heavily. As a result, the stock price dropped to Rs.3,000 all the way from Rs.3,500. Whenever there are new reports regarding Infosys management change, the stock prices react to it.

Assume there are two traders – T1 and T2.

T1’s point of view on Infosys - The stock price is likely to go down further because the company will find it challenging to find a new CEO.

If T1 trades as per his point of view, he should be a seller of the Infosys stock.

T2, however views the same situation in a different light and therefore has a different point of view – According to him, the stock price of Infosys has over reacted to the succession issue and soon the company will find a great leader, after whose appointment the stock price will move upwards.

If T2 trades as per his point of view, he should be a buyer of the Infosys stock. 

So at, Rs.3, 000 T1 will be a seller, and T2 will be a buyer in Infosys.

Now both T1 and T2 will place orders to sell and buy the stocks respectively through their respective stock brokers. The stock broker, obviously routes it to the stock exchange.

The stock exchange has to ensure that these two orders are matched, and the trade gets executed. This is the primary job of the stock market – to create a market place for the buyer and seller.

The stock market is a place where market participants can access any publicly listed company and trade from their point of view, as long as there are other participants who have an opposing point of view. After all, different opinions are what make a market.

What moves the stock?


Let us continue with the Infosys example to understand how stocks really move. Imagine you are a market participant tracking Infosys.

It is 10:00 AM on 11th June 2014 ,and the price of Infosys is 3000. The management makes a statement to the press that they have managed to find a new CEO who is expected to steer the company to greater heights. They are confident on his capabilities and they are sure that the new CEO will deliver much more than what is expected out of him.

Two questions –

a.How will the stock price of Infosys react to this news?
b.If you were to place a trade on Infosys, what would it be? Would be a buy or a sell?

The answer to the first question is quite simple, the stock price will move up.

Infosys had a leadership issue, and the company has fixed it. When positive announcements are made market participants tend to buy the stock at any given price and this cascades into a stock price rally.

In this particular case, the stock moves up because of two reasons. One, the leadership issue has been fixed, and two, there is also an expectation that the new CEO will steer the company to greater heights.

The answer to the second question is now quite simple; you buy Infosys stocks considering the fact that there is good news surrounding the stock.

Now, moving forward in the same day, at 12:30 PM ‘The National Association of Software & Services company’, popularly abbreviated as NASSCOM makes a statement. For those who are not aware, NASSCOM is a trade association of Indian IT companies. NASSCOM is considered to be a very powerful organization and whatever they say has an impact on the IT industry.

The NASSCOM makes a statement stating that the customer’s IT budget seems to have come down by 15%, and this could have an impact on the industry going forward.

By 12:30 PM let us assume Infosys is trading at 3030. Few questions for you..

a.How does this new information impact Infosys?
b.If you were to initiate a new trade with this information what would it be?
c.What would happen to the other IT stocks in the market?

The answers to the above questions are quite simple. Before we start answering these questions, let us analyze NASSCOM’s statement in a bit more detail.

NASSCOM says that the customer’s IT budget is likely to shrink by 15%. This means the revenues and the profits of IT companies are most likely to go down soon. This is not great news for the IT industry.

Let us now try and answer the above questions..

a.Infosys being a leading IT major in the country will react to this news. The reaction could be mixed one because earlier during the day there was good news specific to Infosys. However a 15% decline in revenue is a serious matter and hence Infosys stocks are likely to trade lower

b.At 3030, if one were to initiate a new trade based on the new information, it would be a sell on Infosys

c.The information released by NASSCOM is applicable to the entire IT stocks and not just Infosys. Hence all IT companies are likely to witness a selling pressure.

So as you notice, market participants react to news and events and their reaction translates to price movements! This is what makes the stocks move.

At this stage you may have a very practical and valid question brewing in your mind. You may be thinking what if there is no news today about a particular company? Will the stock price stay flat and not move at all?

Well, the answer is both yes and no, and it really depends on the company in focus.

For example let us assume there is absolutely no news concerning two different companies..

1. Reliance Industries Limited
2. Shree Lakshmi Sugar Mills

As we all know, Reliance is one the largest companies in the country and regardless of whether there is news or not, market participants would like to buy or sell the company’s shares and therefore the price moves constantly.

The second company is a relatively unknown and therefore may not attract market participant’s attention as there is no news or event surrounding this company. Under such circumstances, the stock price may not move or even if it does it may be very marginal.

To summarize, the price moves because of expectation of news and events. The news or events can be directly related to the company, industry or the economy as a whole. For instance the appointment of Narendra Modi as the Indian Prime Minister was perceived as positive news and therefore the whole stock market moved.

In some cases there would be no news but still the price could move due to the demand and supply situation.

How does the stock get traded?


You have decided to buy 200 shares of Infosys at 3030, and hold on to it for 1 year. How does it actually work? What is the exact process to buy it? What happens after you buy it?

Luckily there are systems in place which are fairly well integrated.

With your decision to buy Infosys, you need to login to your trading account (provided by your stock broker) and place an order to buy Infosys. Once you place an order, an order ticket gets generated containing the following details:

a. Details of your trading account through which you intend to buy Infosys shares – therefore your identity is reveled.
b. The price at which you intend to buy Infosys
c.The number of shares you intend to buy

Before your broker transmits this order to the exchange he needs to ensure you have sufficient money to buy these shares. If yes, then this order ticket hits the stock exchange. Once the order hits the market the stock exchange (through their order matching algorithm) tries to find a seller who is willing to sell you 200 shares of Infosys at 3030.

Now the seller could be 1 person willing to sell the entire 200 shares at 3030 or it could be 10 people selling 20 shares each or it could be 2 people selling 1 and 199 shares respectively. The permutation and combination does not really matter. From your perspective, all you need is 200 shares of Infosys at 3030 and you have placed an order for the same. The stock exchange ensures the shares are available to you as long as there are sellers in the market.

Once the trade is executed, the shares will be electronically credited to your DEMAT account. Likewise the shares will be electronically debited from the sellers DEMAT account.

What happens after you own a stock?


After you buy the shares, the shares will now reside in your DEMAT account. You are now a part owner of the company, to the extent of your share holding. To give you a perspective, if you own 200 shares of Infosys then you own 0.000035% of Infosys.

By virtue of owning the shares you are entitled to few corporate benefits like dividends, stock split, bonus, rights issue, voting rights etc. We will explore all these shareholder privileges at a later stage.

A note on holding period


Holding period is defined as the period during which you intend to hold the stock. You may be surprised to know that the holding period could be as short as few minutes to as long as ‘forever’. When the legendary investor Warren Buffet was asked what his favorite holding period was, he in fact replied ‘forever’.

In the earlier example quoted in this chapter, we illustrated how Infosys stocks moved from 3000 to 3016 in a matter of 5 minutes. Well, this is not a bad return after all for a 5 Minute holding period! If you are satisfied with it you can very well close the trade and move on to find another opportunity. Just to remind you, this is very much possible in real markets. When things are hot, such moves are quite common.

I hope you understand the whole process of stock in the stock market . If you have any query or suggestions please write down in the comment .

NSCCL AND ICCL

NSCCL – National Security Clearing Corporation Ltd and Indian Clearing Corporation are wholly owned subsidiaries of National Stock Exchange and Bombay Stock Exchange respectively.

The job of the clearing corporation is to ensure guaranteed settlement of your trades/ transactions. For example if you were to buy 1 share of Biocon at Rs.446 per share there must be someone who has sold that 1 share to you at Rs.446 . For this transaction, you will be debited Rs.446 from your trading account and someone must be credited that Rs.446 toward the sale of Biocon. In a typical transaction like this the clearing corporation’s role is to ensure the following:

a) Identify the buyer and seller and match the debit and credit process
b) Ensure no defaults – The clearing corporation also ensures there are no defaults by either party. For instance the seller after selling the shares should not be in a position to back out thereby defaulting in his transaction.

For all practical purposes, its ok not to know much about NSCCL or ICCL simply because, you as a trader or investor would not be interacting with these agencies directly. You just need to be aware that there are certain professional institutions which are heavily regulated and they work towards smooth settlement, and efficient clearing activity.

IPO SEQUENCE OF EVENTS

Needless to say each and every step involved in the IPO sequence has to happen under the SEBI guidelines. In general, the following are the sequence of steps involved.

• Appoint a merchant banker. In case of a large public issue, the company can appoint more than 1 merchant banker

• Apply to SEBI with a registration statement – The registration statement contains details on what the company does, why the company plans to go public and the financial health of the company

• Getting a nod from SEBI – Once SEBI receives the registration statement, SEBI takes a call on whether to issue a go ahead or a ‘no go’ to the IPO

• DRHP – If the company gets the initial SEBI nod, then the company needs to prepare the DRHP. A DRHP is a document that gets circulated to the public. Along with a lot of information, DRHP should contain the following details..

a.The estimated size of the IPO
b.The estimated number of shares being offered to public
c.Why the company wants to go public and how does the company plan to utilize the funds along with the timeline projection of fund utilization
d.Business description including the revenue model, expenditure details
e.Complete financial statements
f.Management Discussion and Analysis – how the company perceives the future business operations to emerge
g.Risks involved in the business
h.Management details and their background

• Market the IPO – This would involve TV and print advertisements in order to build awareness about the company and its IPO offering. This process is also called the IPO road show

• Fix the price band – Decide the price band between which the company would like to go public. Of course this can’t be way off the general perception. If it is, then the public will not subscribe for the IPO

• Book Building – Once the road show is done and price band fixed the company now has to officially open the window during which the public can subscribe for shares. For example, if the price band is between Rs.100 and Rs.120, then the public can actually choose a price they think is fair enough for the IPO issue. The process of collecting all these price points along with the respective quantities is called Book Building. Book building is perceived as an effective price discovery method

• Closure – After the book building window is closed (generally open for few days) then the price point at which the issue gets listed is decided. This price point is usually that price at which maximum bids have been received.

• Listing Day – This is the day when the company actually gets listed on the stock exchange. The listing price is the price discovered through the book building process.

DEPOSITORY AND DEPOSITORY PARTICIPANTS

When you buy a property the only way to identify and claim that you actually own the property is by producing the property papers. Hence it becomes extremely important to store the property papers in a safe and secure place.

Likewise when you buy a share (a share represents a part ownership in a company) the only way to claim your ownership is by producing your share certificate. A share certificate is nothing but a piece of document entitling you as the owner of the shares in a company.

Before 1996 the share certificate was in paper format however post 1996, the share certificates were converted to digital form. The process of converting paper format share certificate into digital format share certificate is called “Dematerialization” often abbreviated as DEMAT.

The share certificate in DEMAT format has to be stored digitally. The storage place for the digital share certificate is the ‘DEMAT Account’. A Depository is a financial intermediary which offers the service of Demat account. A DEMAT account in your name will have all the shares in electronic format you have bought. Think of DEMAT account as a digital vault for your shares.

As you may have guessed, the trading account from your broker and the DEMAT account from the Depository are interlinked.

So for example if your idea is to buy Infosys shares then all you need to do is open your trading account, look for the prices of Infosys and buy it. Once the transaction is complete, the role of your trading account is done. After you buy, the shares of Infosys will automatically come and sit in your DEMAT account.

Likewise when you wish to sell Infosys shares, all you have to do is open your trading account and sell the stock. This takes care of the transaction part…however in the backend, the shares which are sitting in your DEMAT account will get debited, and the shares move out of your DEMAT account.

At present there are only two depositaries offering you DEMAT account services. They are The National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited. There is virtually no difference between the two and both of them operate under strict SEBI regulations.

Just like the way you cannot walk into National Stock Exchange’s office to open a trading account, you cannot walk into a Depository to open a DEMAT account. To open a DEMAT account you need to liaison with a Depository Participant (DP). A DP helps you set up your DEMAT account with a Depository. A DP acts as an agent to the Depository. Needless to say, even the DP is governed by the regulations laid out by the SEBI.

STOCK BROKER

The stock broker is probably one of the most important financial intermediaries that you need to know. A stock broker is a corporate entity, registered as a trading member with the stock exchange and holds a stock broking license. They operate under the guidelines prescribed by SEBI.

A stock broker is your gateway to stock exchanges. To begin with, you need to open something called as a ‘Trading Account’ with a broker who meets your requirement. Your requirement could be as simple as the proximity between the broker’s office and your house. At the same time it can be as complicated as identifying a broker who can provide you a single platform using which you can transact across multiple exchanges across the world. At a later point we will discuss what these requirements could be and how to choose the right broker.

A trading account lets you carry financial transactions in the market. A trading account is an account with the broker which lets the investor to buy/sell securities.

So assuming you have a trading account - whenever you want to transact in the markets you need to interact with your broker. There are few standard ways through which you can interact with your broker.

1. You can go to the broker’s office and meet the dealer in the broker’s office and tell him what you wish to do. A dealer is an executive at the stock broker’s office who carries out these transactions on your behalf.
2. You can make a telephone call to your broker, identify yourself with your client code (account code) and place an order for your transaction. The dealer at the other end will execute the order for you and confirm the status of the same while you are still on the call.
3. Do it yourself – this is perhaps the most popular way of transacting in the markets. The broker gives you access to the market through software called ‘Trading Terminal’. After you login in to the trading terminal, you can view live price quotes from the market, and can also place orders yourself.

The basic services provided by the brokers includes :

1. Give you access to markets and letting you transact
2. Give you margins for trading – We will discuss this point at a later stage
3. Provide support – Dealing support if you have to call and trade. Software support if you have issues with the trading terminal
4. Issue contract notes for the transactions – A contract note is a written confirmation detailing the transactions you have carried out during the day
5. Facilitate the fund transfer between your trading and bank account
6. Provide you with a back office login – using which you can see the summary of your account
7. The broker charges a fee for the services that he provides called the ‘brokerage charge’ or just brokerage. The brokerage rates vary, and its up to you to find a broker who strikes a balance between the fee he collects versus the services he provides.

WHAT IS A STOCK MARKET

Investing in equities is an important investment that we make in order to generate inflation beating returns. This was the conclusion we drew from the previous chapter. Having said that, how do we go about investing in equities? Clearly before we dwell further into this topic, it is extremely important to understand the ecosystem in which equities operate.

Just like the way we go to the neighborhood kirana store or a super market to shop for our daily needs, similarly we go to the stock market to shop (read as transact) for equity investments. Stock market is where everyone who wants to transact in shares go to. Transact in simple terms means buying and selling. For all practical purposes, you can’t buy/sell shares of a public company like Infosys without transacting through the stock markets.

The main purpose of the stock market is to help you facilitate your transactions. So if you are a buyer of a share, the stock market helps you meet the seller and vice versa.

Now unlike a super market, the stock market does not exist in a brick and mortar form. It exists in electronic form. You access the market electronically from your computer and go about conducting your transactions (buying and selling of shares).

There are two main stock exchanges in India that make up the stock markets. They are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Besides these two exchanges there are a bunch of other regional stock exchanges like Bangalore Stock Exchange, Madras Stock Exchange that are more or less getting phased out and don’t really play any meaningful role anymore.

PUTTING A PRICE ON THE FUTURE

Which factors determine how much you should be willing to pay for a stock ?? What makes one company worth 10 times earnings and another worth 20  times?? How can you be reasonably sure that you are not overpaying for an apparently rosy future that turns out to be a murky nightmare ??

Five elements are decisive :
  • the company's general long term prospects 
  • the quality of its management 
  • its financial strength and capital structure 
  • its dividend record 
  • and its current dividend rate

WORDS OF WARNING IN STOCK MARKET

The need for due diligence doesn't stop once you hire an adviser . If your adviser keeps saying words and phrases that can spell trouble or twisting your arm to do anything that makes you uncomfortable then get in touch with the authorities very quickly . Here is the kind of words that should set off warning bells :

  • offshore
  • the opportunity of a lifetime
  • prime bank
  • this baby's gonna move
  • guaranteed 
  • you need to hurry
  • it's sure thing
  • our proprietary computer model
  • the smart money is buying it 
  • options strategy
  • it's a no-brainer
  • you can't afford not to own it
  • we can beat the market 
  • you'll be sorry if you don't
  • exclusive
  • you should focus on performance , not fees
  • don't you want to be rich ??
  • can't lose
  • the upside is huge
  • there's no downside
  • I'm putting my mother in it 
  • trust me
  • commodities trading 
  • monthly returns 
  • active asset allocation strategy 
  • we can cap your downside
  • no one else knows how to do this 

TRUST THEN VERIFY

Remember that financial con artists thrive by talking you into trusting them and by talking you out of investing them . Before you place your financial future in the hands of the adviser , it's imperative that you find someone who not only makes you comfortable but whose honesty is beyond reproach .

As Ronald Reagan used to say , " Trust , then verify." Start off by thinking of the handful of people you know best and trust the most . Then ask if they can refer you to an adviser whom they trust and who they feel , delivers good value for his fees . A vote of confidence from someone you admire is a good start .

Once you have the name of the adviser and his firm as well as his specialty is he a stock broker ?? financial planner ?? accountant ?? insurance agent ?? You can begin your due diligence . Enter the name of the adviser and his or her firm into an Internet search engine like Google to see if anything comes up . 

If the adviser is a stock broker or insurance agent contact the office of your state's securities commissioner to ask whether and disciplinary actions or customer complaints have been filed against the adviser . If you are considering an accountant who also functions as a financial adviser , your state's accounting regulators will tell you whether his or her record is clean .

INVESTMENT BANKERS

The term investment banker is applied to a firm that engages to an important extent in originating , underwriting and selling new issues of stocks and bonds . To underwrite means to guarantee to the issuing corporation or other issuer that the security will be fully sold . A number of the brokerage house carry on a certain amount of underwriting activity .

Generally this is confined to participating in underwriting groups formed by leading investment bankers . These is an additional tendency for brokerage firms to originate and sponsor a minor amount of new issue financing , particularly in the form of smaller issue of common stocks when a bull market is in full swing .

Investment banking is perhaps the most respectable department of the stock market community because it is here that finance plays its constructive role of supplying new capital for the expansion of industry . In fact , much of the theoretical justification for maintaining active stock markets , notwithstanding their frequent speculative excesses , lies in the fact that organised security exchanges facilitate the sale of new issues of bonds and stocks . If investor or speculators could not expect to see a ready market for a new security offered them , they might well refuse to buy it .

The relationship between the investment banker and the investor is basically that of the salesman to the prospective buyer . For many years past the great bulk of the new offerings in dollar value has consisted of bong issues that were purchased in the main by financial institutions such as banks and insurance companies . In this business the security salesman have been dealing with shrewd and experienced buyers . Hence any recommendations made by the investment bankers to these customers have had to pass careful and skeptical scrutiny . Thus these transactions are almost always effected on a business like footing . 

But a different situation obtains in a relationship between the individual security buyer and the investment banking firms including the stockbrokers acting as underwriters . Here the purchaser is frequently inexperienced and seldom shrewd . He is easily influenced by what the salesman tell him especially in the case of common issues , since often his unconfessed desire in buying is chiefly to make a quick profit .The effect of all this is that the public investor's protection lies less in his own critical faculty than in the scruples and ethics of the offering houses . 

The intelligent investor will pay attention to the advice and recommendations received from investment banking houses , especially those known by him to have an excellent reputation but he will be sure to bring sound and independent judgement to bear upon these suggestions - either his own if he is competent or that of some other type of adviser . 

INVESTMENT COUNSEL AND TRUST SERVICES OF BANKS

The truly professional investment advisers that is the well established investment counsel firms who charge substantial annual fees are quite modest in their promises and pretentions . For the most part they place their clients funds in standard interest and dividend paying securities and they rely mainly on normal investment experience for their overall results . 

In the typical case it is doubtful whether more than 10% of the total fund is ever invested in securities other than those of leading companies plus government bonds including state and municipal issues nor do they make a serious effort to take advantage of swings in the general market .

The leading investment counsel firms make no claim to being brilliant ; they do pride themselves on being careful , conservative and competent . Their primary aim is to conserve the principal value over the years and produce a conservatively acceptable rate of income . 

Any accomplishment beyond that and they do strive to better the goal - they regard in the nature of extra service rendered . Perhaps their chief value to their clients lies in shielding them from costly mistakes . They offer as much as the defensive investor has the right to expect from any counselor serving the general public .

What i have said about the well established investment counsel firms applies generally to the trust and advisory services of the larger banks .

ADVISE FROM BROKERAGE HOUSES

Probably the largest volume of information and advice to the security-owning public comes from stockbrokers . These are members of the stock exchanges who execute buying and selling orders for a standard commission . Practically all the houses that deal with the public maintain a statistical or analytical department , which answers inquiries and makes recommendations . A great deal of analytical literature , some of it elaborate and expensive , is distributed gratis to the firms customers more impressively referred to as clients . 

 A great deal is at stake in the innocent appearing question whether customers or clients is the more appropriate name . A business has customers , a professional person or organisation has clients . The brokerage fraternity has probably the highest ethical standards of any business , but it still feeling its way toward the standards and standing of a true profession .

 It has been logically impossible for brokerage houses to operate on a thoroughly professional basis . To do that would have required them to direct their efforts toward reducing rather than increasing their business . The farthest that certain brokerage houses have gone in that direction and could have been expected to go is to refrain from inducing or encouraging anyone to speculate . Such houses have confined themselves to executing orders given them to supplying financial information and analyses and o rendering opinions on the investment merits of securities . Thus in theory at least they are devoid of all responsibility for either the profits or the losses of their speculative customers . 

 Most stock exchange houses however still adhere to the old time slogans that they are in business to make commissions and that the way to succeed in business is to give the customers what they want . Since the most profitable customers want speculative advice and suggestions , the thinking and activities of the typical firm are pretty closely geared to day-to-day trading in the market. Thus it tries hard to help its customers make money in a field where they are condemned almost by mathematical law to lose in the end . By this I mean that the speculative part of their operations cannot be profitable over the long run for most brokerage house customers . But to the extent that their operations resemble true investing they may produce investment gains that more than offset the speculative losses . 

 The investor obtains advice and information from stock exchange houses through two types of employees now known officially as customers brokers or account executives and financial analysts . The customer's broker also called a registered representative , formerly bore the most part an individual of good character and considerable knowledge of securities who operates under a rigid code of right conduct . 

 Nevertheless since his business is to earn commissions , he can hardly avoid being influenced by speculative considerations till will ordinarily have to be careful and explicit in his dealing with his customer's broker ; he will have to show clearly by word and deed that he is not interested in anything faintly resembling a stock market tips . Once the customer's broker understands clearly that he has a real investor on his hands , he will respect this point of view and cooperate with it . 


INVESTORS AND HIS ADVISERS

The investment of money in securities is unique among business operations in that it is almost always based in some on advice received from others . The great bulk of investors are amateurs . Naturally they feel that in choosing their securities they can profit by professional guidance . Yet there are peculiarities inherent in the very concept of investment advice .

If we assume that there are normal or standard income results to be obtained from investing money in securities , then the role of the adviser can be more readily established . He will use his superior training and experience to protect his clients against mistakes and to make sure that they obtain the results to which their money is entitled . It is when the investor demands more than an average return on his money or when his adviser undertakes to do better for him that the question arises whether more is being asked or promised than is likely to be delivered .

Advise on investments may be obtained from a variety of sources . These include : (1) a relative or friend , presumably knowledgeable in securities (2) a local commercial banker (3) a brokerage firm or investment banking house (4) a financial service or periodical and (5) an investment counselor . The miscellaneous character of this list suggests that no logical or systematic approach in this matter has crystallized , as yet , in the minds of investors .

If the investor is to rely chiefly on the advice of others in handling his funds , then either he must limit himself and his advisers strictly to standard , conservative and even unimaginative forms of investment or he must have an unusually intimate and favorable knowledge of the persons who is going to direct his funds into other channels .

But if the ordinary business or professional relationship exists between the investor and his advisers , he can be receptive to less conventional suggestions only to the extent that he himself has grown in knowledge and experience and has therefore become competent to pass independent judgment on the recommendations of others . He has then passed from the category of defensive or unenterprising investor into that of aggressive or enterprising investor .

KNOW WHEN TO HOLD 'EM

Once you own a fund , how can you tell when it's time to sell ?? The standard advice is to ditch a fund if it underperform the market or similar portfolios for one or is it two ?? or is it three ?? years in a row . But this advice makes no sense . 

The performance of most funds falters simply because the type of stocks they prefer temporarily goes out of favor . If you hired a manager to invest in a particular way , why fire him for doing what he promised ?? By selling when a style of investing is out of fashion , you not only lock in a loss but lock yourself out of the all-but-inevitable recovery .

So when should you sell ?? Here a few definite red flags :

  • A sharp and unexpected change in strategy , such as a value fund loading up on technology stocks or a growth fund buying tons of insurance stocks 
  • An increase in expenses , suggesting that the managers are lining their own pockets 
  • Large and frequent tax bills generated by excessive trading 
  • Suddenly erratic returns , as when a formerly conservative fund generates a big loss or even produces a giant gain . 

THE FIRST SHALL BE LAST - MUTUAL FUND

Why don't more winning funds stay winners ??? The better a fund performs , the more obstacles its investor face :

MIGRATING MANAGERS : 

When a stock picker seems to have the Midas touch , everyone wants him including rival fund companies . This is very big problem .

ASSET ELEPHANTIASIS :

When a fund earns high returns , investors notice - often pouring in hundreds of millions of money in a matter of weeks . That leaves the fund manager with few choices - all of them bad . He can keep that money safe for a rainy day , but then the low returns on cash will crimp the fund's results if stocks keep going up . He can put the new money into the stocks he already owns which have probably gone up since he first bought them and will become dangerously overvalued if he pumps in millions of money and more . Or he can buy new stocks he didn't like well enough to own already but he will have to research them from scratch and keep an eye on far more companies than he is used to following . 

NO MORE FANCY FOOTWORK :

 Some companies specialize in incubating their funds-test-driving them privately before selling them publicly . Typically , the only shareholders are employees and affiliates of the fund company itself . By keeping them tiny , the sponsor can use these incubated funds as guinea pigs for risky strategies that work best with small sums of money , like buying truly tiny stocks or rapid-fire trading of initial public offerings . If its strategy succeeds the fund can lure public investors en masse by publicizing its private returns . In other cases , the fund manager waives or skips charging management fees , raising the net return then slaps the fees on later after the high returns attract plenty of customers . Almost without exception , the returns of incubated and free waived funds have faded into mediocrity after outside investors poured millions of money into them . 

 RISING EXPENSES :

 It often costs more to trade stocks in very large blocks than in small ones with fewer buyers and sellers , it's hard to make a match . The typical fund holds on to its stocks for only 11 months at a time , so trading costs eat away at returns like a corrosive acid . 

SHEEPISH BEHAVIOR :

 Finally , once a fund becomes successful , its managers tend to become timid and imitative . As a fund grows , its fees become more lucrative - making its managers reluctant to rock the boat . The very risks that the managers took to generate their initial high returns could now drive investors away and jeopardize all that fat fee income . So the biggest funds resemble a herd of identical and overfed sheep , all moving in sluggish lockstep , all saying "baaaa" at the same time . This behavior is so prevalent that finance scholars simply call it herding . But by protecting their own fee income , fund managers compromise their ability to produce superior returns for their outside investors .


HOW TO SELECT GOOD MUTUAL FUNDS

Financial scholars have been studying mutual fund performance for at least a half century and they are virtually unanimous on several points :

  • The average fund does not pick stocks well enough to overcome its cost of researching and trading them 
  • The higher a fund's expenses , the lower it's returns 
  • The more frequently a fund trades its stocks , the less it tends to earn 
  • Highly volatile funds , which bounce up and down more than average  are likely to stay volatile 
  • Funds with high past returns are unlikely to remain winners for long 

TOP OF THE CHARTS - STOCK MARKET

Most investors simply buy a fund that has been going fast , on the assumption that it will keep on going . And why not ??? Psychologists have shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes . 

What's more , we know that some plumbers are far better than others , that some baseball players are much more likely to hit home runs , that our favorite restaurant serves consistently superior food and that smart kids get consistently good grades . Skill and brains and hard work are recognized , rewarded and consistently repeated all around us . So , if a fund beats the market , our intuition tells us expect it to keep right on outperforming .

Unfortunately , in the financial markets , luck is more important than skill . If a manager happens to be in the right corner of the market at just the right time , he will look brilliant but all too often , what was hot suddenly goes cold and the manager's IQ seems to shrivel .

This is yet another reminder that the market's hottest market sector that was technology often turns as cold as liquid nitrogen with blinding speed and utterly no warning and it is a reminder that buying funds based purely on their past performance in one of the stupidest things an investor can do . 

But there is good news too . First of all , understanding why it is so hard to find a good fund will help you become a more intelligent investor . Second , while past performance is a poor predictor of future returns , there are other factors that you can use to increase your odds of finding a good fund .

Finally , a fund can offer excellent value even if it does not beat the market by providing an economical way to diversify your holdings and by freeing up your time for all the other things you would rather be doing than picking your own stocks . 

CLOSED-END VERSUS OPEN-END FUNDS

Almost all the mutual funds or open-end funds , which offer their holders the right to cash in their shared at their shares at each day's valuation of the portfolio , have a corresponding machinery for selling new shares . By this means most of them have grown in size over the years . 

The closes-end companies , nearly all of which were organised a long time ago , have a fixed capital structure and thus have diminished in relative dollar importance . Open-end companies are being sold by many thousands of energetic and persuasive salesmen , the closed-end shares have no one especially interested in distributing them .

Consequently it has been possible to sell most mutual funds to the public at a fixed premium of about 9% above net asset value to cover salesmen's commissions ,etc . While the majority of close-end shares have been consistently obtainable at less than their asset value . This price discount has varied among individual companies and the average discount for the group as a whole has also varied from the date to another . 

It does not take much shrewdness to suspect that the lower relative price for closed-end as against open-end shares has very little to do with the difference in the overall investment results between the two groups . If you want to put money in investment funds , buy a group closed-end shares at a discount of say 10% or 15% from asset value instead of paying a premium of about 9% above asset value for shares of an open-end company .

Assuming that the future dividends and changes in asset values continue to be about the same for the two groups , you will thus obtain about one-fifth more for your money from the closed-end shares .

PERFORMANCE FUNDS

meaning and explanation
One of the new phenomena of recent years was the appearance of the cult of performance in the management of investment funds and even of many trust funds . We must start this section with the important disclaimer that it does not apply to the large majority of well established funds , but only to a relatively small section of the industry which has attracted a disproportionate amount of attention .

The story is simple enough . Some of those in charge set out to get much better than average results . They succeeded in doing this for a while , garnering considerable publicity and additional funds to manage . The aim was legitimate enough ; unfortunately it appears that , in the context of investing really sizable funds , the aim cannot be accomplished without incurring sizable risks and in a comparatively short time the risks came home to roost . 

The definition of sound investment was a stock that was likely to have a good rise in the market in the next few months . This led to large commitments in newer ventures at prices completely disproportionate o their assets or recorded earnings . They could be justified only by a combination of naive hope in the future accomplishments of these enterprise with an apparent shrewdness in exploiting the speculative enthusiasms of the uninformed and greedy public .

BUSINESS VALUATIONS VERSUS STOCK MARKET VALUATIONS

The impact of market fluctuations upon the investor's true situations may be considered also from the standpoint of the shareholder as the part owner of various businesses . The holder of marketable shares actually has a double status , and with it the privilege of taking advantage of either at his choice . 

On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business . Here his result are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets . He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet . 

On other hand , the common-stock investor holds a piece of paper , an engraved stock certificate , which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open , that is - and often is far removed from the balance sheet value .

The whole structure of stock market quotations contains a built in contradiction . The better a company's record and prospects , the less relationship the price of its share will have to their book value . But the greater the premium above book value , the less certain the basis of determining its intrinsic value i.e. the more this " value " will depend on the changing moods and measurements of the stock market .

Thus we reach that the more successful the company , the greater are likely to be the fluctuations in the price of its shares . This really means that , in a very real sense , the better the quality of a common stock , the more speculative it is likely to be at least as compared with the unspectacular middle grade issues .