How Do Mutual Funds Work

Posted on by Ryan

So how do mutual funds work? Well, mutual funds are a type of communal investment that gathers money together from numerous different investors to purchase stocks, bonds, and other securities on a larger scale than what an individual investor could afford independently.

When you contribute money to a mutual fund, you get a stake in all of the fund’s investments, and your portfolio becomes more diverse and potentially more profitable.

You also get an investment professional who actively manages the fund; a real plus if you don’t have the market experience or wisdom necessary to make accurate investment decisions.

Mutual Fund Shares

One of the first questions you might ask is, “Since mutual funds are a collection of securities instead of a single company, who determines the cost of each mutual fund share?”

The net asset value (NAV) determines the price per share of a mutual fund. The NAV is calculated by taking the total value of securities that the fund owns and dividing it by the number of outstanding shares.

If a mutual fund’s total value is $50 million and there are 2 million shares, then the NAV would be $25. So if you wanted to invest $3,000 into a mutual fund with a NAV of $25, you would own 120 shares of that mutual fund.

Benefits of Mutual Funds

A Diverse Portfolio – Many financial experts will tell you that a person needs at least $100,000 to adequately diversify their portfolio with individual stock purchases. But what if you only have a few thousand dollars to start with?

Investing in a mutual fund is a great way to have a well-diversified stock portfolio with a minimum initial investment because mutual funds are already diverse and they have a low minimum requirement.

You need diversification to limit your potential risk of losing money. A decline in the value of a particular security within a mutual fund is often offset by the strength or increasing value of other securities within that fund.

Managed by Investment Professionals – Mutual funds are managed and supervised by professional investment administrators. The goals of the fund managers are directly related to the investors’ success because the managers are paid based on the performance of the mutual fund.

The fund manager uses his or her market experience, wisdom, and expertise to decide when to buy and sell securities. Because the manager is making decisions for the mutual benefit of the fund, the individual investor doesn’t have the difficult job of trying to time the market.

The resources and research expertise of mutual fund managers far exceed those of the average investor.

Mutual Fund Risk and Diversity

There are always risks associated with every type of investing, and mutual funds are not immune. Mutual funds also have management fees (although minimal) that don’t normally accompany individual stock purchases.

Instead of labeling these items as disadvantages, think of them as necessary information needed to make wise and accurate investment decisions.

Mutual funds can add diversity, stability, convenience, and high quality purchases to any investment portfolio, no matter if you want to spend $1,000 or $1,000,000.

Financial Risk Tolerance vs. Emotional Risk Tolerance

Posted on by Ryan

One of the terms that you might have heard when you are getting ready to invest is “risk tolerance.” As you might imagine, this term refers to the amount of risk you can handle when you invest. As you evaluate potential investments, it’s a good idea to take some time to review your risk tolerance. For the most part, risk tolerance can be divided into two parts: financial and emotional. Before you make an investing decision, it helps to understand your own risk tolerance; you will make better decisions if you know your own limits.

Financial Risk Tolerance

First, consider your financial risk tolerance. This is represented by how your finances can handle different risks. The old rule is to avoid investing money that you can’t afford to lose. Your first consideration is to figure out, financially, what makes sense for your investment portfolio.

If you are struggling financially, risking a large portion of your paycheck might not be the best plan. You probably need that money for other purposes; you can’t afford to lose it on a risky investment that has the potential to go bad.

In such cases, it might make sense to put a little aside , and take advantage of dollar cost averaging to help you prepare for the future, without sacrificing today.

On the other hand, if you have extra money, you might think it fun to do a little day trading, and take bigger risks. As long as you won’t miss the money if you lose it, it shouldn’t be a problem.

However, be careful when trading on margin. While you could magnify your gains, you will also need to make sure you have a high enough financial risk tolerance to handle magnified losses.

Emotional Risk Tolerance

Determining your financial risk tolerance is fairly straightforward: You just need to run the numbers. Emotional risk tolerance, though, is another matter. Emotional risk tolerance is all about what you can handle emotionally, and has only a little to do with money (although your money situation can contribute to how you emotionally handle risk).

Before you invest, consider your emotional state relative to risk. Some people have a high emotional risk tolerance. They enjoy the thrill of the “game.” Investing in volatile markets, or taking a chance to make it big, holds a great deal of appeal. (Incidentally, you have to be careful if you have a high emotional risk tolerance but a low financial risk tolerance — it can be easy to get carried away and ruin yourself.)

If you have a high emotional risk tolerance, you can mentally handle risks that others have problems with.

A low emotional risk tolerance, though, can mean problems in high risk situations. Constant worry about what will happen next will eventually take its toll on your own health and on your relationships. While you shouldn’t avoid investing altogether, it is a good idea to stick with “safer” investments, such as solid value/dividend stocks, index funds, and stable bonds.

You will need to overcome your risk aversion to some degree, though, since a very high emotional risk tolerance (leading you only to cash products or low yielding bonds) can cripple your ability to build wealth.

Bottom Line

The first rule of just about anything is “know thyself.” Carefully consider the financial and emotional aspects of your risk tolerance so that you can make investing decisions that work better for you.

Stock Valuation – How To Value A Company

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Stock Valuation – The Relationship Between A Company’s Stock Price and Cash

In another article titled Companies To Invest In, I made the point that, at its core, a well-run company is simply a money making machine. That concept – that the value of a company is ultimately tied to cash – is one of the keys to understanding how to value a company and it’s relationship stock price. Stock valuation are great to get quick snapshot of a company’s value. I’ll illustrate this point with a simple example, and then build on it in ensuing articles.

How To Value A Company – Cash Per Share Example 1

If there were a company that had $1,000 in cash with 100 shares of stock outstanding then you could calculate the value of each share of stock as follows.

How To Value A Company – Acquiring 20% Ownership Example 2

If that were the case and you wanted to own 20% of the company then how much stock would you have to buy, and how much would it cost? The answer is that you would have to pay a total of $200 for 20 shares of stock, which can be calculated as follows.

How To Value A Company – 10:1 Stock Split Example 3

What if the company did a 10 for 1 stock split, meaning instead of having 100 shares outstanding, it had 1,000 shares outstanding? Would that change the value of the company? The answer is no. The company’s only asset is $1,000 of cash, and no amount of stock splitting (or combining) can change that. However, by doing a 10 for 1 stock split the value of each individual share is diluted, going from $10 to $1 per share. So in summary, a stock split affects the value of each share of stock, not the value of the company itself, which can be illustrated as follows.

Now, what if our little company went public and was traded on the New York Stock Exchange? Wow, that’s big time! Wouldn’t that would boost its stock price above the $1 it’s now trading at after the stock split? Not at all! The stock could be traded on the moon, and that still wouldn’t alter the fact that the total assets of the company are worth $1,000, making the value of each of those 1,000 shares equal to $1.

How To Value A Company Using The Terminal Valuation Method

But wait, isn’t just focusing on a company’s cash overly simplistic? After all, there’s no company of any size or consequence whose only asset is cash. While that may be true, at the end of the day, determining how to value a company is ultimately measured in money (or cash) – nothing else. This is known as the terminal value of a company.

The application of this concept is known as the Terminal Valuation Method. To illustrate how it works, say a company’s stock price is trading at a value that suggests the total worth of the company is $10,000,000.[1] How can you tell if this stock valuation is reasonable? One way to go about it is by to pretending that the company sold everything off: its inventory, furniture and fixtures, real property, and so on, until it converted all of its assets to cash. After going through exercise you estimate that upon liquidating all of its assets and settling all of its outstanding debts (or “liabilities”) that the company would end up with $4,000,000.

“It’s Important To Note Stock Valuation Can Vary Greatly Depending On A Number Of Factors Such As: Industry, Maturity Level of Company, Ect.”

What…$4,000,000? Didn’t we say that the value of the company’s stock suggested that it was worth $10,000,000? Does this mean that the company’s stock price is vastly over inflated relative to its true worth? Perhaps, but not necessarily. For example, aside from tangible assets (assets that you can touch) that could be converted into cash, an established company might have valuable intangible assets that would substantially contribute to its ability to make money: established business relationships, a highly skilled workforce, an efficient supply chain, secret formulas and patents, widely recognized brands and trademarks, etc. In short, there can be a lot more to the value of a company than just its “hard assets” such as cash, inventory, property, etc.

However (and this is a BIG however), if a company is being valued at $10,000,000 and yet it would only be worth $4,000,000 upon liquidation, there still has to be a financial explanation for where that remaining $6,000,000 of value is coming from. In other words, what is it about the company that makes it worth more than sum of its tangible assets? If there is a compelling story there – a story that explains how the company’s business prospects, activities and operations are worth an extra $6,000,000 – then the stock valuation of the company can be justified. If not then the company’s stock price is being pumped up by hype and hot air.

Summary

While it’s true that you cannot you cannot fully measure the value of a company based on its hard assets (cash, inventory, buildings, etc.), it’s also true that a company’s value is ultimately measured in dollars. That means when it comes to a company’s stock valuation, cash is king!

[1] This would be the case if, for example, a company’s stock was trading at $50 a share and there were 200,000 total shares outstanding ($50 x 200,000 shares = $10,000,000).

Companies To Invest In – 3 Principles To Follow

Posted on by Ryan

Investing means giving up some of your money now with the expectation of getting even more money in return in the future. Did you catch that? Money. Investing is about money. The bottom line when it comes to investing in stock (or anything else for that matter) is that you want a company that can profitably convert its goods and/or services into cash, lots and lots of cash. Well, isn’t that incredibly obvious? You would think so, but when it comes to identifying companies to invest in, it can be oh so easy to take your eye off the ball. Following are 3 principles that can help you to avoid getting distracted and maintain an investment-oriented focus for deciding which companies to invest in.

3 Principles For Finding Companies To Invest In

Principle #1 – Don’t Confuse Investing With Donating to a Cause

When considering investing in a company’s stock it’s vitally important to distinguish between evaluating the company vs. considering the companies valuation. To evaluate a company means to consider its overall suitability as an investment and to otherwise determine whether you’re comfortable with it. In other words, I don’t ever recommend investing in a company if you have a problem with the kind of business they’re in, or the goods and services they produce. For example, if you think smoking is bad for society then by all means don’t invest in a cigarette company, no matter how well you might think the stock will perform. Having said that, once you’ve evaluated a company and determined that you don’t have any ethical or moral problems with its business, it’s then time to consider the valuation of the company, or how much it’s stock is actually worth in dollars.

“Find Companies To Invest In That You Don’t Have Any Ethical or Moral Problems With It’s Business”

This is an important concept, because people sometimes confuse investing with donating to a worthwhile cause. For example, if a company is pursuing green initiatives such as clean energy, there are certain people who will almost blindly pour money into it. Is that a wise or unwise use of money? It depends. If your intention is to “invest” in a clean energy company without a thorough analysis of its business prospects then you’re acting unwisely because remember, when investing, the question you’re asking is not whether a company can save the world, but whether they can bring their products to market and generate a pile of cash in the process. On the other hand, funding a clean energy company can be a good use of your money even though it may be years away from producing a commercially viable prototype if your primary intention is to help the environment and profit is an afterthought (or not a consideration at all).

In summary, when looking for companies to invest in I think we would all like to invest in companies that both benefit society and would make us a lot of money in the process, but the reality is that such investment opportunities are few and far between. In other words, most companies aren’t out there saving the world, but they’re not destroying it either. Instead, they’re usually somewhere in between, trying to make as much money as they reasonably can by selling their products and services within the confines of the law and their business practices. For that reason, my recommendation is that if you intend to use your money to donate to a cause that will help society then by all means do so, but temper your expectations of getting anything (or even nothing) in return. On the other hand, if your intention is to invest in a company’s stock with the expectation of a solid financial return, make sure to keep your focus on the profit generating aspects of the company.

Principle #2 – Investing is About More Than Products, Services and Technology

Again, investing is about making money; it’s not about products, services, or technological advances in and of themselves, no matter how groundbreaking, novel, beneficial or noteworthy they may be.[1] To illustrate, I was once doing onsite professional work at a company. During one visit I noticed that an employee had a yellow sticky affixed to their computer on which they had written the most popular, trendy dot.com companies of the day – companies whose stock had skyrocketed even though they had no proven profit-making business models. We talked for a minute and I said, “I noticed you’re a big fan of dot.com companies.” The person said yes, and that they were an enthusiastic investor in them, to which I said, “Aren’t you concerned about the high valuations of these companies, even though they’re not making money?” To that the person said, “It’s not about valuation, it’s about revolution.” Upon hearing that my immediate thought was, “SELL! Everybody sell your dot.com stocks now!”

Why my reaction? Because it became clear to me that the whole dot.com-induced investment mentality had become so enamored with the life-changing technologies bringing on the Information Age that it had become unhinged from financial reality. But like any other law, financial reality cannot be defied forever, and not that long afterwards the vast majority of the dot.com’s burned through the remainder of their cash and crashed in spectacular fashion, leaving only those companies that had focused on realistic, workable, and sustainable profit-generating activities (Amazon and eBay, for example). The lesson? Remember that investing is not-about the products, technology, or services of a company, but whether a company can covert its products, services, or technology into more money (profit) than it costs to generate those products, services or technology!

Principle #3 – Don’t Buy into the Hype (or sell due to a lack of it)

When deciding which companies to invest in you may begin to notice that companies can be hip one day with a high-flying stock price and fall out of favor the next leaving their stock in the tank. Does that make sense? Does the financial outlook of companies really rise and fall so quickly? While it is possible, in the short-term a company’s stock (and the market itself) can frequently be driven by a herd mentality. Warren Buffet has a great quote that summarizes this concept: “In the short run, the market’s a voting machine, and sometimes people vote very non-intelligently. In the long run, it’s a weighing machine, and the weight of business and how it does is what affects values over time.”

In other words, over the long haul investing isn’t a popularity contest. No, in the end investing is about substance (or “weight”), or how much profit a company can churn out over time. So don’t get caught up in the hype and buy into a company just because it’s the latest market darling (you’ll likely buy too high), and don’t abandon ship just because a company is getting beat up in the media for making an understandable mistake (you’ll likely sell too low). Instead, step back, get some perspective, consider the big picture, and base your investment decisions on a company’s medium and long-term profit potential.

Summary of Companies to Invest In

When you boil it all down, all well-run companies have at least one thing in common: they’re trying convert their goods, services, and/or technology into as much cash profit as they can in accordance with the law and their overall business principles. In other words, at their core, companies (or any other kind of investment) are capitalistic, profit-centered money-making machines. If you don’t remember that then I don’t think you can ever properly judge the actual monetary value of a company’s stock. So, to maintain that investor-oriented focus, keep the following 3 things in mind:

While reviewing companies to invest in don’t invest in companies that you have moral or ethical problems with, but don’t confuse investing (making money) with donating to a cause (benefiting society).
Investing is about more than products, services or technology; it’s about efficiently converting products, services and technology into cash.
Investing isn’t a popularity contest; it’s about substance in the form of profits.

[1] Also, don’t automatically dismiss as an investment opportunity what may on the surface appear to be mundane or “boring” company. Fortunes have been made in the garbage collection business, and Gillette has made billions by cranking out massive quantities of sharp little strips of steel called razor blades!