A Brief Forward

Dear Investor,
Investing wisely is not just about looking for good shares to buy. There are many questions to consider. How many companies should I invest in? How many stocks should I buy? When should I buy and when should I sell?

We hope that this section helps you find better answers to these questions.

Yours always,

Tradingmalaysia
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Great Resources
Before we get started here are some links to great resources.

Motley Fool - This site contains more than just information about investing. It is a great place to learn about money in general and how to manage your personal finances. Before I even knew anything about investing I was learning a lot already from this site. It is a great primer to develop the correct attitude to money.

Investopedia - This is an encyclopedia. Everything you need to know. But this is more of a resource. If you hear me using any terms which are unfamiliar with you should be able to find it here.

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Introduction to Risk and Reward
Every investment has a risk. The greater the risk, generally the greater the reward. Assets ranked in terms of risk are: cash - bonds - property - equities.

Time is also an important factor. The sooner an investor needs his money, the shorter his investment time frame becomes and consequently the lower the risks he should take (think about your son’s school fees next month compared to you pension investment).
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The Importance of Asset Allocation
With the 2 key concepts above, the following general observations can be made:

1. Every portfolio should consist of those 4 asset classes (or variation of them).

2. How much is invested in those 4 asset classes depends on the risk / reward appetite of the investor.

3. An optimum portfolio will contain not only contain investments in the 4 asset classes, but the assets themselves will complement each other to an extent that the whole portfolio will produce the best performance given its risk. This is called an “optimum portfolio”.
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Constructing an Optimum Portfolio
The performance of a portfolio is measured not only in terms of how well it does, but also in terms of how badly it does when the market goes down. A perfect portfolio will go up when the market is up, but hopefully stay up when the market does down (or not go down as much). It will also be less volatile. But how can one achieve that? The secret lies in being able to pick the correct shares and assets as well as the amount to buy. And one of the ways to determine is it by studying their “correlation”.

Correlation is calculated using historical prices and measures the extent to which one stock moves in relation to another. Typically, fund managers compare correlations between individual stocks and some type of general index. A score of “1″ means that the stock is perfectly correlated, such that the movement in the index will mean that the stock will also move by some proportionate amount. Anything greater than 1 means that the stock will move by a greater disproportionate amount and anything less than 1 means that the stock will move by a smaller disproportionate amount.

An easy way to measure correlation would be to put stock / index prices next to each other on a spreadsheet and use the “correl” function in excel (e.g. type in ‘=correl(A1:An, B1:Bn)’ in the relevant cell to compare correlations between stock prices in column A1 to An and B1 to Bn.

A very simple example of highly correlated stocks are Maybank and Commerz. These are in the same sector and susceptible to the same risks. However it is less so the case with Maybank and Genting as they are in different sectors. A prudent investor may choose to hold Maybank and Genting as opposed to Maybank and Commerz.

It’s important to realise that this is only a historical measure, so just because something is or isn’t correlated in the past doesn’t mean that it will share the same correlation in the future. Also, correlation is not so meaningful for stocks trading in low liquidity. This is because it is meant to show how company prices react to the same factors which affect an index. Needless to say, if a stock price moves purely as a result of trading (e.g. sale or purchase of a large block of shares by an institution), it is moving as a result of a factor which will not affect an index, so its correlation to the index will be distorted. This is one of the major weaknesses of studying correlation and one of the reasons why active selection is a more widely favoured approach for emerging market stock markets.

In this section we will discuss general ideas on this topic and go onto some more advanced, scientific methods to arrive at the optimal portfolio.

Relevant Posts
Asset Allocation - A quick and dirty view on how much money one should invest, how much to put into stocks vs cash or other assets and how much to put into short term vs long terms trades. (Note that there are alternative, more scientific ways of doing this which we will write about soon.)

Constructing A Core Portfolio - Another general view of how to think about what to put in your core portfolio.
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Active Stock-Picking Techniques

There are very many ways to pick stocks and many books have been written on the topic. However, all of them try to do the same thing - find stocks with share prices which will rise in the future and there are 2 approaches to this.

The first is technical analysis and the second is fundamental analysis.

Technical Analysis

Technical analysis is by far the easiest of all the techniques for analysing share prices. It does not look at the intrinsic value of a company - only historical share prices. By comparing current prices and their trading ranges (open, high, low, close and volume) technical analysts try to look for patterns or evidence of the psychology in the market. What are buyers and sellers thinking.

The main disadvantage of this approach is that it is subjective. Also, technical analysis cannot be deployed on its own without sound money management techniques, which is why I believe that successful analysts make good gamblers too as they develop an instinct for controlling such risks. The secret to being a technical analyst is not just being able to identify entry and exit points, but also knowing how much money to put into a trade. In poker parlance, this is called ‘bet sizing’. Which is the same principle.

I will go into some more specific techniques later.

Fundamental Analysis

Fundamental analysis is by far the harder of the two techniques. It tries to measure the intrinsic value of the company by asking fundamental questions such as: Is this company cheap and what is its potential for profit? These analysts don’t time their trades. They just go in when they perceive that there is value in the stock, regardless of the price or its recent trading behaviour.

The main disadvantage of this approach is that it is extremely time consuming and requires access to balance sheets and financial reports. In some cases it requires access to the company itself! Also, just because there is value in a stock does not mean that the stock price will go up. Many ‘value’ stocks can lie undiscovered for years. Therefore, good fundamental analysts look not only at the balance sheet itself, but also at the extent to which the company is or will be noticed by the investment community, and what other analysts are saying.

Another disadvantage with this approach is that different companies report their numbers differently. Therefore it can be difficult to compare one company against another. This is even more the case where the companies has different businesses, like in Malaysia.

This is why the concept of the “ratio” is important in fundamental analysis. This normalises numbers so that it is possible to compare one against another. The most common number is the PE ratio - which compares prices against earnings.

Tradingmalaysia has a method of valuing stocks which is based on Harry Domash’s book “Fire your analyst” and can be found in the Company Scorecard section.

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Trading Notes
Commissions eat into your portfolio. They are the single biggest reason why mechanical trading rules tend to underperform most of the time.

Trading out of emotions are also another big way to lose money. That is because the primal instincts that drive us naturally put us in a losing position when it comes to trading. Greed causes us to buy high and fear of losing stops us from buying low.

Here we will explore how to ensure that we trade more effectively.

Relevant Posts
A Note On Technical Analysis - a brief description of what it is and how to use it.
Managing Costs - discusses why and how one should keep ones trading costs to a minimum.
How to use stop-losses - This is a link to a post by another blog. Very useful!
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Popular Myths
In this section we breakdown some popular myths.

1. Trade High PE Companies - They have a high PE for a reason.
2. Buy Malaysia - It’s cheap compared to other countries
3. Investing in blue chips will not make you rich