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Ten Fundamental Rules of Investing (stocks) by Eric Schkolnik EX: never borrow money to invest (and here's why)

Updated on July 25, 2011

Eric Schkolnik and his book "When Buy Means Sell"

Eric Schkolnik wrote the book "When Buy Means Sell" after the dotcom crash in 2002, when Enron and other scandals proved that analysts in Wall Street are often guilty of exuberance. Here are his ten fundamental rules to help you invest wisely.

Money and Investing
Money and Investing | Source

1) You Can Lose What You Don't Have (If You Borrow)

Never invest in the stock market what you can't afford to lose. And you don't want to lose something that doesn't belong to you.

If you don't invest what you don't have, you can't lose what you don't have.

In other words, do NOT borrow money to invest. And "margin" is borrowing. So is "shorting".

2) Margin Threatens the Success of the Long-term Investor

Investment houses WANT you to use your margins, because they make a LOT of $$$ off of that. They can borrow money from the banks at prime rate, but they charge you a MUCH higher rate for your margin usage. The difference is their profit.

They can always do a margin call on you so they can't really lose much. And if things go badly, you are the one ending up with no stock, no money, and a huge debt, not them.

3) Shorting Stocks Can (and Most Likely Will) Leave You Short

Do you know how "shorting" a stock works? You 'borrow' the stocks you intend to short from the brokerage, sell it, pocket the money, then hope to buy it back later at a cheaper price, thus you keep the "difference". Thus, remember, you are selling something you don't have, and thus, you can LOSE what you don't have!

Shorting a stock is risky because your risk is actually infinite. Why? Read carefully.

Let's say, you buy a stock for $10, and then the company goes bankrupt (stock is now worthless). How much have you lost? $10. You can't lose any more than $10, right?

Let's say, you short a stock at $10, then the company announced some breakthru, and their price doubles. How much did you lose? $10.

But keep in mind... 0 can't go any lower, but going UP can go a lot higher. What if instead of just doubling in price, the company quadruples in price to $40? Now your loss is $30! And theoretically speaking, there is no limit to your loss.

And remember rule 1? You can lose a LOT MORE than you put in if you borrow, and shorting is borrowing.

4) Investing in IPOs is a Trap

Any one still remember Palm? The folks who made PDA popular? In late 1990's Goldman Sachs underwrote their IPO for $38 per share. The actual closing price on their first day of trading is $126. A few days later, their price surpassed $165 per share, giving them a market cap LARGER than General Motors! A year later, Palm is trading at about $7.

Albeit this is just ONE example, but similar incidents are plentiful in the late 90's when the dotcom boom was in full swing.

What you may not know is that the underwriters actually assigns blocks of those shares to their best customers (mutual funds, other brokerages, banks, etc.) with additional agreement that a) they can't sell their allocated shares for a certain period, and b) they need to buy MORE SHARES on open market when the market opens. This basically creates artificial shortage of the stocks, and thus driving up prices, which makes news media report it more, thus creating MORE frenzy buying, which also drives up prices. As a result, many IPO underwriters were sued for illegally manipulating the market with those agreements.

5) Things Are NOT What They Seem

While the insiders, such as company execs, buying shares in their own company is usually a bullish sign, that the execs are confident in their own company's future, that can now be manipulated. How? the execs actually "borrow" money from the company to buy their own stocks, with a certain "forgiveness" clause written into it. We the outsider sees insider buying stock. What actually happens is the company is artificially generating these records by using its own execs to generate stock sale records without actually moving any money.

When a company issues stock, a lot of it is actually kept by the company itself, so it counts as "asset". When company exec borrows money from the company to buy the company's stock, the company "loses" the shares as asset, but gain the amount back as "debt". So net asset change is ZERO, as debt owed is also asset. Company's asset and financial situation did not change much, yet we outsiders see "exec buying own company stock" and think "exec confident about company future", when it may not actually be the case. It may just be market manipulation.

6) The Risks May NOT Justify the Rewards

Mergers and acquisitions are NOT always wise, and often, downright foolish. (Peter Lynch called it di-worse-ification, when two companies that are NOT in similar businesses decided to merge.) One prime example was the America Online merger with Time Warner, but there are many others.

When one company chooses to merge with another, you may want to consider getting out of BOTH just to see what happens, unless the company doing the acquisition is already huge, and has good track record merging its acquisitions into its corporate structure. Merging two separate companies always involve a lot of risk, to the companies and employees, as well as to the shareholders.

7) Buyback Gets The Company on the Right Track

There are two and only two ways to increase price of a company's stock: increase demand, or reduce supply. Buyback of company stock reduces supply and thus increase price. However, it is also beneficial in other ways. Buybacks reduce outstanding shares, and thus, also increases earning per share, which will also lead to increased demand, and thus, higher stock prices!

Also, consider that a company must have excess cash to do buybacks, which means they must be doing pretty good in their business! Buybacks with dividend increase is even better.

8) Beware of Stock as Dividends

Usually dividends are paid in cash. However, some companies do issue dividend in shares of their own stock instead. This is essentially a "partial stock split", and thus does not really help investors, but make the shares value less.

Why split stocks at all? The "common wisdom" is based on psychology, not reality. The idea is that investors buy shares in 100 share lots/contracts. Thus, if you have $2000, you may entice them to buy 100 shares at $20 instead of 50 shares at $40, even though you get exactly the same thing. Even then, not all companies subscribe to this "psychology". Berkshire Hathaway, Warren Buffet's company, has a huge stock price because they don't split their stock at all.

9) Magic of Diversification Is You Do It Every Day

Diversification may be for the ignorant, according to Warren Buffet, but compare to him, we are all ignorant when it comes to investing. And diversification can be a powerful tool for risk management.

Risk management is maximize control over the parts you CAN control, while minimize the parts you CANNOT control. Think of it this way: you cannot control how others drive on the road. You can only control how safe you are driving (speed limit, seatbelt...), and how safe your car is (properly maintained, tires...). You don't just control ONE of the risk factors, but you try to control as many of them as possible. That's diversification. Same in investing.

Thus, the idea of "buy more of this stock when the prices are down" is bad for you because it increases your exposure to risk instead of decreasing it. Think about that. What sort of factors can you control?

10) Investigate Before Invest

Invest-igate, get it? There is this thing called "due diligence" before you invest. That's investigate. Study the investment thoroughly, or else stick to index funds. That way you can blame the market instead of your lack of preparation.


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