An Introduction to Investment and Personal Financial Planning
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Scientific genius Albert Einstein was sufficiently impressed by compounding to describe it, according to varying sources, as: "the eighth wonder of the world", "one of the most powerful forces in the universe", and/or "the greatest mathematical discovery of all time".
If Anne Scheiber had drawn the income from her investments and spent it her final portfolio valuation would have been considerably less than $20 million.
Compounding describes the effects of re-investing the income from an investment. Imagine $1000 invested at a return of 5% per year. After 10 years with compounding would be worth $1559.08 compared to $1050 without. After 20 years compounding would yield $2539.58 compared to $1100.
The moral is that if you don't need the income from your investments, particularly in the early growth years, re-invest it.
Investment v Trading
The difference between investors and traders is that of timescale.
Investors seek to build assets over time. While investors should certainly monitor their portfolio, and economic events in general, and move failing investments into those with greater potential return they don't monitor markets minute by minute.
Traders operate on a much shorter timescale. They take positions for days, hours, or even minutes which they hope to close at a profit. Traders often employ margins which allow them to trade many times more than their own capital. The leverage afforded by margin trading allows gains to be magnified, but also losses. Traders not only need to make a profit on their trades, but to make sufficient profit to overcome dealing costs. Trading is a specialized activity, requiring much time and effort. It should not be attempted by those simply seeking to build assets.
The growth of the Internet in recent years has had a massive impact on the world of investment.
Firstly, the Internet has unleashed numerous online execution-only brokerage services, all competing against one another in terms of price. This is good for the investor, since previously bloated brokerage commissions have now been pared to the bone. Thus, the world of trading (as opposed to investing) is now open to the individual operating on a home computer.
The second effect of the Internet is the proliferation of timely information now available to everyone. Thus the small investor/trader can compete on a level playing field with the institutional giants. However, individual and institutional investors now face the potential problem of information overload, ie being faced with more information coming at them faster then they are able to deal with, though this is a "nicer" problem than the information drought previously faced by lone players.
One particular market that has been opened up to the little guy by technological change is foreign exchange (FOREX) trading. Home computers can now easily run sophisticated trading platforms giving individuals access to this massive, highly liquid, 24 hour a day market. Brokerages are keen to secure the custom of individuals and are offering leverage of up to 200 making this market one of the most potentially lucrative for the sole trader.
Fundamental Analysis v Technical Analysis
There are two schools of thought concerning the analysis of potential investments, fundamental analysis and technical analysis.
Fundamental analysis is concerned with the analysis of all relevant financial and economic data connected with the proposed investment. This includes the particulars of the investment in question, ie financial statements, order books, competition, sector prospects etc. It also includes data and events from the wider economic, social and political environment in which the investment exists, ie interest rates, inflation, unemployment etc.
The main problem with fundamental analysis is that everyone else has access to the same information as you (plus all the information you didn't find or take account of), so the conclusions you reach (or more informed ones) are likely to have already been reached by the market as a whole and thus already reflected in the price of the investment, ie you can't win through fundamental analysis alone.
Technical analysis is the belief that an investment's price already reflects everything there is to know about the investment and the factors affecting it. Therefore there is no need to study anything more than price. Furthermore, technical analysts (aka technicians. chartists) believe that price movements tend to follow patterns and that by studying past price movements it is possible to predict future movements.
Technical analysis does not only study price movements, but also volumes of stock traded, as well as open interest (ie number of open options/futures contracts). Patterns of significance to technical analysts include the colorfully named "head and shoulders", "double top (or bottom)", "flags", and "pennants". Other indicators include resistance and support levels, moving averages, and the "relative strength indicator".
Technical analysis is highly controversial topic with many believing it as useful as reading tealeaves. Successful investor and academic Burton Malkiel, author on investment classic A Random Walk Down Wall Street, has conducted extensive research into its effectiveness and is scathing in his analysis. However, prices do tend to move in trends, and it may be that SOME technical analysis indicators are beneficial in the SHORT TERM.
The very fact that many investors do attempt to base decisions on technical analysis may make this somewhat esoteric discipline a self-fulfilling prophecy, ie when a particular pattern emerges lots of people buy or sell, thus making the outcome of the pattern actually take place.