WHAT TYPE OF INVESTOR ARE YOU?

When you are new to the stock market and seeking a way to maximise the benefits that can be obtained from trading, it is important that you understand your profile as an investor before you begin investing. In order to ascertain your investor profile, you must consider your goals as an investor, how much you have to invest, your time outlook with regards to investing, and your risk tolerance.

Investment goals

It is important to work out what it is you want from your stock market investments and this should help you to work out your profile as an investor.

Are you looking for solid 15% gains over a year, or are you looking to double your money in a year in the stock market? Whatever the case, your goals should be realistic. There is no point in wanting to make 100% on your money in a year if you are unwilling to accept any substantial risk.

It is obvious that the higher risk an investment is, the greater potential rewards it offers and the lower risk an investment is, the smaller potential rewards it offers.

Therefore, your goals as an investor will largely sort themselves out when you have determined your risk tolerance, your time outlook and how much you have to invest. Obviously, if you have only $5000 to invest and your risk tolerance is low, it would be foolish to expect to become a millionaire in any short period of time.

However, if you have $400,000 to invest and you are willing to accept a decent amount of risk, it is not unreasonable to expect to make a million dollars.

Amount to be invested

This is obviously a crucial element when it comes to determining what sort of investor you are and what sort of risk you are willing to assume.

If you have $5000 to invest, you would most likely have a low risk tolerance, whereas if you have $1m to invest, you can afford to spread your portfolio over a range of stocks, some low risk and some more speculative.

How much you have to invest is really worth considering in light of the risk that one is forced to accept to an extent, and also in light of your expectations, as it is obvious that you can achieve more with $300,000 than you can with $3000.

Time outlook

There are basically three types of investment: short, medium and long term. The three different types of investments require differing degrees of consideration and attention.

It is very important that you invest in a way that is consistent with the time and effort you spend at this task. You should develop a system that suits your personality, your financial circumstances, investment objectives and particular needs.

It is no good having a short-term outlook if you can't put the time into the market on a daily basis and are not able to move quickly. And it is no good having a long-term outlook if you can't help looking at the market and checking your holdings every day.

Short-term investors

Short-term investors should watch the markets daily. They should be prepared to enter and exit trades quickly and effortlessly. One must be able to take a loss when a trade is not progressing as anticipated. Short-term investors should also be able to take profits. A short-term investor or trader must be prepared to exercise vigilance in watching market developments.

Medium-term investors

Medium-term investors generally measure investment periods in months, up to about two years. Fundamentals and timing are the main issues and buying at the correct price will affect annual returns significantly.

Long-term investors

Long-term investors basically ride out the cycles and accumulate good shares. They rarely sell and don't worry about medium- to short-term downward moves in the market.

Remember, over the long run, the market has always gone up and will continue to do so. Hence, it is more about time rather than timing.

The major focus of a long-term investor is to be confident that the shares they are holding are, and remain, blue chips. Secondly, these investors should always be looking to add capital to their portfolios.

Finally, they should definitely refrain from watching the markets daily, because there may be several times over a decade or so when their positions aren't looking healthy, but short- to medium-term aberrations aren't of any consequence to the long-term investor who is holding blue chip shares.

RISK (AND RETURN)

This brings us to the topic of risk. Risk is an incredibly important concept to consider when it comes to investing. The Rivkin Report's investment philosophy revolves around a risk/reward ratio style of investing, and we persistently counsel investors to consider the downside of an investment first.

This is because risk is a concept that is greatly misunderstood and neglected by investors. Understanding the risk of any investment, your personal tolerance to risk, and how to minimise risk is essential if you are to begin investing. Your risk tolerance will depend entirely on your financial situation and on your goals as an investor. So determining who you are is the first step that you must take.

Once you know who you are and what you want out of investing, you can assess your tolerance to risk and you can then build a portfolio accordingly. This is where we return to the concept of risk versus reward. You should be aiming for the highest return (your reward) possible at an appropriate comfort level (your risk tolerance). And different investments offer different risk/return ratios.

Obviously, if you have a high tolerance to risk, you can aim for higher-risk investments, which in turn offer higher potential rewards. If, however, you have very low risk tolerance, you will aim for low-risk investments, which offer lower potential rewards.

The comfort zone, or risk tolerance, can be broken into roughly five groups.

• Conservative
• Conservative to moderate
• Moderate
• Moderate to aggressive
• Aggressive

Working out which category you fall into shouldn't be too hard. If, for example, you have painstakingly saved $10,000 over many years of hard work, and you are looking to make it grow and to start a family, you would be somewhere in the conservative to moderate range.

However, you may be someone who has multiple assets and investments, and are looking for high growth in a shorter time frame. In that case, you would be moderate to aggressive and hence, your investments could be somewhat exposed to the higher-risk end of the spectrum.

Working out your risk tolerance is one thing. However, it is also important to work towards minimising risk, and by investing with The Rivkin Report's guidelines in mind, you will be doing so. Minimising risk is also achievable through smart capital allocation and diversification.

TRADING WITH DEBT

The use of debt in your investing is like a turbo charger to your driving; it increases the upside performance but if things go wrong, the crash at the end is much bigger too.

Debt is a tool that increases risk in the investment process. Therefore, it should only be used by those with the adequate skills and financial position to live with the risk and use it properly. Sound investing is tough enough without increasing the stakes with debt.

So, if you are not sure if you should be using debt for investing, then you are probably not ready. This is a decision that requires a strong understanding of the investment process and financial management, including the taxation implications.

There is no doubt that there are times when using debt is appropriate for experienced investors. But until one has acquired the knowledge and skills to use the turbo charger, it is probably best to avoid it and develop your investment skills without the extra risk of debt.

BUILDING A PORTFOLIO

After gaining an understanding of The Rivkin Report's investment principles, you may want to begin building a portfolio, but first of all there are a couple of important things to consider in doing so.

Capital allocation

Capital allocation is a critical part of successful investing. Yet, how to allocate your hard-earned capital is one of the greatest mysteries to any market newcomer.

Many members to The Rivkin Report have asked how they should go about allocating their capital to our recommendations. Obviously, giving specific figures to follow is impossible. How much you put into each share you invest in will depend on the share itself, your overall profile as an investor (risk profile, time outlook, personal goals, etc.), how much capital you have, and so on. To help guide members, The Rivkin Report issues capital allocation guidance with each new recommendation.

Diversification

Diversification is the other important issue to consider when building a portfolio. Often, if you have $20,000, for example, it would be better to invest $4000 into five companies, rather than $20,000 into one company, or $10,000 into two companies. The reason for this is that by diversifying, you are effectively lowering your risk.

Diversification works in two ways. Firstly, by reducing the chances of being overexposed to a bad situation and secondly, by increasing the chances of being exposed to a profitable situation. While it is difficult to pick which sector will perform, having a diversified approach will enable you to be exposed to the sectors that are performing well.

Junk collecting

It would seem that taking losses is the hardest thing for most investors to do. At The Rivkin Report, when we concede a mistake and suggest taking a loss in a stock, we find that most members are reluctant to take a loss. This is probably the single biggest mistake we see in our members' investment habits. This unwillingness to take a loss leads in one direction… to junk accumulation.

Just think about it. If we make both good investments and bad, as all investors do, and take profits on our good investments but hold our poor ones, what happens? We end up with a portfolio of losses and poor quality investments.

The excuse "I can't sell because I am losing too much money" is the absolute incorrect view. We should be looking at all our losing investments regularly with an intention of getting rid of the investments that are not performing and keeping the ones that are doing well. To do the opposite is just junk collection, not investing.

Stop losses

Stop losses are mechanisms, implemented by the investor, designed specifically to limit risk and minimise losses when trading. A stop loss, specifically, is a point at which a long position is sold out or a short position is bought back. The size of the loss is a predetermined amount, which is dependent upon the investor (their risk profile, their time outlook, the size of their portfolio, etc.).

An example of a stop loss in a trade is as follows. If a speculator buys $10,000 worth of Qantas (QAN) at $3 as a short-term speculation, they may decide to sell if the share price drops 10% below the purchase price. Therefore, if QAN hits $2.70, the speculator will automatically sell their holding, without hesitation and without considering the likely future performance of the stock.

This stop loss serves two purposes. Firstly, to make sure that losses never become so large as to inhibit the speculator's ability to trade (by too much money being lost on one trade); and, secondly, to remove the emotion from the decision-making process.

So if you are the kind of investor who can't stand the pain of being down a substantial amount in a trade, or if you are a short-term trader who can't afford to have your capital tied up in a falling company for the medium to longer term, you may want to consider implementing stop losses.

BUYING SHARES IN A FLOAT (IPO)

When a company wishes to float, which basically means be listed on the stock market, it must prepare a prospectus, which is simply a legal document that outlines the history, operations and financial situation of a given company. The prospectus must be lodged with the Australian Securities and Investments Commission (ASIC) and ASIC must approve it before shares can be offered to the public. All companies seeking an IPO (initial public offering) must follow this procedure.

Once the prospectus has been lodged and the company is approved for listing, the prospectus must be made available to the public. This enables potential investors to have access to all information required to make an informed investment decision.

If it is a large company that is floating, such as Telstra or the Commonwealth Bank (which were Government-owned before they listed), a multitude of media advertisements inform the public of the upcoming float. If it is a small, speculative company, it may only be publicised in the financial press or by the stockbrokers underwriting the float.

There are two major reasons why companies go public (float). Firstly, a company may float in order to raise capital to expand the business itself. Secondly, it may be used as a sale strategy by the shareholder(s). This was the case with the Government floats, such as Telstra and the Commonwealth Bank.

As with any float, it is important to read the prospectus, to understand what it is you're investing in and to be fully aware of the potential downside. Also, don't be afraid to ask for help in reading and understanding the prospectus. These are often arcane, complex documents, especially for beginners.

Despite what some people believe, not all floats come on at a profit. Many floats come on at a substantial discount to the issue price. This may not depend on the company, but rather on the prevailing state of the market at the time.

How to read a prospectus

For the beginner investor, reading a prospectus is very daunting, often leaving the investor confused and mystified, rather than informed. A prospectus, as mentioned already, is simply a legal document that outlines the history, operations and financial situation of a given company. A prospectus must be lodged with ASIC, and ASIC must approve it before shares can be offered to the public.

A prospectus generally includes key information on the float (the main details, dates and so forth), a chairman's letter, an investment summary, a business description, other financial information and accountant's reports, a list of the proposed directors, any additional information and an application form.

One thing to mention is to always be sceptical and scrutinising when it comes to prospectuses - particularly if it is a prospectus for a start-up business, as the prospectus is pure guesswork and these ventures are often established to make the promoters richer and the public poorer. If you feel some details are questionable, or some questions are left unanswered, don't hesitate to contact the company. They are obliged to provide you with any information regarding the business and the float. Don't forget that at the end of the day, the information provided in the prospectus is all you have to go on to make an investment decision.

Here are the things to look at when analysing a prospectus and, hence, an IPO.

• The first thing to ascertain is the market feedback. This can't be found in the prospectus: rather, it will require some outside research and investigation. Are the shares being heavily applied for, or are they relatively untouched? What does the market, the financial press, brokers, etc. think of the float? By ascertaining how many shares are being taken up, you receive an indication as to the sentiment relating to the float.

Following what the market thinks is very important: it is the biggest factor in determining whether the opening day will present an opportunity for a good profit.

• The next thing to examine is the sector that the company is in and the general market strategy. For example, if a company was floating, and it was in the renewable energy sector, you would have to be cautious, as this presents a somewhat high-risk opportunity (as alternative sources of energy are as yet unproven in terms of their viability).
• Then, look at the management's and the board's track records. It is important that the people running the company are honest and capable. Something to look out for is management below the age of thirty. Experience is important, and it's unlikely that a twenty-five-year-old will have enough experience in running a company well.

Apart from age, the other thing to look out for is, obviously, any criminal record or illicit past of any kind. In addition, do enough research to confirm that the management and board don't include people who have a dubious history with other listed companies.

• Moving along, it is also imperative that you examine the earnings history and the projected earnings for the short-term future. Have a look at the size (in relation to company capitalisation) and reliability (consistency) of the earnings. Furthermore, make sure you do a little research and compare these earnings to the earnings of other companies in the same sector.

Also have a look at the P/E ratio of the company, and compare this ratio to other companies in the same sector. This will at least give you some basis for comparison.

Another thing to examine is how the company performed in bad times. A company whose profits are down only 5-10% during a recession is reassuring in terms of its resilience to adverse conditions.

• The next thing to look at is how the funds, raised through the float, are going to be used. Do the projects and strategies make good business sense? If the prospectus is vague as to how the capital is to be used, then be suspicious. Is the money going to be used to buy out the controlling shareholder? This is a warning sign.

The reason for this is that if the directors and/or major shareholders are selling out completely, it doesn't really reflect their confidence in the business. This applies only to a complete sell-out. Obviously, if the major shareholder has a $100m holding, and is realising $10m worth via the funds raised, this is of no concern.

• Finally, have a look at the balance sheet and try to ascertain the risk of investing. The company's net asset position, compared to the proposed listing capitalisation, gives an indication of the safety of the float. The closer the NTA is to the capitalisation of the company, the safer the investment. If the NTA is very low, then the company being capitalised much higher poses a riskier proposition. Also, have a look at the debt-to-equity ratio. This figure is used to assess the amount of borrowing compared to the shareholders' equity. The lower the debt-to-equity ratio, the less likely that the company will go broke.

So a company with a 100% debt-to-equity ratio has more chance of going broke than a company with a 30% debt-to-equity ratio. So look out for companies with favourable debt-to-equity ratios, compared to other companies in that sector. For example, if a company's debt is $30m and its equity is $100m, the company has a debt to equity ratio of 30% ($30m ÷ $100m, which equals 0.3, or 30%).

Summary

All this is the nuts and bolts of what you should keep an eye out for when looking at a prospectus, with a view to making an informed investment decision.

The variables to consider are market feedback, the company sector, the management and board of directors, earnings information (P/E ratios, etc.), the planned business strategies and the balance sheet (and debt-to-equity ratio, etc.).

Undoubtedly, there will be parts of a prospectus that you don't understand, and so it may be wise to consult an investment professional. However, for a basic understanding of what to look out for and what it means, the previous guidelines should be of some assistance.

Follow the leaders

This is a very easy and sensible rule. As already stated, follow people such as Frank Lowy, Gerry Harvey and Solly Lew. There are numerous examples over time where following these gurus into a share has proven extremely beneficial to the average investor.

Following the leaders into a stock is one component of this rule. The other component is following leaders out of stocks. Solly Lew selling out of Coles Myer (CML) is one such example. The corollary to the rule of following the leaders is that you should follow them, but only in their field of endeavour.

SMART BUYING AND SELLING

Having attained an understanding of risk versus reward, there are a few 'tricks of the trade' worth learning when it comes to buying and selling shares. They all revolve around the concept of evaluating the risk/reward ratio and they might just end up saving you money on the market.

I have already explained the terms 'bid' and 'offer'. The bid price is the highest price that buyers are willing to pay for a stock and the offer price (often known also as the 'ask' price) is the lowest price that sellers are willing to accept for their shares.

An understanding of these terms is required before understanding the following basic trading strategies.

Sell at the bid

If you wish to sell some shares, you should sell at the bid price. Sounds bizarre, but I'll explain what I mean. Let's look at an example so I can explain what I'm getting at.

Let's say you want to sell company ABC shares and the shares are at 70c bid, 71c offer. If you want to sell, you should sell at the bid price, which is 70c in this example. Don't be greedy by holding out for the 71c, which is the offer price. I'll explain why.

If you believe it's time to sell the shares and you are correct in doing so (i.e. the share price drops), you don't want to miss out on selling your shares because you were greedy for that extra one cent. If, by trying to sell at the offer, your shares don't get bought and the share price drops, you miss the sale, the shares drop and your downside is however far the share price drops. And presumably you are selling because you think the stock is going to go down, so why risk missing out on selling a stock you think is going lower for the extra 1c!?!

The upside of queuing up at the offer price is one cent only. What I mean by this is that if you queue your shares up at the offer price of 71c and the stock proceeds to go up to $1, you still only get the 71c. You don't have exposure to that upside beyond the extra cent.

On a risk/reward ratio basis, it is simply a poor decision to be greedy for the extra cent. The downside is much greater than the upside, so sell at the bid!

Avoid trading at round numbers

If you wish to buy or sell shares, don't try to trade at a round number, even though it's human nature to do so. Here is an example.

If you own shares in XYZ and you decide you want to sell them at $1, because it's a nice, round figure, offer the shares at 99c instead. You will often find that shares may trade around the round figure, but will struggle to break through it.

One of the reasons for this is that, like you, most other sellers in the market want to sell at the nice, round figure, and so selling builds up at that figure and the shares struggle to break through.

And as with selling at the bid, if the share price goes through the figure and keeps going up, your downside is one cent. If, however, the share price drops, your downside (if you held out for the round number) can be substantial. The downside is much greater than the upside, so avoid trading at round numbers!

Short selling

Most investors buy shares that they think are undervalued, hoping to profit by the share price rising. This is known as being 'long a share'. If you think BHP, for example, is cheap and you buy shares in the hope that they will go up and you can sell for a profit, you are long BHP.

However, some investors 'sell short a share'. They hope to profit by identifying shares they believe are overvalued. They sell shares in the hope that the share price will go down, and they will buy back the shares at the lower level.

Instead of the usual buy low, sell high, short sellers sell high and then buy low, the reverse of being long; hence, it is known as short. Usually, short selling involves the short seller borrowing shares to deliver to the buyer and repaying the borrowed shares when the short is bought back.

When you sell a share short, you don't actually own the shares to deliver to the buyer, so the process of short selling requires you to inform your broker, and many brokers are not even able or permitted to facilitate the transaction. It is tightly regulated by ASIC and only certain shares can be short sold.

Averaging down

If you buy shares in company XYZ at $1.00, and the stock then falls to 50c, you can obviously buy shares at that price if you want to and hence reduce your average. So if you bought 10,000 shares at $1 and then 10,000 more at 50c, your average price is now 75c.

So should you do it? Well, there's no hard and fast rule, as your investor profile and the shares being invested in determine whether it's a sensible course of action.

To simplify the matter somewhat, the following rules generally apply. If you are an investor, that is, you accumulate quality shares and watch them grow over the long term, then obtaining more shares at a cheaper price is a sensible idea, which is not dissimilar to the concept of dollar cost averaging (discussed next).

However, if you are a trader, buying shares for the short-term and following the market trend, it is not the most sensible course of action. Traders generally cut their losses when a position goes against them, rather than averaging down.

To sum up, only average down if it is a quality, blue chip share and if you are happy to have a long-term outlook.

Dollar cost averaging

Dollar cost averaging is a fascinating concept that is probably not entirely understood by investors without much experience.

Imagine the following hypothetical scenario. Let's say you save $100 a month and you invest it in Telstra shares. The month you start, the shares are trading at $10 a share. Your $100 buys you 10 shares. The second month, let's say Telstra has dropped by 50% to $5 a share. Not good news at all! Your $100 now buys you 20 shares.

In the third month, Telstra has rebounded somewhat to $7.50, which is still well below the original purchase price. Your $100 now buys you 13.3 shares. So what is the overall net result at $7.50?

The first and most obvious answer that jumps into your head would be that you are even at $7.50, having bought $100 worth at $10, $100 worth at $5 and $100 worth at $7.50. You work it out on the average price... right? You're down $2.50 on your first lot, up $2.50 on your second lot, and you're even on the last lot.

But, this is wrong! The question is, how many shares do you own? You own 43.3 shares. And how much did you invest? $300 dollars over the three months. So if Telstra is trading at $7.50, your 43.3 shares are worth $325, which leaves you up $25, or 8.3%, in a matter of three months! Funny how that works out, isn't it!

By investing a fixed amount each month, you obtain more shares at lower prices. If you were buying the same amount of shares (simple averaging down) at the three prices, then you would be even at $7.50. However, because you are spending the same amount of money each month but getting more shares at the lower prices, your average cost per share will be lower than your average price per share.

Obviously, this concept does not prove effective in just any scenario. As with simple averaging down, there are two conditions that apply. Firstly, the shares must be blue chip and secondly, you must be in it for the long term.

If you were to employ dollar cost averaging with Telstra, for example, over nine months only, you may well be down. However, over the long-term, the stock market has been shown to rise, and the All Ordinaries going up is effectively the large capitalisation blue chips going up, as it is these shares that make up the All Ordinaries.

Timing

The other benefit to dollar cost averaging is that it takes the problem of timing out of the equation. This is because you are buying continuously, rather than only once.