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The Australian Investors Association

Share Market Investment Course

Introductory Material

The aim of the Introductory Material. This introductory material provides the essential background to investing in the share market. If you have had some investing experience you may need only a little time to review this material. If you have had no previous investing experience then it may take several hours. An understanding of this material ensures that everyone starts the course with a similar understanding. You do need an overview of this material but if there are some sections which you do not fully understand please do not be concerned as these areas can be discussed during the course. While you may wish to print this material, it is convenient if you save it to your computer and read it from the screen. Then you can obtain direct access to suggested URLs simply by holding down the Control key and left clicking the appropriate link.

The References and Other Requirements for the Course.

There is a list of books on one of the early slides on the Power Point presentation. Two of these books will be the basis of part of the course. These are:

Hull, A. (2008). Blue Chip Investing. Wright Books. Nicholson, C. (2009). Building Wealth in the Stock Market. Wiley.

They are both very useful references on investing. If you are interested in buying these books they will be available for sale at the sessions at a 15% reduction on the RRP. In this introductory material we will take advantage of sources on the internet which provide a detailed view of many facets of investing.

Why some Investment Knowledge is Essential

The Australian education system provides a very poor preparation on matters of finance and managing money, so many Australians have a poor understanding of how the investment process works. As a consequence Australians tend to find investing complicated and confusing and they often have no choice but to use investment professionals to manage their assets. It is very unfortunate that in most cases they take no further interest in their investments. With some knowledge of the share market and the investment process, the investor can make sound decisions as an independent investor. If the decision is made to use investment professionals then there needs to be enough understanding of the whole process so that the investor can select and communicate with those investment professionals who are likely to provide them with the best investment performance

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There are seven sections in this introductory material

1. What is the stock market?

2. What are shares, why invest in them, how are they bought and sold?

3. The overall investment strategy: understanding the variables.

4. The investment plan: why this is essential and what is required?

5. Risk and risk management: understanding what the risks are and how to

manage them.

6. The essential tools for investors : technical analysis and fundamental

analysis

7. Software: an introduction to technical analysis software.

1. What is the Stock Market?

The stock market is one of the most important sources of finance for Australian companies and allows businesses to be publicly traded, or to raise additional capital for expansion by selling shares in the company in a public market. Shares are first purchased by investors directly from the underwriting investment bank or stockbroker. This is called the Initial Public Offering (IPO) which is the primary market. Investors who want to sell their shares must then do on the secondary market or stock market. In the primary market (the IPO), prices are usually set beforehand, whereas in the secondary market the basic forces of supply and demand determine the price of the security. Actual trades are based on an auction market model where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. When the bid and ask prices match, a sale takes place. If there are multiple bidders or askers at a given price, the sale takes place on a first-come-first-served basis. Until recently stock exchanges were physical locations where transactions were carried out on a trading floor by a method known as open outcry. Increasingly stock exchanges have become electronic or virtual markets comprising a network of computers where trades are made electronically. The Australian stock market, (the Australian Securities Exchange or ASX) is an automated electronic market known as the Stock Exchange Automated Trading System (SEATS) that started in 1987. The liquidity of the stock market offers investors the opportunity to quickly and easily buy or sell securities such as stocks. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. Participants in the stock market range from small individual investors to large managed funds. In Australia the stock market activity is dominated by managed funds and institutional investors.

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There are about 2000 stocks listed on the Australian market. The major market index (the ASX200) is made up of the top 200 stocks by capitalisation. (The capitalisation of a company is the number of shares of that company that are on issue, multiplied by its current share price.) The ASX200 is now the most important index because it serves as the benchmark for fund managers. The other well-known index, the All Ordinaries Index, comprises the top 500 stocks by capitalisation. Stocks are classified according to their major business type into sectors. Since many investors are looking for a global approach to investing, the sectors are now classified according to an international classification system. This Global Industry Classification Standard (GICS) allows local investors to compare stocks in very different markets by industry classification and encourages foreign investors to enter our market. 2. What are shares, how are they bought and sold and why invest in them?

a. A share entitles an investor to a part ownership in a company’s business. The

investor becomes a shareholder in that company and entitled to a shareholder

benefits, including dividends.

While the terms shares and stocks are sometimes used interchangeably,

they are different. Note that the term stock is equivalent to a company while a

share is a part ownership in a company. For example an investor’s portfolio

might have 10 stocks, one of which is BHP. The investor has 1000 shares of

BHP.

The Australian Securities Exchange (ASX) website has a wide diversity of

information for investors. You can find the ASXS courses at:

http://www.asx.com.au/resources/shares-courses.htm.

If you are reading this material from your computer screen, you can use each

of the links below by pasting it into your web browser or go directly to the

webpage by holding down the control key while left clicking the link. From the

ASX course material there are three sessions that you should look at before

you attend the course. Each session should take you about 10 minutes and

the purpose of this exercise is to get an overview of the significance of

shares. These three ASX sessions are quite detailed and have much more

information than you really need at this time. So you don’t need to go into

detail, just get an understanding of the general principles.

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(i) What is share? About 10 mins:

http://www.asx.com.au/documents/resources/shares_course_01.pdf?shares_course

_01_text

(ii) Why and how to invest in shares? About 10 mins:

http://www.asx.com.au/documents/resources/shares_course_02.pdf?shares_course

_02_text

(iii) Risks and benefits of shares about 15 mins:

http://www.asx.com.au/documents/resources/shares_course_03.pdf?shares_course

_03_text

b. Not all securities listed on the Australian Securities Exchange are

Shares

There are many securities listed on the Australian Securities Exchange (ASX)

that are not shares. They may be trusts, derivatives, hybrid securities, etc.

These different securities may have a place in your portfolio and will be

discussed briefly during the course.

Many securities that are listed on the ASX are not shares. The following are examples, where XYZ is the designated ASX code:

• fully paid ordinary share (FPO) XYZ

• preference shares XYZP, XYZPA

• contributing share or partly paid share XYZC

• company options XYZO, XYZOA, XYZOB

• ETF, AREIT, LIC, etc. XYZ

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c. Why Shares? A Comparison of Share Performance with other Asset

Classes.

While this course is about investing in the stock market, any investment

portfolio should be diversified and may include other asset classes such as

real estate, fixed interest and bonds. Table 1 compares the performance of

the major asset classes over recent time, where shares have outperformed

other asset classes.

Table 1 Returns on Asset Classes as at December 2009

12 months 3 years 5 years

Australian Shares 41.17% 1.07% 9.13%

International Shares 19.32% -7.60% 2.30%

Property -1.85% -1.36% 6.00%

Alternative Investments -12.86% 0.47% 7.97%

Australian Fixed Interest 0.98% 7.15% 6.00%

International Fixed Interest 17.71% 6.05% 5.86%

Indexed Bonds -0.53% 3.14% 4.15%

Cash 3.81% 5.41% 5.96%

While Table 1 shows the out-performance of shares over a 5 year period, over the very long term, shares have still outperformed other asset classes with International shares sometimes outperforming Australian shares. Shares are an attractive investment because they are very liquid. This means that while it may take three or more months to complete a sale of property, shares can be sold on the market immediately and the funds are in the investor’s account within three days. Shares also offer the opportunity to diversify investments over very different businesses and over international markets.

2. The Overall Investment Strategy: Factors that Determine the Outcome.

Most people do not achieve the financial independence that they desire. Yet the investment process is so simple that anyone who earns an average wage and has a savings and investment plan has the potential to achieve financial independence and a comfortable retirement. Procrastination is probably the most common reason why people don’t invest. But other excuses people make are that investing is too risky, too complicated and too time consuming. There is also the myth that investing in the stock market is only for the wealthy? None of these reasons are correct. In fact a person who is on a modest wage and makes sound plans for saving and investment can expect to retire in a comfortable position compared to a person who earned much more money during their working life but has no savings and investment plan. It is all in the planning and execution.

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There is nothing complicated about investing techniques but it does take a little effort to learn and understand the basics. The biggest risk we face as investors is in failing to educate ourselves about how investments may be able to help us achieve our financial goals and how to approach and plan the investing process. We will address the special topic of the investment plan in Section 4 but first we need to understand the different factors that affect the investment process and which determine how successful a specific investment will be.

Saving versus Investing

Both saving and investing have their place in your financial future. However, they

are different processes and you can’t invest unless you have accumulated some

funds through a savings plan. The important thing is to have a savings plan,

save regularly and start as early as possible. It is imperative that we understand

the devastating effects that imprudent use of credit cards or gambling can have

on our potential to save.

With savings, the principal typically remains constant and earns interest or

dividends. Savings are usually kept in a cash management account, a term

deposit or savings account. Savings leave an investor vulnerable to inflation and

may have no tax advantages.

By comparison, investments can fluctuate considerably in value and may or may

not pay interest or dividends. But with care, investments should provide a

protection from the ravages of inflation and may often have tax advantages.

Examples of investments include stocks, bonds, managed funds, collectibles,

precious metals, and real estate.

a. Understanding the factors that affect the accumulation of assets.

As investors we are looking for high returns on our investments. This section looks at the

factors that affect investment performance and these are the factors we need to

understand when we select one investment option over another. To get the best

investment result we need low or reasonable fees, a high rate of return, consistent

investment over time and an awareness of the challenges of inflation and taxation.

The following are the factors that we need to take into account when we invest:

i. the impact of time

ii. the impact of time with consistent continuing investment

iii. the impact of yield on the rate of asset accumulation

iv. the investment returns that we should be expected from investing in stocks

v. the impact of fees on asset accumulation

vi. the effects of inflation, taxation and fees

vii. the rule of 72, a simple planning tool.

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(i) Understanding the impact of time (the power of compounding) As investors we need to have an understanding how certain things affect our investment results. Of particular importance is an understanding of the role of time. The longer that the investment is held, the more the impact of compound interest becomes evident. Investors need to take advantage of the power of compounding which Einstein once described as “the most powerful force in the universe”. Compounding is the earning of interest on interest, or the reinvestment of income. For example, if I invest $1,000 and get a return of 12.5% p.a., I will earn $125 in the first year. By reinvesting the earnings and assuming the same rate of return, the following year I will earn $140.62 on my $1,125 investment. The next year I will earn $158.20 on the investment of $1265.62. Figure 1 shows just how effective this is as an investment strategy. Figure 1 illustrates the impact of time and compounding on the single investment of $1000 in year 1, over a 31 year period. Note how the asset increases very slowly in the early years but grows very rapidly towards the end of the investment period to provide an asset of nearly $40,000 after 31 years. So time is a very important element in investing

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$5,000

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Fig 1 Effect of Compound interest and time on investment returns over 31 years.

$1000 invested in year 1 at 12.5% pa. for 31 years

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(ii) Understanding the impact of time with consistent continuing investment While in Figure 1 the investment grew significantly over the 31 years, the long term effect of investing is much more significant if there is a continuing addition of funds each year. The following Figure 2 shows how significant the power of compounding can be over a long period with continued regular investment.

In this example a student aged 20 plans to invest just $1 a day into a fund that returns 12.5% pa. He started his investment program in January 2010 by investing a mere $1 every day in an index fund that returns 12.5%. Assuming that the fund continues to return 12.5% for the life of the investment, the value of that asset in 45 years in the year 2055 when the student is 65 is shown in Figure 2.

So for investing a trivial $1 every day over a 45 year period the accumulated asset is worth in excess of $1million on retirement at 65. This illustrates the impact of a continued investment program and the impact of compound interest over time. Compounding offers real opportunities if the right choices are made:

Credit card debt has a huge impact on the potential to accumulate assets? Take the example of a young person who has a credit card. He does not pay the full balance each month and instead pays interest of $30 every month. If he had fully paid the credit card balance each month and put the $30 into an investment returning 12.5% p.a. over a 45year period his savings would have been in excess of $1million.

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$250

$500

$750

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$1,250

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$2,000

4-Jan-10 4-Jan-20 4-Jan-30 4-Jan-40 4-Jan-50 4-Jan-60

Thousands

Fig 2. The Power of Compounding where $1 is invested every day for 45 years at 12.5%

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Life style choices. A student aged 21 smokes a packet of cigarettes a day which costs her $10 every day. She decides to give up smoking and invest the $10 per day into a fund yielding 12.5% pa. Over a 44 year period when this person reaches the age of 65, this investment, as a result of continuing investment of $10 every day and the power of compounding, will be worth approximately $9 million.

As investors we simply must understand the power of compounding.

(iii) Understanding the Impact of Yield on the Final Value of an Investment

Yield (the annual return on the investment), is another important factor that we need to understand. Consider the situation where $1000 is invested for a 30 year period at two different rates of return

• The rate of return of 12.5% pa. (ASX200 accumulation index return) • The rate of return of 5% (an average return for a managed fund) •

The rate of return has a very significant effect on the outcome of a long term investment. Although investment returns will be expected to vary each year it is essential to keep the average rate of return as high as possible. Figure 3 shows that the impact of rate of return on this investment over the 30 year period. The final asset value is either $34,000 or $5,000 depending on the rate of return.

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$10,000

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Fig 3 Effect of Rate of Return (5% & 12.5%) on Asset Growth over 31 Years

12.5% yield

5% yield

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(iv) What Investment Return should we expect from the Stock Market? The best indicator of potential returns from the stock market is the All Ordinaries Accumulation Index. The All Ordinaries Index is the average price of the top 500 stocks on the Australian Securities Exchange (ASX) by capitalisation. If we were able to buy all 500stocks weighted according to their contribution to the index and reinvest all dividends, then we would replicate the performance of the All Ordinaries Accumulation Index. Over a long term the All Ordinaries Accumulation Index has returned about 12%. So this provides a reference point or benchmark for our investing activities.

While it is totally unrealistic for any one investor to buy all 500 stocks we can invest in an index fund. An index fund does hold all 500 stocks in the index weighted according to their contribution to the index. The ongoing fees for index funds are lower than other managed funds, so one way to achieve a good return is to invest in an index fund.

The returns from the All Ordinaries Accumulation Index provide a convenient measure of our performance as investors. It is of interest that very few managed funds are able to outperform the index. So when selecting to invest in managed funds we need to select the fund with care. We could be investing in a fund that underperforms the index significantly but still charges very high fees .

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(v) Understanding the Impact of Fees on Asset Accumulation There are many services available to investors and most of them charge fees. Investors should understand what impact fees have on their investments. Fees are a significant component of investment costs and over the term of a long investment will significantly reduce the return on the investment. This section shows graphically the impact that fees have on investments while the next section discusses the different types of fees in some detail.

Figure 5 shows the effect of two different fees on of an investment of $1000 over a 31 year period. If the investor invested directly in the market and paid no fees, the return was nearly $40,000, while the same investment at the same rate of return but paying 2% fees returns only about $23,000. Since many managed funds charge fees well in excess of 2%, the impact of fees on the final investment outcome is very significant and must be watched with care. So fund performance is important but so are the fees that are being charged.

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Fig 5 Effect of Fees on return on $1000 invested for 31 years.

12.5% return

10.5% return (2% Fees)

The effect of fees on the investment return

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(vi) Understanding the Effects of Inflation, Taxation and Fees

Inflation, taxation and fees are all factors that reduce the rate and efficiency of asset accumulation. If these factors are understood then they can be taken into account in the investment plan.

Inflation Perhaps the biggest risk that we as investors need to understand is the problem of inflation. Inflation is the rise in consumer prices and the loss of purchasing power. We see this where the cost of goods and services is rising so that the purchasing power of the dollar is falling. The generation of Australians that lived through the depression and World War II experienced very low inflation. This generation was very security conscious and investments were made in savings bank accounts at about 3.5%. While this approach worked in the low inflation environment of the 1950s and 1960s, the serious inflation of the 1970s destroyed wealth and reduced retirees to poverty. A retiree who invested $10,000 in 1970 would have to have seen it grow to $81,140 by 1993 just to maintain its real value (Higgins and Abey 1995) The long-term rate of inflation in Australia is about 4%. This means that if a loaf of bread costs $1.00 now, in one year’s time with an inflation rate of 4% that loaf of bread can be expected to cost $1.04. The following year that same loaf of bread will cost $1.082 and in 18 years it will cost $2.00. This means that an investor needs to make 4% on any investment just to retain the purchasing power of his money. At a 4% return in real terms, he has made nothing and we need to recognise that many investments return less than 4% after having been charged high fees. See also the next section that explains how to use of the Rule of 72 to calculate the effects of inflation. This emphasizes the very critical role that inflation plays in investment and in retirement plans. During the 1970s the inflation rate in Australia reached 17%. The Reserve Bank of Australia (RBA) is very concerned about inflation levels and one may hope that we do not see the dangerous level of inflation that was experienced during the 1970s again. Cash accounts that have no tax benefits leave an investor exposed to inflation. This is compared to most investments such as real estate, collectibles and shares where the value of the investment will rise with inflation. In many cases these investments may also have tax benefits as discussed below. Shares have the particular benefit of dividend imputation which is discussed next under taxation.

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Taxation

Taxation is a fact of life and we all expect to pay our due contribution to help run the country. There are legal deductions and mechanisms that can be used to reduce taxation effects on asset accumulation. These include using the correct business structure, be it a sole trader, partnership, company, trust or a self managed super fund. Investors need the advice of a competent professional to determine and establish the appropriate structure.

One of the advantages of investing in shares is that most blue chip shares

are in companies that have already paid company tax so that franking

credits are attached to the shares you own. This means that the company

paying the dividend to the shareholder imputes (credits) the tax paid on

this dividend to the share holder as a franked dividend. This process is

known as dividend imputation.

Therefore, if you receive dividends on which 30 percent company tax has already been paid and your own marginal rate of personal income tax (the highest rate of tax you pay) is also 30 percent, you owe no further tax on the dividends on those shares.

If your marginal tax rate is higher than the rate at which the dividends have been taxed, you will need to pay the Australian Tax Office the difference. Conversely, if your marginal tax rate is lower than the rate already paid on the dividends, you will receive a tax credit for the difference. And where the tax credits are great enough to reduce your tax payable to nil, any remaining credits will be refunded.

If you are interested, further information on franked shares and dividend imputation is available at: http://money.ninemsn.com.au/article.aspx?id=226025.

Fees Investors may pay fees to stockbrokers, solicitors, investment advisors, accountants, banks and managed funds. Banks and managed funds often charge multiple fees and these are not always easy to understand.

The Australian investment industry is huge and very profitable. The funds under management in Australia exceeded $1.4 trillion in early 2010 and are growing at the rate of $6 billion per month. So at a fee of 2%, the investment industry has a minimum income of $28 billion every year. As investors we pay these fees and they have a significant detrimental effect on the final value of our investments.

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Managed funds are of concern as they are the most important investment vehicle for many Australian investors. Fund managers may charge fees of up to 5% for their services and investors need to be aware that there are often multiple fees charged even on a single investment. These may include entry fees, establishment fees, exit fees, management fees, an annual fee, withdrawal fees, a member fee, switching fees, advisor fees etc.

The effect of fees on the final investment yield has been addressed above in Figure 5. The important thing is to be aware of what fees you are asked to pay and the impact that this fee will have on the outcome of the investment. We will discuss fees briefly during the course.

(vii) Understanding The Rule of 72: a very simple planning tool The Rule of 72 is a useful calculation used to understand the potential of any investment to double over time. The rule of 72 is applied in this way. If you divide 72 by the projected percentage return: the answer is the number of years that it will take for the investment to double in value.

For example, an investment that earns 8 percent per year will double in 9 years (72/8). An investment returning 10% will take 7.2 years to double (72/10).

The Rule of 72 can be used in a number of ways. The following are two examples:

The Rule of 72 and Retirement Planning Fred is aged 50, planning to retire at 65 and has capital of $100,000. He needs to know if his investment strategy will allow him to achieve a comfortable retirement. He estimates that he will need $40,000 per year to live comfortably in retirement.

If Fred is an investor who averages a return of 14% p.a. At a rate of about 14% Fred will double his capital of 100,000 about every 5 years (72/14), so by retirement at age 65 he should accumulate about $800,000.

If Fred invests in managed funds with an average return of 5% p.a. He can expect to double his capital every 14 years (72/5), so by retirement at age 65 he should accumulate about $200,000.

So if Fred is able to maintain a return of 14% and accumulate $800,000, in retirement, he can expect to get a safe $40,000 (a 5% return on capital), without depleting capital. On the other hand if Fred can only achieve a 5% return with a managed fund, over the next 15 years he will accumulate only $200,000 and this sum will soon be depleted in retirement.

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The Rule of 72 and the Effects of Inflation Inflation is the loss of purchasing power of the dollar. If inflation is 4% pa then the rule of 72 can tell an investor something about the purchasing power of his money in the future. If my retirement assets are $200,000 then the rule of 72 tells me that in 18 years at an inflation rate of 4% (72/4) my spending power for this $200,000 will be equivalent to only $100,000. So if my $200,000 is kept under the mattress it will only have a spending power of $100,000 in 18 years. If my $200,000 is invested in a fixed interest account giving 4% return then I will have received an increase in asset value to$400,000 but my purchasing power in 18 years will still be equivalent to $200,000. As investors we must understand the impact of inflation.

Factors affecting Investment returns - Concluding remarks Part of the planning process is to select investments that provide an acceptable risk, have low fees, have good returns and minimise the problems of taxation and inflation. There is no perfect investment and it is often a balance between safety and yield. It is important to have an understanding of the many factors discussed in the above section that will have an impact on the final investment returns.

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4. The Investment Plan The investment plan is central to successful investing. It provides a guide as to what to buy and sell and how to manage risk; it protects the investor during periods of market instability.

a. Some interesting statistics

The following are the statistics (adapted from Whittaker 1989), for a group of 100 typical young Australians aged 20, who in 45 years time will be age 65.

In 45 years: 31 of this group will no longer be living 69 will be alive

Of those 69 who are living and are now 65 years old: 40 will be dependent on a government pension 21 will still be working 8 will be wealthy or self funded retirees

The interesting thing is that the 8 persons who are wealthy or self funded retirees will probably not be those who inherited wealth or had high paying jobs or careers. They will be the people who recognised the need to learn about investing and had goals to achieve financial independence by having a sound financial plan and applying it. This course is about how we as investors need to develop and apply an investment plan to become financially secure and ensure that we are in the 8% of Australians. b. Knowing your profile as an investor

The investment plan is a written document that should address the following information:

The investment style (buy and hold or managed) Time frame for the investment (considers your age/retirement plans) Which stocks, managed funds etc., to buy and how to select them How many stocks or funds are in the portfolio? Your tolerance for risk Risk management strategies, sectors, diversification, balancing the

portfolio. How many shares of each stock to buy – money management - the

2% rule Market entry - managing the investment Rules for selling the stock or switching the managed fund.

The above characteristics create your investor profile. The following site provides an opportunity to consider some of the aspects of your investor profile that determines the most appropriate investments and diversification. It also expands further on the investor profile that is basic to developing the investment plan and to developing a portfolio. To make use of this website, you provide data (any data) on your investment needs and you will be provided with an investment profile and suggested asset allocation. Note that you don’t need to submit these details to the Mutual fund in question http://www.nbc.ca/WebInfoWeb/DispatchRequest?aliasDispatcher=investorQuestion&action=51&lang=en.

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c. An example of an investment plan

The following is an example of a very basic outline of an investment plan. It is worth remembering that the investment plan is something that is unique to any one investor and will depend on the investment profile. Also we need to accept that any investment plan evolves with time and this may reflect our experience in the market, changing market conditions or our changing needs as we perhaps need more security and less growth from our investments. While in this course, we consider the investment plan in the context of the stock market, any investor should have a broader approach to planning and include investments from other asset classes such as real estate, cash, and bonds in the overall investment portfolio. The following is the very basic outline of an investment plan appropriate to the stock market.

Strategy: managed (not buy and hold) - hold for months to years. Asset classes: Australian stocks or cash Market entry: enter at start of a new bull market using Coppock indicator Market exit: manage trade based on continuing trend. Sell if trend is broken Diversification: hold no more than 15 stocks and no more than 2 in any one sector Risk management: diversify, do not borrow to invest and avoid illiquid stocks. Type of stock: must pay fully franked dividend, no IPOs, P/E ratio less than18

d. Asset Allocation One aspect of the investment plan is to diversify the investments and to determine how funds will be distributed among the different asset classes. This is the most obvious way that an investor can protect herself. There are often news stories about investors who have put all of their assets into one investment and suffered significant losses. There have been a number of cases in Australia in recent years where mortgage, investment or real estate companies have collapsed and investors have lost their entire life savings. This situation can be avoided by diversifying across asset classes and within asset classes as a means of reducing risk. The major asset classes are stocks, bonds, precious metals, collectibles, and cash. There are all sorts of subdivisions within these classes. Asset allocation will vary over the lifetime of an investor. Investors have different needs at different ages. A young investor would normally have a portfolio that was very much oriented to growth stocks while an investor nearing retirement age would hold higher yielding blue chip stocks with perhaps more assets in cash and bonds. Investor tolerance to risk also changes, so as investors our portfolios require frequent updates to account for our changing needs and asset allocation. e. Portfolio Evaluation

A good record of all investment transactions is essential. This then allows a regular evaluation of the investment portfolio which in most cases should be

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carried out monthly as part of the investment plan. If there are any significant changes in the portfolio an investor may need to take action to sell some investments or buy others or perhaps remain in cash. If the investments are handled by an investment advisor, broker or fund manager, regular portfolio evaluation is still an essential exercise because the professional are probably not be doing this exercise on your behalf. It is the only way that an investor can keep a close watch on the progress and health of her portfolio. During the bear market of 2007-08 many investors a lost significant percentage of their assets and this could have been avoided if the investments had been monitored regularly. The evaluation could simply be a matter of entering the value of the major investment categories into a note book at the end of each month. A better approach is to use a spreadsheet which is a simple process and need not take more than a half hour at the end of the month. Later in the course spreadsheets will be made available and we will consider how these can be used to maintain simple but efficient records. The following are the questions that an investor needs to ask at the end of each month when reviewing investments. o Is the return on this investment meeting my expectations? o Have my investment goals, time horizons, or needs for cash changed? If so,

are my investments still suitable? o Do I fully understand my account statements? o Are the criteria I used when to buying this stock, still valid? o How much gain (or loss) will I realize if I sell now? Will there be tax

consequences? o Do any investments need to be sold: have stop losses been violated? o Are there any stocks that I should buy? o Do I need to rebalance my portfolio?

f. Market Psychology

Although the process of investing is relatively simple, actually obtaining a good

and consistent return is not easy. The human emotions of fear, greed, hope and

despair make what should be a relatively simple process very complex. We are

risking our savings in the market so we need to understand how our emotions

may get in the way of profitable investing. Emotions are heightened by our

constant exposure to news about the stock market and much of it is emotional

and often inaccurate.

Market psychology is a very important subject and while we will discuss it on

several occasions during this course, the limited time available does not allow the

coverage that this subject warrants. As you increase your knowledge of

investing you may wish to read the excellent book on The Psychology of

Investing by Nicholson (2006).

Our best protection from erratic investment decisions is to have a good written

investment plan which will guide our decisions and protect us from making rash

and emotional judgements about the market.

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5. Investment Returns, Risk and Risk Management

There is no easy path to wealth. Some Australians seem to believe that wealth is based on chance and millions of dollars each week are “invested” in Lotto and other forms of gambling. The odds of winning the Lotto jackpot are about 1 in 10 million. Investing in the share market is not gambling but does entail some risk. Consider the study by a mathematician who compared different forms of gambling (Higgins and Abey 1995) and ranked them according to how much on average, a person betting one dollar, could expect to get back. Blackjack returned about 99 cents in the dollar, horse racing about 85 cents and lotteries 61 cents for every dollar “invested”. By comparison for over a century of investing in the Australian share market the average return was $1.11. So the very long term average return for an investor was 11%.

As mentioned above, the return for the All Ordinaries Accumulation Index over the last 40 years is about 12%. This return comprises about 4% from dividends, 4% from inflation and the remainder from capital gains. As investors we can use a return of 12% p.a., the return for the All Ordinaries Accumulation Index as our benchmark. Investing in the stock market does carry risk and investors need to understand these risks and to take them into account. At this time we need to address four of these risks that are very important to understand:

Market risk If the market falls, most stocks will fall in price too. So investors need to have an understanding of the position or stage of the market. That is to say they need to understand that if the end of a bull market is approaching then this a dangerous time to invest. By comparison, the early stage of a bull market is the safest.

Specific risk This is the risk that the stock you buy will fall in price. Not all of our stock selections will be profitable. To avoid significant loss investors need to diversify a portfolio and to use stop losses. The stop loss is the point at which we admit we were wrong and must sell the stock.

Liquidity risk Stocks in which there are very few trades each day are said to be thinly traded and are illiquid. If you buy such a stock it may be very difficult to sell. Avoid such stocks.

Financial and credit risk A financial risk is incurred when an investor borrows money to buy shares. If the shares fall in value then the investor will lose money and lose even more if he is forced to sell the shares to repay the loan. A credit risk is where a company has high debt to service. As a result it will probably pay lower dividends and the share price will fall.

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Conservative investors avoid stocks where the debt to equity ratio is greater than about 60%.

The aspects of risk, return and risk tolerance are often poorly understood. The following website provides useful information on risk, return on investments, risk tolerance and risk management. http://www.moneysmart.gov.au/investing/investing-basics/risk-and-return. 6. The Essential Tools for Investors, Fundamental Analysis and Technical Analysis Stocks are analysed to determine which ones an investor should buy and at what price. Such analysis aims to find stocks that represent good value or are undervalued at the current market price and also to determine the best time to buy the stock. There are two basic and different methodologies, fundamental and technical analysis. For the most effective investment result, the combined tools of fundamental and technical analysis should be used. If an investor rejects one of these tools, either fundamental or technical then she is depriving herself of information that will give the best investment outcome.

a. Fundamental analysis

This type of analysis uses economic data and company statistics to value a company. It involves reviewing company balance sheets, profit and loss statements and studying the company, its management, what it does and who its competitors are, to evaluate the actual value of a share in that company. Fundamental analysis tells the investor which companies or stocks are sound businesses to buy.

Analysts use the fundamental data on companies, to derive ratios. These ratios are valuable as analytical tools because they can be used to make comparisons between the values of two or more different companies. There are a large number of different ratios that are used. Four of the most useful are:

Return on Equity (ROE). The ROE is the company net profit divided by shareholder equity. This provides a very useful insight into how efficiently a company is investing its capital. A company with a ROE of 15% should be a more attractive investment than a company with a ROE of 8%. Earnings per Share (EPS)

The earnings per share ratio is calculated by dividing the net profit of a company by the total number of shares on issue. By looking at a company's EPS history, it is possible to see the growth in earnings from one year to the next and compare earnings to the dividend payouts and the share price each year.

Price to Earnings (P:E). This ratio is obtained by dividing the share price by the earnings per share. In effect the P:E ratio tells the investor how many years it will take

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to recover an investment in this stock from the earnings the company makes. So with a P:E ratio of 15, it will take 15 years to cover the cost of buying that share in the first place. While such data is historical and may be 6 months or more out of date, it does give valuable information. A company which has a P:E ratio of 20 may be considered to be quite expensive compared to one which has a P: E ratio of 10. But care needs to be taken when interpreting P:E ratios as different sectors may have very different ratios. Also a rapidly declining P:E ratio may simply reflect a rapidly falling share price by a company which is having problems and could eventually go into receivership. Dividend Yield

Dividend yield is calculated by dividing the most recent dividend by the current share price and multiplying by 100 to achieve a percentage figure. Dividend yield is a measure of the regular income return (rather than capital growth) that a share is paying. This allows a comparison between different stocks and also with other asset classes. However, when the share price changes the dividend yield will also change. Indeed, if the share price declines rapidly, the yield would increase rapidly, until the next dividend is declared — if there is one. (i) How the analyst uses fundamental data You should now read the Morningstar publication, “How to Read an Equities Report” that is available from the course website. This report which is provided by the courtesy of Morningstar provides an excellent insight into how each fundamental ratio is calculated and how fundamental analysis can be used to value a company. In this case study the analysis of Woolworths (WOW) provides an insight into how Morningstar uses these data to provide recommendations on stocks to their clients. You should note that one aspect of this report (e.g. the Style Box) is unique to Morningstar and is not in general use. (ii) Software for Fundamental Analysis There are a number of software packages available for fundamental analysis. Some of these only analyse fundamental parameters while others incorporate technical parameters as well. Some of the better known fundamental software packages are StockVal and Stock Doctor. The larger online stockbrokers also offer software that will allow stock selection based on fundamental parameters. During the course the fundamental filter available to clients of E*TRADE will be used as an example. (iii) Stock Categories used in Fundamental Analysis As a matter of convenience there are a number of ways in which stocks can be classified. A blue chip stock is a company which has a large capitalisation, has been profitable over a long period and pays a regular dividend. Another way in which stocks are grouped is to classify them into

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defensive stocks and speculative stocks. Defensive stocks are those companies that provide essential services or products and their share price does not fall very much in a market decline. Woolworths is an example of a defensive stock. By contrast speculative stocks are companies that may have low capitalisation, may have high debt and/or are in high risk enterprises. Small mining stocks are an example of this latter category. Two categories that are often used by investors - Growth Stocks and Value Stocks.

o Growth stocks

Growth stocks can be generally expected to have a high P/E ratio and a low dividend yield. Investors are willing to pay more for these stocks with the expectation that the company will continue to expand and grow and that profits and dividends will continue to grow also. Woolworths (WOW) is an example of a growth stock. Woolworths is also a defensive stock, so will resist excessive falls in share price during a market pull back. In this case during the 2008 bear market when many stocks lost 50% to 80% of their value, WOW as a defensive stock lost about 30% of its value. The following monthly chart of Woolworths from 1994 to 2010 shows how the chart of a typical growth stock continues to rise over a long time period. This is a direct reflection of continuing growth of this company.

A Growth Stock - Woolworths Monthly

Chart-

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o Value stocks

Value stocks are cyclical in nature. The share price will often fall to low levels that may not be associated with market declines but may be associated with sector or industry cycles or cycles in the economy. The monthly chart below for the period 1996 - 2010, is of retailer Harvey Norman (HVN) and is a typical chart for a value stock. This is a well run, profitable business but is considered cyclical and offers the patient investor very good opportunities. While the value stock may not be so profitable for the buy and hold investor, this type of stock is excellent for the investor who is content to hold stocks for periods of 6 months to several years and buy and sell at strategic times.

Created with AmiBroker - adv anced charting and technical analy sis sof tware. http://www.amibroker.com

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

HVN - Monthly 22/02/2010 Open 3.64, Hi 3.82, Lo 3.59, Close 3.71 (0.8%)

3.71

A Value Stock - Harvey Norman monthly

chart – a value stock

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b. Technical analysis

In technical analysis, charts are used by the investor to determine the best time to buy and sell a stock. A technical analyst studies the way the buyers and sellers are reacting to a stock through its price movements, rather than studying the company itself. Technical analysis involves a review of the actual price and volume activity of stocks using graphical representations called charts. The next figure shows a monthly chart of Commonwealth Serum Laboratories (CSL) over a 15 year period with the volume illustrated by the red and green lines in the sub-chart.

The stock market is made up of hundreds of thousands of investors who are buying and selling stocks. The price of a stock is related to the emotions of the mass of market participants who have a perception of the value of a stock, rather than the actual intrinsic value of the stock itself. So in the stock market prices are usually reflect human emotion and not necessarily the intrinsic value of the stock. To take an example: If the San Andreas fault in California, becomes very active tonight, there will be absolute chaos in the USA and the Dow Jones Index will probably fall by more than 50% tomorrow. Our market will follow. We could see the share price of a blue chip stock such as Commonwealth bank (CBA) plunge, perhaps from $55 to $35. However CBA as a business would have lost no value over night and would in all probability continue to pay the same dividend in the future. This is an example of raw human emotion at work and this is where technical analysis is important. As investors we need to be able to make investment judgements without being unduly influenced by the market emotion (and this is where technical analysis is so useful).

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There is a huge diversity of techniques that come under the heading of technical analysis. Some of these techniques appear to be rather bizarre and have on occasion caused the general area of technical analysis to come into ridicule. There is now wide acceptance of the value of these analytical techniques in trading and investing with all large institutions now employing technical analysts. The strength of technical analysis is that it is able to evaluate the emotional responses of market participants. These emotions lead to price movements that in turn produce recognizable chart patterns. Technical analysis provides the information on when to buy and when to sell a stock.

The Techniques of Technical Analysis

Some applications of technical analysis are so good that if you use learn to use them you are unlikely to be caught in a bear market and should never be left holding a collapsing stock such as Enron, One Tel or ABC Childcare etc. etc. The same cannot be said of fundamental analysis because the fundamental data of a company in risk of bankruptcy, may be out of date, may not be available or may be falsified. Having explained how useful technical analysis is, it is important to point out the limitations of technical analysis. There are a huge number of indicators available in charting packages. The majority of these indicators have little value and often provide an illusion of a good entry with price data that may be little more than random price movements. Technical analysis has a very important place in investing but it can be quite misleading if the analyst is not careful. In this course we will introduce the basics of technical analysis and how it can be applied to the selection of stocks and the management of the investment. Only a few indicators will be used during this course: the intention being to provide an overview of potentially very useful approaches. The techniques that will be used include:

o chart patterns which give an insight into investor emotions. o indicators which provide an assessment of the strength of a trend. o an assessment of the role of market cycles. o volume changes that provide an insight into investor interest in a

stock and also provide information on insider trading which is impossible otherwise to detect.

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7. An Introduction to Technical Analysis Software. Technical analysis depends on the analysis of current and historical stock market data using charting software. Since the major tool of technical analysis is the stock chart we start by looking at the different types of charts. We will consider only line charts, bar charts and candlestick charts. Use the sites below to get an understanding of the differences and uses of line charts, bar charts and candlestick charts.

The first site is used by foreign exchange traders but the charts described here are exactly the same as those used by technical analysts in any market. http://www.cmsfx.com/en/forex-education/online-forex-course/chapter-3-technical-tools/technical-analysis/chart-types/

This next site (Investopedia) provides a concise description of the three basic chart types and includes more detail of candlestick charts which you may wish to consider later when we discuss charts in the course sessions. http://www.investopedia.com/university/technical/techanalysis7.asp

Technical analysis requires the use of a charting software package and access to a reliable market data. So there are two parts necessary before the analysis can be carried out. The first part is to obtain reliable data on stock prices and volume from a data provider and this may cost $20 to $50 per month. These data which are downloaded every day, include the open, high, low, close and volume of share activity. These data are then accessed and processed by the software to carry out the analysis. Software can be very expensive (as much as several thousands of dollars) allows a very large number of techniques to be used to analyse the market reaction to a particular stock. In this course we use the software package, “Incredible Charts” which is freely available on the internet. This package is not only available without cost but it includes all the necessary data and analytical tools we need as investors. The Incredible Charts Software Incredible Charts (IC) is available as a free or subscription version on the internet. The free version that we will use in this course is very useful for investors and a good package to learn on. Apart from the fact that it is free, the advantage with Incredible Charts is that the data comes with the package and it is available on the internet and is not based on your computer. You can set up the software package to your needs and this configuration is then saved on the IC server. This means that you can then access Incredible Charts configured to your needs on any computer, anywhere and at any time. There are no time-consuming data downloads and database maintenance. Data is delivered online from high-speed servers while individual stocks are being analysed.

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If you go to the IC website you can download a free version of this software and we will use it every week in the course. At this time it is a matter of downloading the software, installing it on your computer and becoming familiar it.

Access the Incredible Charts site at: http://www.incrediblecharts.com/

Click on the download button, which leads you to another screen.

Click on this next download button

When you get the popup window, RUN the software and accept the

directory suggestions.

Get a feel for incredible charts by having a quick tour at:

http://www.incrediblecharts.com/online_charts/quick_tour.pdf This 8 page quick

tour demonstrates the potential of this package but does not provide instruction

on use. Details on use of the software are found on the charting package. If you

click on the help menu on the top tool bar this will provide access to manuals and

details on the use of the IC software.

If you have never used technical analysis software before, then use this

opportunity simply to get an over-view of the package. Do not feel that you

have to have an understanding of this software at this time. At this stage

merely become acquainted with some of the features of incredible charts.

This free package provides delayed data (17 hours delayed). By paying a subscription of $20 per month investors can receive the Premium Data option where data is not delayed. For most investors the free version is quite satisfactory. After 30-Days free trial, you will be asked if you wish to subscribe. There is no obligation to do so and if you decline to subscribe, you will continue to get access the incredible charts software but with a slightly smaller screen plus the inconvenience of some advertisements. The free version is still an excellent package and particularly useful in this course.

Getting Started with Incredible Charts

If you are new to technical analysis you will find three short video clips on the AIA website useful. These are available through this link: http://www.investors.asn.au/resources/products/sharemarket-investment-course/. On the right hand side of the page you will find the three video clips which are on public access.

References

Higgins, E. and Abey, A. (1995), Fortune Strategy, Allen and Unwind Nicholson, C. (2006), the Psychology of Investing, Wilkinson Whittaker, N. (1989), Making money made simple, Boolarong Publications