Diversification and Commissions

Many stock pundits and advisors strongly recommend diversification, that is, holding more than one stock to reduce risk.  This is the idea that it is a good idea to put all your eggs in one basket.  More on the concept later, but I wanted to address the impact of diversification on commissions here.

Different experts (and I will use the term loosely) recommend different numbers of stocks to be diversified, but for our example we will use five.  Assume a starting portfolio of $10,000, a not insignificant sum for most people.  In order to purchase five stocks at $8 per buy, the investor is down $40 from the get-go.  Of course, in order to unwind the positions, that is, sell the stocks, he will have to pay another $40.  Diversification has cost him $80, or 0.8%,   He could have put all $10,000 in one stock and been better off even if the stock went down in value by one half of one percent. 

Whatever the benefits of diversification, and there is some debate on the value, it does create a financial hole that the investor has to dig out of.  It may be better to put all of your eggs in one basket if the cost of buying many baskets is going to cause you to go broke anyway.       

Commissions Add Up Over Time

Commissions are insidious.  For each transaction, they are relatively small, but after repeated buys and sells, they add up quickly.  And they always come in pairs.  Every time you commit to buying a stock, you will eventually have to sell it to get access to your money, whatever might be left. 

If there were commissions for movie theaters, you would have to pay to get AND to get out, though it might be worth it for some films.  If there were commissions for bank accounts, you would have to pay ATM fees to deposit and withdraw funds, which is likely to happen soon anyway.

Getting Lucky on Stock Picks

I understand that you didn’t intend to sell the stock at the same price you bought it.  Your goal was to buy the stock at $425 and sell it at a zillion dollars.   Or two zillion, if you hold it a bit longer.  Sadly, the former example is much more likely.  But, even if you were successful, the stock would have had to rise to $443 just to break even, a 4.2% increase. 

Logically, the way to reduce your breakeven point is to invest even more.  Instead of one share, you buy the 10 at $4,250.   Then you only need a 0.42% increase in the stock to break even.   Mathematically, it makes perfect sense.  If it goes up to $443, you are making some money. 

If it goes down to $420, you are not only paying for the broker’s lunch, you are also doing a favor to the guy who sold it to you at $425.  The more shares you buy the more risk you are taking on. 

The downside of a drop in prices is obvious.  But what happens if you are successful?  You buy 10 shares of AAPL (the stock symbol for Apple Computer) at $425 and sell it at $443, making a nice profit of $164 ($180 less $16 in commissions.)  Then what do you do?  Go out and buy another stock, locking in another $16 (you’ll have to sell that one too) until you aren’t smart or lucky anymore. 

The Cost of Commissions

When investing the very first things you need is an account with a stockbroker and an idea.  These are today, generally, free.  After that, you start paying.

In order to buy shares of stock, brokers charge a commission, or fee.  Rates of commission vary between brokers for reasons that have nothing to do with anything related to the actual purchase of stock. You can pay $7 at Scottrade, $8 at Fidelity or $8.95 at Schwab for the exact same service. 

You pay this commission every time you buy or sell transactions.  For instance, if you want to buy a share of Apple Computer from your Fidelity broker, you will pay the price of the stock, currently $425 plus $8 commission.  If you buy 10 shares, you will pay $4,250 plus, still, an $8 commission.  If, after a time, you decide you don’t want to own your share of stock, you less it at whatever the market price is less another $8 commission. 

If you sell the stock at $425, you have paid $16 to your broker for the privilege of holding the share, which you made no money on.  You started with $425 and now have $407.   It is important to note here that $16 would have bought you a large pizza and your choice of beverage.  The good news is that the broker will now be able to now be able to buy that pizza for his family. 

Buying Stock in a Company

There are lots of way to invest your money, but the most common way, the one most investors take part in, and follow, is to invest in common stocks.  The simple definition of a share of common stock:  Equity in a publicly traded company.  A single share of stock is a piece of ownership of a company, and affords the same rights as other owners. 

The problem is that a single share of the company gives an almost infinitesimal share of a company traded on the stock market.  For instance, at this time, Bank of America has 10.54 billions shares outstanding.   So, a single share has an ownership percentage of                                                                         0.0000000000949, or 9.49E-11 in scientific notation. 

An ownership percentage such as this, or even 100 or 1000 times that isn’t going to give you much leverage in how the company is run.  So, we can discount any ownership advantages that shares might bring the small investor. 

Therefore, the reasons for owning a publicly traded stock are pretty much limited to the ability to make money off of the investment.  There are two main ways of accomplishing this:

• Selling the stock to someone else at a higher price than you paid.
• Receiving cash dividend payments

Sounds simple, right?  In concept, it is.  Making it happen consistently is beyond the reach of most small investors.  It is, studies show, even beyond many professional investors. 

The reasons why this is so difficult will be explored in the first section of this book.  If this gets too depressing, feel free to put the book down, (or more accurately, shutdown the computer or e-reader) and take a break.  Be sure to come back, though.  Knowing the downside of investing in stocks might save your financial fortune.   

Things Your Broker Won't Tell You

There are a lot of investing professionals and websites that can tell you how to invest your money.  The goal of most of these people is to get you to invest by telling you that you can make money, retire early, and provide for your family today and into retirement. 

The real reason to get you to invest is, of course, so that they can make money, by selling you investment products, books or educational courses.  There is nothing really wrong with this.  People have a right to make a living, and as long as the information is appropriate and sales tactics aren’t high pressure, there can be a mutual benefit. 

Unfortunately, this isn’t always the case. Much of the investment products and advice aren’t appropriate for you.   

The goal of this book is different.  I don’t have anything to sell you (well, other than the book) but to show you that it is really easy to lose money by investing in the stock market.  The active of an investor you are, the more you are likely to lose. 

Maybe the best thing you can do with your hard earned money is to dig a hole and bury it in the backyard. At least it will be there when you actually need it, and not frittered away on some harebrained scheme, flawed strategy or run of bad luck.

That may be overstating it a bit.  You can invest wisely.  But that’s not what this book is about.  This book is about how following most investment advice is likely to end up making someone else rich with your money.  As they say, Las Vegas wasn’t built by the winners.         

How to Lose Money in Stocks

Small investors have found many ways to lose money in stocks.  I could write a book about it.  As a matter of fact, that's what I am doing here.  Whether you invest in equities, bonds, options, ETFs or mutual funds, there is a way to generate losses quickly. 

The worst part is, the more you lose, the more desperate you are to find a way to get it back, and that generally leads to more losses.  The best thing you can do is stop the losing cycle. 

Before that happens, you need to recognize how and why you are losing money.  Don't make other people rich  That's the purpose of this book.