The basic language of online investing
Do-it-yourself (DIY) investing, more often referred to in today’s world as online investing, has a language all of its own. Understanding this language can help you succeed in managing your investments.
First, lets begin by understanding the two basic types of accounts you can open with an online broker. The type of account you open determines both the risks you will be taking, and how you will be funding your investments.
A cash account is exactly what it means; you can invest up to the maximum amount of cash you deposit into the account. The total that you are risking in the market is the total cash deposit you make into the account.
Remember that a cash account can be either registered, such as a tax-free savings account or a registered retirement savings plan; or non-registered, which means that you do not get the benefits of tax-free (TFSA) or tax-deferred (RRSP) savings.
On the other hand, a margin account allows you to borrow funds from your online broker based at a pre-set margin rate. Think of margin as a down-payment.
For example, a stock may have a margin requirement of 30 per cent. This means that if you buy 100 shares at $10 a share you must have a minimum of $300 cash in your account.
Your on-line broker will loan you the remaining 70 per cent, or $700, charging you interest of course. The interest rate is usually referred to as the call money rate.
As I have discussed in previous articles, borrowing to invest — sometimes also referred to as leverage — is a very risky proposition. I do not recommend it for the majority of do-it-yourself investors.
For example, a cash investment of $1,000 would incur no interest expense, and if the stock rose 20 per cent over time (let’s assume one year) you would reap the full capital gain. On the other hand, if the stock declined over the year, your loss would be -20 per cent.
In contrast, using leverage could potentially result in a return on investment of as much as 53 per cent but at much higher risk.
How much more risk? If this same stock fell by 20 per cent in price, and you had borrowed money to invest, you could suffer as much as a 76 per cent loss. So margin accounts are not for the faint of heart.
Setting aside which type of account you choose to open, you also need to keep in mind that the price you pay for a stock will not be a single price that fits all investors.
Buying and selling a stock is surely about price. This might seem obvious but not for the reasons you would think.
Warren Buffet is quoted as saying “price is what you pay, value is what you get.”
This is never more true than in the stock market. In fact, one investor’s price is not necessarily the same price that other investors pay.
Two investors buying at the same date and time can, of their own volition, pay different prices. Why? It is all about the conditions that you accept at the time of purchase.
When investing, you can choose to buy “at the market” or “at a limit price.”
At the market means that you are willing to pay the current price for a stock. Think of at the market as paying list price for a home or a car that you want to buy.
In contrast, if you do not want to pay list, you can process a limit order in which you specify a price that you are willing to pay. The risk is that your buy order will not get processed because no other investor is willing to sell at your limit price.
The same is true when selling your investments. You can sell “at the market,” or request a “limit order” that specifies the lowest price at which you are willing to sell your stock.
Investing is not just about returns or making money. It is also about managing the risks that you take to earn those returns.
Stop loss orders can help investors manage downside risks. For example, if you purchased a stock at $10 a share that later rose in value to $12, you could lock in all or a part of the profits by initiating a stop loss order at, say $11.50. If the price of the stock drops below the stop loss price of $11.50, your online broker will sell on your behalf, locking in a profit of $1.50.
Of course, as an online investor you need to realize that too much trading (buying and selling) can diminish your return on investment (ROI). Remember, trading costs — money that reduces your ROI.
Indeed numerous studies have shown that online investing can encourage a feeling of excitement about trading that overtakes the reason for investing: making a profit.
So, to be successful in an online investing environment you need to have a long-term buy and hold philosophy that emphasizes investing in securities that deliver a consistent internal rate of return, a solid understanding of your personal risk profile (refer to my previous two articles) and a good understanding of the language of online investing.
Finally, remember that in the final analysis you are in control of your financial destiny.
Easy Money is written by Patrick O’Meara, a former instructor at Red Deer College’s Donald School of Business, who is now chair of finance and accounting programs at Centennial College in Toronto. He can be reached at firstname.lastname@example.org.