The stock market is a mystery to many and treacherous waters to even more. At one point, everyone had their own misconceptions on the mechanics of investing world.

There is no doubt that investing is an emotional roller-coaster ride. The passengers who can tolerate the ups and downs would be less likely to make a bad investment decision.

When I first started, I made many of these same mistakes with real money. The rookie investor in me didn’t realize that I made these exact mistakes when I was fooling around with virtual stock portfolios. I’ve become much wiser since.

I hope the many rookie investors out there don’t repeat them:

• Investing in the popular brands. So, you saw an appealing Abercrombie ad on the side of a building and you see all the teens wearing their clothes. That does’t make Abercrombie a good investment. Frequent exposure to a brand only reveals a successful marketing campaign but says very little about the company’s performance.
• Buying high dividends. Compared to a high-yield savings account, a company’s dividends might look like a golden. Dividends are typically cash that a company doesn’t need and is returning to shareholders. This could signal lagging growth that deserves some research before a stock with a dividend yield of 9+% goes bankrupt the next year. Recently, BP was speculated to be on this path.
• Buying in on dips. If a stock (or the stock market) takes a dive, many investors are learning to buy instead of sell. Sure, this is a way of getting discount stocks through dollar-cost averaging – but buy only after you’ve done the necessary research so that you aren’t buying poor value.
• Putting money on that stock tip. Stock advice always seems convincing to an amateur investor. It’s normally those who start investing with very little funds and end up losing most of it within the first few trades. When it comes to investing, tread along with this golden rule in mind – there are no guarantees in the stock market.
• Playing according to the news and media. Whether you are a fan of CNBC or Bloomberg, it is common to have the news and media sway your investment decisions. Any of the so-called experts and analysts are voicing their opinions and beliefs. What they say have no effect on the company in question. Also, any news, whether positive or negative, shouldn’t be indicative of the future. Most news on TV represents short-term influences on investment analysis. Research the news much like how you’d perform a full body checkup on a company.

There is No Right Way
Sadly, no matter how often we preach the sound methods of investing, everyone (including the best investors) will make mistakes. There are infinite ways to do something wrong and few way to do it correctly. Don’t be surprised to hear preposterous methods such as selecting stocks with ticker symbol that include only vowels or jotting down the letters in a child’s spoon of alphabet soup.

There is a chance that these five wrong ways end up making you money. But, when you stop to think about it, how would it be any different from gambling?

(Photo credit: Jesse Gardner)

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Two weekends ago, the retro release of the Nike Air Max 90′s Infrared colorway was the only thing on my mind on that Saturday morning.

It is a timeless style that any sneakerhead could not afford to miss – that’s right, I still consider myself somewhat of a “sneakerhead” even though I’m not that punk in high school anymore.

Luckily, the local Footaction and Modell’s still had my size in stock and I picked up a few pairs.

This may seem like the obsessive jibberjabber of a compulsive spender deeply immersed in a subculture suffering from a sneaker fetish. But, there is nothing weird about it when it presents a business/investment opportunity.

Economics of “The Shoe Game”
The top echelon of the this subculture includes classic Air Jordans and limited edition Nike sneakers. Like all commodities in the world, they’re part of an economy that is governed by the laws of supply and demand. More and more young kids are being introduced to “the shoe game” and I see everyone trying to be part of the cliques rocking $300 pairs of sneakers. Demand continues to grow and I don’t see any resistance.

Supply decreases as everyone starts to wear their new sneakers. Demand increases as more people adopt this fashionable subculture – and from my personal experience, it becomes an obsession and addiction. The natural effect is a price increase as quantities of the limited sneakers begin to dwindle while the amount of buyers continue to grow.

Any pair of unworn Air Jordan sneakers from the 1990s can easily be worth thousands of dollars (since there aren’t many of them lying around).

Any investor can identify this recipe for a profitable market.

Why Kicks Are More Profitable Than Stocks
My favorite unique property of a popular sneakers is that they have the ability to retain or increase in value despite having been worn and used. Most people feel that it is disgusting to wear shoes already worn by someone else. To the sneakerheads, worn shoes is not a significant issue. On the other hand, condition and appearance is most important. After all, these sneakers are worn to make fashion statements.

If the sneakers are worn but kept in good condition, it is possible to still make a profit after a year or two.

The main reason popular Nike sneakers remain popular is because there is an ever-growing consumer base. If you have the right sneakers, there will always be buyers. The subculture has a loyal following that is passed on to future generations and spreads like wildfire. It is contagious among family members and friends. Soon, everyone is competing with each other to see who has the rarest pair of sneakers among the group.

Although I’m an advocate of frugality, I can’t help but admit that I’m glad that the subculture breeds an addiction that keeps people spending even though they’ll probably never wear the 50 pairs of sneakers in each of their closets. It’s a trait supporting my confidence in sneakers as a great investment opportunity.

Each pair of Air Max 90′s that I bought two weeks ago cost me $94.99. Assuming Nike doesn’t release this classic colorway again in the next two years (and history has told us that it most likely won’t), I can guarantee each pair will sell for at least $130. That is equivalent of a 16.98% annualized return – topping the S&P 500 average return of roughly 9 to 10 percent. But, I wouldn’t be surprised to find myself getting $150 for each (25.66% annualized return).

Disclosure: I do not own any shares of Nike (NKE).

(Photo credit: AchimH)

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Payback Time is an investing book written by Phil Town, a well known investment guru. Town actually puts his investing advice in a step-by-step format with examples in a comprehensible format – a rare sight among many investing books these days.

Town’s investing philosophy is very much based on the success of Warren Buffett’s endeavors. The strategy taught in this book involves value investing over the long-term.

He shows no respect for the mutual fund industry and reluctantly mentions index funds for investors who simply want to take the easy way out. Therefore, stocks are his weapon choice for revenge. Against who or what? I’m not too sure.

These are the highlights of the book:

• The Three M’s. Meaning. Moat. Management. Town stresses that we are not dealing with stocks but we are meddling with businesses. So, we would like to invest in a business that 1) is simple and understandable to the investor, 2) has a competitive advantage versus those in the same industry, and 3) has stellar cast in management to keep the business running as it should.
• The Big Five Numbers plus Debt. After finding the right companies, we want to find the value of that company through return on invested capital, earnings growth, sales growth, equity growth, cash growth and debt. This was the formula taught in Town’s previous book, Rule #1, to find value of a company.
• Stockpile at the right prices. As Town puts it, the key to growing wealth through stocks is stockpiling – hoarding shares at an optimal discount price. It represents a refined and picky version of dollar-cost averaging. He throws a bunch of different nicknames for numbers (Sticker Price, Margin of Safety Price, Payback Time) but they all point to a set price-point criteria for buying stock that yields a low-risk, profitable investment.

Instructional Investing is Hard to Find
Payback Time is written in a great instructional format that teaches the reader what to look for and how to look for it. In my opinion, the most valuable content is the set of parameters that Town uses to identify a good investing opportunity. Along with guidelines to find the right company, he tells you when you should buy and when to sell.

Town gives a complete example of how to enforce the strategies that he teaches. To top it off, he touches upon the various investment vehicles that would maximize earnings and advises on making routine contributions – which is the best way to begin saving to invest.

Town’s value calculations include data research from many years ago. He likes to look at the trends of a company’s core financials dating back up to 10 years before. While historical numbers tell how a business became what it is today, I’ve always been skeptical as to how it translates into future performance – especially in the fast-paced, volatile age that we live in now.

He also wrote a section on trending and the use of technical indicators to pick out the right times to buy and sell. Again, technical analysis was invented to time the market, which is something I wouldn’t attempt. Instead, I prefer his price indicators over such hooey. If the stock’s price has reached its value without significant potential for growth, sell it. If the stock’s price reaches a significant discount to value, buy it.

Overview
This book definitely encompasses the investment mentality that any stock investor should have. Town stresses that we are investing in a business of which we are looking to become part-owners. Therefore, we must start from the perspective of a owner, not just an investor.

I am someone who is starting to jump into individual stocks rather than simply relying on index funds. Payback Time is just the book to learn more about sound long-term investing with stocks, which has greater potential for higher returns compared to diversified funds.

For anyone looking to become more active in building a stock portfolio, Payback Time is worth the read. The concepts are basic and simple (you probably already know them) but the book provides a systematic approach won’t leave you in the dark.

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If you follow me on Twitter, you will find that I often cheer when the stock market falls a few hundred points. Some investors will think that I was drunk and cursing me in their minds as their investment portfolios bleed money.

But, I have investments in my portfolio too. Shouldn’t I be sulking like most other people?

No, Because that is the time when the stock market goes on sale and I buy in every time it does so – essentially, I dollar-cost average whenever a discount stock market presents itself. Obviously, I’m not the only one who lurks in the bushes. There are plenty of other prospective investors ready to pounce on a sale.

What is dollar-cost averaging?
Dollar-cost averaging is an investing technique where you invest in increments over time. You would buy more as prices drop and buy less as prices go up.

This attitude applies the same way for a trip at the supermarket. If you are confident and steadfast with a particular item, there is no doubt that you’d buy it. It just comes to how much of it you will buy – which is often determined by its cost. Once in a while, you may find a 12-pack of Coke or a box of Cheerios on sale. You know you found a deal and these goods can last quite a while, so you buy multiples of them at a discount price. But when it isn’t on sale, you’ll still buy them but much less in quantity.

If you trust your selection in a stock, ETF, or mutual fund for the long-term, you’d prefer to purchase shares with as little cost to you as possible. When the share price ringing in a profit but you feel that the company still has room to grow, you’d continue to invest in it – but less. And finally, if you feel the share price has reached its maximum potential, it may be the time to sell.

An example of dollar-cost averaging by buying shares of Company X with $10,000:

• 400 shares at $5/share
• 500 shares at $4/share
• 800 shares at $2.50/share
• 500 shares at $4/share
• 800 shares at $2.50/share

You acquired 3,000 shares of Company X at $3.333/share. A one-time purchase of Company X at $5/share would have resulted in only 2,000 shares (1,000 less).

Since you are confident in Company X’s long-term growth, the current price only dictates the rate at which you can accumulate shares. If you figure Company X’s value to be $6/share and the business has no major negative changes to its operations, then you’d probably expect the share price to reach that level sometime in the future. Any price you pay under $6/share is considered a discount.

The Arguments Against It
The biggest factor to employ this technique successfully is the ability to shun emotion from investing. Watching my stock portfolio drop and in the red is not a pleasant site. As a human being we all feel fear when we lose something, especially money.

I conquered my fear of investing by educating myself and learning that a stock market slump isn’t a bad thing. Nevertheless, it’s not surprising that an investor doesn’t want to continue buying a stock that went from $50 to $10.

Dollar-cost averaging will never beat the guy who can time a stock’s trend. An investor who does make that one-time purchase at or near the bottom will make much more money. This person could be someone who did his homework or is plain old lucky. This person also saves on trading fees while making the most out of dividend payouts (if any). But, are you or can you be this person?

Who Should Dollar-Cost Average?
This method of investing is ideal for anyone who is incapable of, or doesn’t want to try, timing the stock market.

Mutual fund and index fund investors can dollar-cost average with less work since their funds’ performance is often based on a large, diversified selection of stocks. If the general belief is that the stock market or specific industry is bound to go up, investors simply have to follow market or industry news. When financial advisors tell clients to rebalance their portfolio by selling the funds that made money and buy more of the funds that lost money, it is essentially dollar-cost averaging.

Investors in individual stocks would have to remain informed on a company’s activity to make sure that there isn’t loss in value. And if there is, the investor’s dollar-cost averaging may not yield profitable results as expected. The entire stock market breathes more confidence in investors versus a single stock. But, individuals stocks have more growth potential.

(Photo credit: mvhargan)

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Price-to-earnings ratio. Market capitalization. Operating cash flow. 20-day moving average.

Say what?

Back in college, these were the very terms of an overwhelming presence despite my growing interest in investing. When I hear that college students are buying luxury cars and eating out because they were making a fortune daytrading stocks, my intuition told me I can do it too. What a typical get-rich-quick pitfall that turned out to be.

Failure is a Lesson
I opened my first investment account with $500 (a significant amount of money for a college kid) through Scottrade with the push of a friend. And with that money, I bought shares of a small, growing company that seemed to have great potential on the day of their quarterly earnings report. There it is – the first stock I ever owned.

Immediately after the stock purchase, I was addicted and refreshing the stock quote like mad. On my way to class, I found that the company’s earnings did not meet analyst expectations and took roughly a 5% dive during after-hours. The next day, the stock fell approximately 10% from the price I paid.

And the dreamer in me was hopeful that it would eventually rocket to the moon and I refused to sell my shares to minimize my loss. Within months, the company went bankrupt.

That’s right. The first company I ever invested in went bankrupt. How’s that for welcoming me into the world of investing?

Luckily, I ditched my shares when the stock nearly lost 50% of its value. As with every negative experience in life, I didn’t want to go through it again. There was precious money on the line that I couldn’t afford to lose. My first investment instilled the fear of investing in general. As a result, I went on a 2 year hiatus.

Down But Not Out
While I didn’t have real money in the stock market, I continue to learn more about investing. Every morning, I’d wake up in my dorm room and turn on CNBC or Bloomberg. Not only was it beneficial to become regularly exposed to stock market news for the purpose of learning, it also serves the purpose of developing a filter to the “noise” of the media.

I took an introductory business course and a course in financial accounting. Understanding the basics of a business offers better decision-making when it comes to investments. Although financial statements may seem confusing to many investors, it actually reveals plenty of of clues regarding the performance and health of a company.

Because I didn’t want to lose the little money that I had, I played around with investment simulations. It was fun to mess around with short sales, options, and whatnot but like many other people, I tend to not take my stock picks seriously. What I did take away from managing a virtual stock portfolio is to, once again, immerse myself within the realm of investing.

I’m Back
The monumental step that led to my comeback to real-money investing was the acknowledgement of a man named Warren Buffett. I researched and researched how this man became one of the wealthiest people and why he held the title as the greatest investor. As the stock market started to tank, his principles and advices mitigated my fear of investing.

During the recession, with stocks at bargain prices, I knew I was buying low and looking to sell high. With everyone pulling money away from their investment accounts and hiding in cash, they were being fearful and it was my time to be greedy. My entire mindset has changed. I made regular contributions to my Roth IRA and invested in mutual funds and ETFs. Whenever the stock market took a huge dive, I would put so more money in it.

Although I began investing again, I was cautious in my ability to select a winning stock. But, after living with my diversified investments for a while, I feel more confident with individual stocks. Sure, no one knows what the future will hold but at the very least, I should be comfortable with my stock picks on a long-term basis.

One major change in my investing outlook is that I’ve ditched the short-term opportunities and look for stocks that I’ll carry with me long into the future.As of now, my Roth IRA portfolio is up and I won’t hesitate to buy in as the market takes the occasional dip. Yes, I think I’m addicted to investing (again) as I’m checking up on my phone regularly – ready to pull the trigger on a buy order.

You Shouldn’t Be Scared Neither
While I went from a coward to a minor addict, those who’ve had the same fear need not live with it forever. Conquering the fear of investing is the same with any other fear we encounter in life. Understand it. Get used to it. Be careful around it.

Here are some of tips from my personal experience:

• Read investing books. My top recommendation would be to read The Intelligent Investor but it may have technical jargon that could make it difficult to understand. Pick up any general guides to investing that you find on the shelves of your local public library. Once you understand the basics, move up to the harder stuff.
• Learn to read financial statements. Like I said, financial statements contain plenty of information on a company. An accounting course would be great but the more realistic way is to, once again, utilize your library and supplement with information on the Internet.
• Manage a virtual stock portfolio. If you can take it seriously, unlike me, you can really put your investing ideas to good practice.
• Turn on CNBC or Bloomberg. The constant stock market news really put me in the middle of investing. I may not understand everything they talk about but they do keep me up-to-date. Occasionally, I learn something new.
• Start small. My reemergence in the investing world began with $1,000. Slow and steady. It is now valued at nearly $5,000.
• Diversify. And of that $5,000, $4,000 is in mutual funds and ETFs across different indexes. I sleep easy knowing that no single company could lead me to lose all my money.
• Dollar-cost average. I cannot time the market and you most likely can’t neither. So, buying on the way down allows us to purchase cheaper stocks without the risk of losing ton on a single, large purchase.

Having friends who are interested in investing goes a long way to when it comes to your own investments. My friends chat about our thoughts and analyze the chatter in the markets and the economy. I’d suggest refraining from taking and offering stock picks as those situations don’t usually turn out well.

(Photo credit: azrainman)

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As a LendingClub investor, I’ve spent my share of time browsing the notes that are up for funding. While the information the a borrower provides in the loan application offers a substantial amount of background knowledge, investors would always appreciate more information to help them decide whether or not they should fund a particular loan.

The basics of peer-to-peer lending should mimic the approach that banks take when conducting their lending operations. Banks ask a plethora of questions during the loan approval process and so should us investors. Luckily, LendingClub allows potential investors ask questions to the loan applicant.

Upon scanning through loan notes, many of the same questions will appear because they pertain to every borrower’s financial health.

These are the most common questions asked by LendingClub investors and why they are so important:

• What is Company ABC? What is your job title and what are your duties?

These questions help the investor assess a borrower’s job security and income stability. Understanding the industry in which the employer operates provides insight to the business’s functional stability compared with economic conditions. The job title and duties are more important because they define the significance of the position.

If the job lies on the upper echelon’s of a company’s ranks, it’s less likely the employee will get fired due to greater responsibilities. For example: a regional manager position for Walmart beats a sales associate position for Walmart. Basically, the safer the business and the securer the job, and the better the chances of repayment.

• What debt obligations do you currently have (please provide balances, interest rates and monthly payments) and which debts do you intend to pay off with this loan?

Investors like to see that borrowers have a sound plan when it comes to managing debt. They want to see that the borrower knows what to do with the LendingClub loan such as applying the funds from the loan towards balances with interest rates higher than that of the loan.

If the loan is used to pay off part of the outstanding debts, investors will need to account for the separate repayments when assessing the borrower’s repayment ability.

• Can you list your monthly itemized expenses and their amounts?

Knowing the monthly expenses will allow the investor to determine the borrower’s net cash flow. After verifying the borrower’s monthly income, deducting monthly expenses from this amount would result in the net cash flow, based on which investors assess the borrower’s ability to make the monthly LendingClub payments.

If the net cash flow is less than the monthly LendingClub payment amount, the borrower won’t be able to repay the loan. If the net cash flow exceeds the monthly LendingClub payment by just a sliver, the borrower represents a high risk because there will be very little money left for discretionary spending while there is a greater chance of defaulting.

• Can you explain the reason for your delinquency or public record on your credit report?

Delinquencies and public records represent tarnishes on a borrower’s recent credit history (they wouldn’t show up on the credit report after 7 years). The negative marks could result from things such as a loan sent to collections or declaration of bankruptcy. They may reveal underlying problems with the borrower or they could just be small, honest mistakes.

Most investors prefer a clean record but if the borrower explains that the situation was just a one-time error, many investors won’t mind it. Outstanding delinquencies would alert investors of risky borrowers with bad debt relationships that would jeopardize the safety of their investment.

• How much equity do you have on your house (please include appraisal value and remaining mortgage balance)?

For most homeowners, a mortgage constitutes their greatest financial debt and, for some, has become a dangerous asset in recent years due to falling housing prices. Investors frown upon homeowners with negative equity in their houses because most people would choose to default on other loans rather than default on their mortgage and risk foreclosure.

Just like banks will do, investors can look at a borrower’s residential location and see the location’s frequency of foreclosure. Also, investors would feel somewhat safer that a borrower can access the equity on their homes in order to repay the LendingClub loan if the need presents itself.

• How did you accrue your debt and what steps will you take to stop incurring more debt?

How one accumulates debt exhibits his or her spending habits. Obviously, investors don’t want to see that the high balances across multiple credit cards resulted from a shopping spree to help treat depression after a bad breakup.

Simply put, they want to see a mindset that is determined to become debt-free from now on. Some borrowers have said that they’ve stopped using credit cards and resorting to cash only, or started using financial tools such as money management and budgeting software, or begun taking classes from Dave Ramsey’s Financial Peace University.

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As the Great Oracle of Omaha preaches:

“Be fearful when other are greedy and be greedy when others are fearful.” – Warren Buffett

What was once one of the safest, must-have stocks in a portfolio, BP will be held in a different light as of April 20, 2010.

The incident at their Deepwater Horizon offshore oil rig marks the largest offshore oil spill in the history of the U.S. and the well continues to leak oil despite multiple efforts to stop it.

And to add to the pain, the oil spill poses a significant danger to the marine life in the Gulf of Mexico and to the coastal life surrounding the body of water. The seafood and tourism industries will also suffer a drastic impact.

And so far, BP has taken responsibility for all of it.

Nearly two months after the explosion, BP’s stock has lost approximately half its market capitalization. At one point, it’s dividend yield was at a tempting 9.90%. So, is BP the value stock that it once was?

Since April 20, 2010, BP has:

• went from $60.09 per share (closing) to $31.76 per share (June 18 closing).
• lost $87 billion of its shareholders’ equity.
• spent $1.8 billion on the Gulf oil spill.
• suspended its dividend payout for the rest of 2010.
• spewed over 118 million gallons of oil into the water.
• paid $104 million to Gulf coast residents.

Reasons for Concern

• Failure to stop the oil leak. Of course, the sooner that BP can control the oil leak, the sooner that it can return to profit. After many failed attempts, BP seems incapable of stopping the oil leak – equal to leaking millions of dollars. Two relief wells to contain the oil are being constructed. Their estimated date of completion is around August. Until then, some of the oil is being collected by a drilling ship.
• The $20 billion escrow fund. BP has complied with the Obama administration’s request to set aside $20 billion in an escrow fund that would be used towards compensation for people who suffered losses as a result of the oil spill. The fund would require BP to sell off some of the assets in its U.S. portfolio to support it.
• Increasing U.S. government intervention. Regardless of exactly how well President Obama is handling the oil spill fiasco, history has told us that he has effected major changes in the financial industry after holding banks responsible for the recent recession. Global energy companies could see similar changes if Obama decides to make a change – and that could lead to less profits.
• Falling oil prices. The price of oil will play a primary role in the future of BP because falling oil prices decrease earnings and make the company insolvent. The possibility of bankruptcy or a takeover would increase when BP cannot generate the funds to pay for damages caused by the oil spill.

Signs of Relief

• BP posted $17 billion in profits last year and is expected to generate $30 billion this year in operating cash flow.
• It has 18 billion barrels of oil in reserve – enough to fulfill U.S. oil consumption for two years.
• Delaying dividends for 2010 would create an extra $8 billion in cash.
• BP plans to raise $10 billion by selling some of its assets.
• Relative to the size of the company, BP carries little debt.
• Although BP’s credit rating has been downgraded quite a bit, it has already established a readily available $10 billion line of credit.

To Buy or Not To Buy?
At this point in time, the government has poked its nose into the situation. The residents of the Gulf coast are acting up. Cleanup costs, victim compensation, and claims are adding to the tab. Oil is still gushing out into the gulf. Essentially, BP’s wallet is a bottomless pit.

Certainly, it would seem that the average investor wouldn’t have the guts to invest in BP. And by that assumption, now would be the time to load on some shares.

Even if Warren Buffett acknowledged that everyone was scared to add BP to their investment portfolio, he probably wouldn’t – nor would I (at least not yet). There are simply too many variables that can decide the fate of BP. While the 50% discount is enticing, I’m going to wait it out.

The first sign of improvement would be the second that BP stops that oil leak. Of course, everyone is hoping for this. But from an investor’s perspective, this golden moment is the patch that would cover the hole in BP’s wallet. BP continues to be a highly speculative position if it doesn’t plug the leak.

Next, we must stay on top of government actions against BP and the legislations that might result from this incident. Just as the Credit CARD Act has stifled the earning potential of banks, new laws could arise and weaken oil companies or just BP alone.

As said before, the trend that oil prices take will play a huge role in BP’s journey toward recovery. It will have a good chance of survival as long as oil prices do not fall.

BP has long held a formidable position in the portfolios of mutual fund managers and dividend investors for its attributes of a value stock and income-generator. While CEO Tony Hayward has stated that he will not cut dividends, the suspension of dividends for 2010 will rule out BP as a dividend stock for the time being. At the current price levels, I am more interested in the ability of the stock to gain value rather than the insanely high dividend yield.

Since BP has been a well-managed company up until now, I remain optimistic in its future. Although I don’t believe now is the right time to buy, BP represents a great opportunity the instant it stops the oil leak.

Disclosure: At the time this article was published, I do not own any shares of BP.

(Photo credit: hill.josh)

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This is a guest post by Mariusz Skonieczny, founder and president of Classic Value Investors, LLC, an investment management company. He is also the author of Why Are We So Clueless about the Stock Market?, a book on the fundamentals of stock investing.

Did you know that there are more mutual funds than there are stocks? Have you ever wondered why mutual funds are such popular investment vehicles?

Conventional wisdom will tell you that mutual funds are popular because:

• they do not carry hefty commissions.
• they allow the little guy to invest in the markets because the start-up capital can be small.
• they offer diversification because they hold many investment positions.
• they are managed by professional money managers.

Unfortunately, these are the reasons given to investors, but the truth is that mutual funds are popular because mutual funds are extremely profitable to the investment industry.

High Costs of Mutual Funds
Mutual funds may seem inexpensive because the costs are hidden. Mutual funds are loaded with fees such as sales charges, management fees, and 12b-1 fees. Sales charges are front-end loads charged by the broker or advisor for buying mutual fund shares, and charges for selling mutual funds shares are back-end loads. These charges depend on the various classes of shares.

For example, Class A shares usually have front-end loads and Class B shares usually have back-end loads. Front-end charges can be as high as 8.5% for Class A shares. This means that an investor with $10,000 is only putting $9,150 to work while $850 goes toward the sales charge.

In addition to sales charges, someone has to manage the fund and therefore, also has to be paid a management fee. This fee can range from 0.10% to 2.00% per year and depends on the fund itself and its investment style.

Another type of fee is 12b-1 which is paid to brokers or advisors to pay for marketing, distribution and service costs. The Financial Industry Regulation Authority (FINRA) allows funds to charge 12b-1 fees as high as 1.00% on an annual basis.

High-Fee Mutual Funds Are Moneymakers
Adding up all of the fees, it is no wonder that mutual funds are popular on Wall Street. It’s a great business because everyone except the investor benefits from this investment vehicle. Unfortunately, for the investor, the returns are not as good as the investment industry promises.

The average investor in a stock-oriented mutual fund generated 5.66% per year over the ten-year period ended December, 31, 2007, according to a study by Dalbar, Inc., a leading financial services market research firm. Notice that this doesn’t include the stock market decline in 2008.

Choose Mutual Funds Diligently
But are all mutual funds bad? No, not all mutual funds are created equal. Saying that all mutual funds are the same would be equivalent to saying that all restaurants are the same. Mutual funds are simply investment companies that make investments on behalf of their investors.

There are some mutual funds that delivered fabulous investment performances for its investors and did not charge outrageous fees. But, the problem is that most of the investment public would never know about them because these funds don’t advertise much, and they don’t pay high commission fees to entice brokers and advisors to sell them. In other words, they don’t play the Wall Street game.

Simon’s Note: Low-cost index funds, from companies such as Vanguard or T. Rowe Price, are a great way to invest without having to deal with the headaches and worries of picking the right mutual fund. ETFs are another great option with super low fees.

(Photo credit: alancleaver)

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For more than two years, I’ve been using Scottrade, an online discount brokerage. When I first decided to start investing, I managed to have only $500 to mess with. So surely, I couldn’t afford the high commission fees from brokerages such as Charles Schwab, TD Ameritrade, and Fidelity. While Zecco was offering free trades, I didn’t have the $2,000 requirement to get them.

I ended up at Scottrade and they’ve been great so far. Currently, I have a regular brokerage account and a Roth IRA with them. Initially, I was trading stocks but my focus has been diverted towards mutual funds and ETFs.

What’s So Great

• No account maintenance or inactivity fees
• No minimum balance required
• $7 online trades
• Huge selection of mutual funds
• Local branches

What’s NOT So Great

• $7 online trades (other discount brokerages are getting cheaper)
• No automatic dividend reinvestment for stocks and ETFs
• A somewhat sub-par feel to the account interface (a personal opinion)
• Popular mutual funds like those from Vanguard and Dodge & Cox have transaction fee of $17

The Trading Experience
Scottrade offers Live Streaming Quotes that allows you to create your own trading station – you know – just to feel cool and sophisticated. It allows you to watch your favorite stocks go up and down along with the ability to observe charts and stock quotes – and you can purchase shares within seconds.

Every time that I’ve used Scottrade’s Streaming Quotes to buy stock, execution is instantaneous. The price, as always, will be fractions of a penny off the ask price. On one occasion though, a market order had to be completed in two batches because of trading volatility but I wasn’t charged double commission.

For the average investor, it is a great feature that probably won’t see much use because we all know that the stable long-term investor doesn’t watch the volatility of the stock market. Right?

The research tools available through Scottrade aren’t the worst among online discount brokerages but it isn’t as extensive as a comprehensive investor would like. Even though I rarely do much of my research through Scottrade’s website, it’s still nice to see that it is available.

Excellent Customer Service
Scottrade customer service is awesome to say the least. Professional and helpful. They even have customer support on Twitter @scottrade! No complaints about customer support from me (and I haven’t found much, if any, from others).

Note: Troublesome Safety Measures
I do have a bone to pick with Scottrade though. Well, after several failed attempts to log into my account, Scottrade automatically suspected my account of being compromised and went on to suspend access to it. Then, they sent me snail mail requiring that I verify the integrity of my account and confirm that I have antivirus software installed. Even though I could walk into a local branch office to get things cleared up, it is just a hassle to have to do this. All the while, I wasn’t be able to check on my account.

Although it was nice to see that Scottrade cares about security, I’d much rather prefer a simple phone call to get my account back into action.

Perfect for the Average Investor
So far I’m quite satisfied with Scottrade and look forward to sticking with them. I recommend them for the average investor – long-term non-daytraders. For the more technical and frequent traders, there are probably cheaper and more comprehensive brokerages elsewhere. If you are going to be making your own investment decisions and buying stocks or mutual funds a few times a year, then Scottrade is great for you.

If you would like to sign up for Scottrade and get 3 free online trades ($21 value), click here.

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Thursday May 6, 2010 was a fun day for the stock market and all investors – pardon my enthusiasm. As I had my Scottrade streaming quotes on my screen and the Dow went skydiving, I was able navigate my account in such a flawless manner to transfer some cash over in order to not miss the largest sale of the year on the stock market.

It became a saddening sight to watch the Dow pull back up from its 900-point drop as I was about to punch in my buy order. Nonetheless, I shopped and I bought.

Clearly, it was an odd day to the jittery souls at the New York Stock Exchange and at home with their daytrading stations. The weirdest part is the speculative theories on what caused such a financial anomaly.

Do you really think a guy who had mistyped a “B” for an “M” could wreak such a havoc? Even if this person had input “billion” instead of “million”, the collective automated sale of stock is the true cause of the steep market dip. Add on the fears of Greece’s debt and other economic noise and we’ve got a recipe for pandemonium.

Don’t point the finger at the fat-fingered individual and blame those who scheduled stop-loss orders. Maybe automation wasn’t such a good idea….

Personally, I don’t agree with the actions that stock exchanges are taking – canceling orders on stocks that experienced sharp volatility. There was no computer error. Automated electronic trades are legitimate orders, correct? Can you cancel my order when I buy a stock that goes from $100 to $70 then to $120 and back to $50 in 20 minutes?

In fact, I hope this happens again – so I could continue to build my portfolio on a tight budget. Praise the Oracle of Omaha, “Be fearful when others are greedy and greedy when others are fearful”.

Don’t mind my opinion, there’s more to life – like these great posts:

• Money, Stress, and Your Health at Get Rich Slowly. Money affects everything we do. Money can ruin relationships and break up marriages. Whether we have it or not, money is a reason for concern, worry, and stress – which then trickles down to your health.
• Six Psychological Reasons Consumer Culture is Unsatisfying at PsyBlog. Shopping makes you happy? I wonder why… The things you never think about when you go out an buy stuff. Studying consumer behavior can curb your spending – not to mention how cool it is.
• 44 Ways to Ruin Your Financial Life By Age 30 at Frugral Dad. I think I’m doomed…

Carnivals that Realm of Prosperity participated in recently:

• Carnival of Personal Finance #253 (Demotivational Version) at Punch Debt In The Face

(Photo credit: artemuestra)

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