Cautionary investments - a guide and review (full sample)

Cautionary investments - a guide and review (full sample)

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This guide covers various types of investments that you might want to think carefully about before you part with any money. In this guide, we’ll explore:

  • Algorithmic trading

  • Collectibles

  • Technical and swing trading

  • Selling stocks short

  • Initial Public Offerings

Areas of expertise

Cautionary investments — A review

This guide covers various types of investments that you might want to think carefully about before you part with any money. In this guide, we’ll explore:

  • Algorithmic trading

  • Collectibles

  • Technical and swing trading

  • Selling stocks short

  • Initial Public Offerings

Algorithmic trading

Algorithmic trading and the people who practice it (known as "quants") use dedicated trading algorithms to buy and sell stocks automatically. These algorithms are programmed, tested, and tweaked on specialized trading platforms. When they are launched, they analyze the markets to find stocks that meet their criteria and then buy and sell them.

How does it work?

Investors and traders with computer coding knowledge can write specialized trading algorithms that identify stocks based on certain features (both fundamental and technical indicators). These algorithms are then back-tested on stock market data to see how they perform. They can then be launched into a live trading account where they will buy and sell stocks based on those criteria.

What are the risks?

  • Time investment and expertise - As you've guessed, it requires computer coding, math, investment, and trading knowledge to create algorithms that can perform well. Algo trading has a steep learning curve.

  • Lack of control - Because algorithms trade automatically, it takes control away from the investor, not something you really want to happen.

  • Historic results don't equal future results - A popular aspect of algo trading is back-testing the algorithm to see how it performs. Unfortunately, good past results don't guarantee good future ones.

  • Specialized platform - Algorithms need to be deployed on specialized software that links with a brokerage account.

  • Fees - Algo trading can involve relatively frequent buying and selling; broker commissions and transaction fees can eat up a lot of profit.

If you want to algo trade, what can you do?

  • Algo trading is not recommended for new investors.

  • You can algo trade through various software packages like NinjaTrader or retail investment algo platforms like Quantopian.

Collectibles including wine, art, and memorabilia

Investing doesn't have to involve stocks, bonds, and other financial instruments; some people invest in more tangible areas - including wine, art, antiques, autographs, books, and other memorabilia - in the hope they will increase in value.

How does it work?

An investor in collectibles will typically buy items that they hope will increase in value over time. They may hold these items themselves or they may be held on their behalf by a specialist broker. There are many different types of collectibles that an individual can choose to invest in, including:

  • Fine art by sculptors, painters, and other artists, both historic and modern.

  • Wine and liquor - Old and rare wine and liquor including whiskey, brandy, and port.

  • Memorabilia - Sports team memorabilia, uniforms and the like; signed photos and autographs of celebrities.

  • Books - First editions and other folios from writers.

  • Antiques - Beautiful and historic craftsmanship.

  • Other memorabilia - Early examples of important inventions and historic artifacts from other fields.

What are the risks?

  • Supply and demand market - The world of collectibles is based almost entirely on rarity and supply and demand; predicting what types of collectibles will significantly increase in value can be difficult.

  • Lack of liquidity - To make money on a collectible, you need to find someone willing to buy it from you. Unlike many other investments, it can be difficult to find a buyer, particularly one who wants to pay the price you are asking.

  • Capital outlay - Collectible investing can require large amounts of capital outlay to buy a good selection of high-quality collectibles; additionally, a dealer is normally putting a hefty markup of their own on the collectible when selling it to you.

  • No interim income - Unlike most investments, collectibles don't provide any interim income.

  • Unpredictable - It can be difficult to predict exactly which collectibles are going to increase in value substantially.

If you want to get involved with collectibles, what can you do?

  • Collectibles are not recommended for new investors.

  • There are specialized brokers, dealers, and traders in every type of collectible.

Technical and swing trading

Traditional stock investing relies on analyzing and understanding the fundamentals of a business (value, earnings, and other factors) to predict long-term growth. Technical trading (or swing trading) uses shorter-term, technical indicators to try to predict price movements over shorter periods. Swing traders typically hold stocks for a few days to a few weeks.

How does it work?

A swing trader will look at various technical indicators to help them decide if the stock is going to go up or down in price. There are dozens of these indicators (e.g., moving average, volume, Bollinger Bands, relative strength) that change on an hourly and daily basis. Investors will then attempt to use these indicators to buy into and sell out of stocks.

What are the risks?

  • Trading, not investing - Swing trading isn't investing; it's using short-term indicators to try to make money on relatively random stock movements. It can be very difficult to predict if prices are going to go up or down in the short term, making it difficult for a novice investor to make money with this type of trading.

  • A different way of thinking - Swing trading approaches stocks in a very different way. Rather than looking at reliable, fundamental, long-term indicators, they concentrate on short-term movements. This involves a whole new way of thinking, and new terminology.

  • Time-consuming - Like day trading, swing trading needs a lot of time and attention from the people who practice it.

  • Fees - Due to the relatively frequent buying and selling involved in swing trading, broker commissions and transaction fees can eat up a lot of profit.

If you want to swing trade, what can you do?

  • Swing trading is not recommended for new investors.

  • If you do want to swing trade, you can do it through your online broker account, but be aware of commissions and any other fees.

Selling stocks short

Investors normally count on stock prices increasing over time, but by selling stocks short, investors can profit from falling stock prices. In other words, as a company's share price falls, your return on that share increases.

How does it work?

Short-selling works through investors "borrowing" shares from their broker. You effectively sell the shares before owning them with the promise that you will buy them back in the future. If the price of the share falls, you receive the difference in value as profit. If the price rises, you will take a loss.

What are the risks?

  • Investing in failure - When you sell a stock short, you're hoping that the value of the stock and the company behind it will go down over time. This means that you're relying on the failure or weakness of the company; unfortunately, it can be as hard to pick losers as it is to pick winners.

  • No limit to how much you can lose - With a normal stock position (where you invest in the hope the price will go up) the most you could lose is your initial investment. When you sell short, you could lose more than you invest. For example, if you short sell 100 shares in Amazing Blue Widget Co. at $10 each ($1,000 borrowed) and the price then goes up to $30 each, you'd be liable for $3,000 worth of stock, a $2,000 loss.

  • Liable for dividends - With most stocks, you profit from dividends they pay out because you own the stock; this is not the case with short-selling. If the stock pays dividends, you are liable for them and your broker will deduct the total value of the dividend payment from your account.

  • Uptrend over time - The trend of the markets is to increase over time. This means that you're trying to pick a losing stock and wanting to buck the general trend of the overall market. This can be tough.

If you want to invest in short-selling stocks, what can you do?

  • Short-selling stocks is not recommended for new investors.

  • You can short-sell stocks through your online broker account; you simply put the stock position in as a "Sell" without buying the stocks first.

  • Remember that you could lose more than your original investment so make sure that you put "limit orders" in place to reduce your risk of this happening.

Initial Public Offerings

An IPO happens when a company launches its stocks onto the stock market for the first time (initial), allowing you (the public) to buy (the offering) into the business through investing in those stocks.

How does it work?

When a privately owned business grows and becomes profitable, it will often want to become public by offering stocks for sale on the open market. This allows the business to raise more money, increase its valuations, and reward the private investors who originally put money into the business.

What are the risks?

  • IPOs tend to be heavily marketed and over-hyped. This increases demand for the shares, drives the price up, and can overvalue shares in the business, which means that IPO investors often pay a premium to get in early.

  • The stock price on IPOs can take a while to normalize and will often fall in value in the few months following an IPO as the euphoria fades and financial realities set in. Strong businesses will continue to grow their share value over the medium to long term.

  • Because there are very little public earnings, valuation, or fundamental analyses available, it can be difficult to measure the true worth of a business at its IPO.

  • Be aware of the "lockup" period. Certain people who already hold shares in a business before an IPO have a lockup period during which they cannot sell their shares (generally three months to two years). Once this period expires, they can sell large numbers of their holdings which can affect the share price.

If you want to invest in IPOs, what can you do?

  • Don't buy into an IPO on the day of launch or for some time afterward; wait for the hype to die down and for the share price to normalize.

  • Carry out the same analysis and due diligence on IPOs as you would on any other business you're considering investing in.

  • Delay investing in a new business until you can get a good idea of earnings potential, history, and other essential and objective fundamental factors; you may also want to wait for the lockup period to expire.

  • You can normally invest in IPOs via your online broker account.

Content originally written by Paul Maplesden, a freelance writer, and edited by me.

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