What is a Short Sale?


The term “short sale” has come more into the popular vernacular lately in reference to the real estate transaction in which the lender allows the borrower to sell a house for less than is owed for the property.  In stocks and other securities a short sale is something entirely different.  Today I will discuss short sales as they relate to securities.

In securities, a short sale goes as follows – An investor (or speculator) calls her broker and says that she wants to sell 100 shares of company XYZ short at $50 per share.  Her broker goes out and borrows the shares (usually from someone who has a margin account who is currently on margin) and then sells the shares for $50.  The broker deposits the proceeds, less commissions, in the investor’s account.  At some later date, to close the transaction, the investor must purchase the shares, replacing those that were borrowed.  (Note that this person will probably not know that the shares were every borrowed, and if he decides to sell his shares during the period shares from another person must be found and used for the sale.)  If the company pays a dividend while the short seller still has the position open she must pay the dividend to the person from whom the shares were borrowed (who again doesn’t know they are gone).

 

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If the investor who did the short sale is able to buy the shares back at a lower price, say $40 per share, she will make the difference in price ($50-$40)x100 = $1000, minus commissions and any dividends she had to pay.  If the stock rises above the price she sold them for and she closes the position, she will lose money.  Obviously, stocks are sold short when an investor thinks it will decline in price.  Because stocks naturally tend to increase in price (because of inflation if nothing else), selling short is not a long-term strategy.

Now that I’ve explained the basics, you may wonder if short selling is a good strategy for and investor.  After all, why not make money when the market is going down as well as when it is going up.  The issue is that you really don’t know very often when the market will be going down.  You can certainly tell when the market is overpriced, but that does not mean that the market won’t continue to be overpriced, or even get more overpriced, before stocks finally pull back.  Sometime earnings will also increase rapidly, making stocks fairly priced again.

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There are maybe two situations where short selling might be worth it.  The first is called selling short against the box.  In this strategy you sell short shares of a stock you already own, telling your broker that you want to sell short against the box.  He will then borrow and sell some shares, yet leave your original position alone, meaning that you’ll have both a long position and a short position.  When you are ready, you simply tell your broker to wash the two positions and you close both sides.  The reason for doing this is if you want to take a profit in case the stock is about to decline, but want to move the gain into a future year for taxes.

The other time is when the market is really, really overpriced and ready for a fall, or you see something coming like the 2008 housing crisis, and you want to protect your portfolio without selling everything.  In this case, you can take some short positions, effectively going neutral or near neutral on the market, as a way to protect yourself,  For example, in 2007 I was shorting mortgage companies since I figured they would decline when the housing boom ended.

 

 

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Accounts You Need to Have for Financial Security


Today I wanted to talk about how one in general should be allocating funds.  As stated previously, this blog is primarily concerned with strategies to grow funds quickly, assuming that an investor is starting out with little money but working a steady job with a reasonable income.  It also assumes that an individual has scaled her “lifestyle” so that she is making more than she is spending.  This is the most basic requirement for becoming wealthy.  Virtually everyone can scale back to have extra income left over, but it takes a degree of sacrifice and patience since one will need to wait a bit longer to buy things but they will be quite a bit less expensive when one does (because one will be paying cash rather than buying them on credit).

The first place a person should put extra income is in a cash account that is readily accessible.  This should be built up until it contains enough to cover several months worth of expenses.  These funds are used to take care of the various unexpected expenses that occur (such as the car breaking down, heater going out, roof leaking, unexpected surgeries, etc…).  These funds should be guarded judiciously and not spent for things such as vacations, shopping, etc… since these are the funds that prevent you from needing to take out loans or run up the credit cards if something happens.  This account will also be used to live on if one loses one’s job, allowing time to find a good job, not just one taken out of desperation.

                                   

The second account is a retirement account.  This is the money you will live on when you’re ready to retire and also should be guarded carefully.  The only reason to access this kind of account is if you’re about to be out on the street if you don’t.  Absolutely don’t use this money for any other purpose, including taking out a loan against it.  The reason is that if you start saving in your 20’s each dollar will be worth over $128 when you retire, so if you take out $10,000, for example, you just robbed yourself of $128,000 in retirement worth, which translates into $12,000 per year in income.  This account should be filled with index funds when you’re young and gradually be filled with more dividend paying stocks, bonds REIT’s, and cash as you get closer to retirement.

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The third account is your investment account.  This is the account that will use the strategies in this newsletter to grow large, allowing you the financial freedom at some point to work or not work, as you choose.  This account will be invested in stocks starting with 1-3, and eventually growing to 10-20 as your wealth builds to the $500,000 – $1 million range.   Because the money in this account is not critical – you still have enough money to pay for emergencies and fund your retirement with the other two accounts – you can afford to take the risk of one or two of your positions taking a substantial loss.  Also, if you find you are not a good stock picker, such that your investment account does not do as well as the markets, the other accounts will make sure you end up in a good position as well.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Empty Nest Insurance- Start Your Kids with a Nest Egg


Today the news is full of stories of children returning home to stay after college.  The recession has certainly made it difficult for some to find jobs.  In some cases parents may also be making their homes a little too comfortable. With few rules, no expenses and no responsibility, who wouldn’t want to stay?

By starting children out early learning about saving and investing, and by giving them a little nest egg with which to start, you can dramatically reduce the chances that they will be knocking on your door, duffel bag in hand after college.

Starting an investment fund can be very quick and easy.  It simply takes a couple thousand dollars and some mutual funds.  If you start a fund about the time they are born, and add to it as they get those checks from relatives early on, and then match their contributions once they start to earn their own money, you can build up a substantial fund by the time they leave the house.  This is money they can then use when they have the unexpected expenses that always occur instead of running up credit card debt.
              

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The first step is to find a fund family with a low enough minimum.  I personally like Vanguard because their funds have very low expenses and the minimums for many of them are only a couple of thousand dollars.

You are looking for a fund that invests in a large number of stocks over a broad range of the market.  Good choices would be a largecap fund such as an S&P500 fund or a midcap or smallcap fund.  Selecting specific sector funds or ETFs is probably not a good idea since you want something you can hold for years rather than needing to move in and out of it, incurring capital gains taxes.


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Once you have selected a fund, simply create a custodial account in the child’s name and send in a check.  (Warning:  When your kids go to college, the college may see the custodial account and expect it to be used for tuition before they’ll kick in financial aid.  If you’re worried about this, keep the money in your name and then gift it to your child over a period of a year or two, staying below the gift tax exemption, when they are near graduation.)  As time passes, add extra money to the fund.  You should avoid the temptation to make many if any changes – you want to minimize expenses and taxes.  Just let it grow with the economy.  If you need to do something, wait for dips and buy more shares.

Once the fund has grown large enough, you should consider selling part and using the proceeds to buy another fund in a different sector of the market.  For example, if you’ve amassed $15,000 in a largecap fund, you may want to sell half and buy a smallcap fund.  This diversification will reduce the risk of losses and smooth out the fluctuations that occur.  In general, different sectors of the market do well at different times.


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Note that capital gains and dividends will be tax-free below a threshold amount, but be sure to check with your accountant on what those minimums are in any given year.  They are generally less for investment income than earned income.  You may also need to file tax returns in some years if the income is large enough even when they haven’t made enough to pay taxes.  Payment of quarterly estimates may also be required.  Minimization of trading, and thereby the realization of gains, will delay the time at which you will need to start preparing tax returns for their accounts.

Once the child reaches 18, the money will be theirs (you have no say over this).  You therefore should have been teaching them all along that the money is there to help them in emergencies, such as when the car breaks down, and not just for day-to-day expenses.  You should also be teaching them to leave the principle alone and just spend the interest/dividends.  In that way, even though they may waste some, hopefully there will be enough remaining when they are older and wiser to help secure their financial security.

By giving your children a nest egg with which to start their lives, you can help keep them out of debt, help them have a down payment for a house when they are ready, and be able to stay out on their own between jobs and other issues. You will also give them an extra source of income that they can use throughout their lives.

 

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.