Vol 1, Issue 3 Mar 4 2013

What should everyone know about investing. pg.2

How ETFs workpg. 6

How Stock markets work? pg. 7 What does GDP mean? How is it measured? pg.12

Why is Gold so Precious?

What Everyone Should Know About Investing

1. Magic of Compounding: In 1626, Peter Minuit of the Netherlands bought the island of Manhattan from the Lenape people for a basket of clothes, beads, and other items that would have been worth just $24 then. Now, you might think that the Native Americans were robbed. Actually, if they were able to invest that $24 in an 8% bond, that account would be worth $26 trillion in 2012 - enough to buy all of America. That is the magic of compounding. Your money keeps multiplying the longer you save. If compound interest is the only thing you remember from your high school math class, you will survive. 2. There is no Return without Risk: Your return in any investment is always proportional to the risk you take. There is no such thing as a low-risk, high-return investment. If someone says that, run as fast as you can from them. 3. There are 3 main classes of investment - Stocks (owning a part of a company), Bonds (loaning a company money), and Commodities (holding the rights to a physical good). Unless you are a smart trader, stick to only the first 2 classes of investment. Also, when someone tries to sell you a Forex account dont walk away, run. Unlike stocks, which are quite strongly regulated in favor of investors thanks to the SEC, Forex has very weak protection for common traders (CFTC is usually very non-aggressive in going after scammy brokers).

There is no return without a risk. Carefully understand the risks.

4. Own stocks when you are young and own bonds when you are old: Stocks are highrisk, high-return investments and are suitable for an investor who doesnt need the money in the short term. As you age, you must slowly move your money from stocks to bonds. Stocks are ALWAYS riskier than bonds given the fundamental reality - bondholders ALWAYS get their money before stockholders in any liquidation. Here is the quantitative data to back that up. 5. You can never be too young to save. Save and invest as early in life as possible. If you have kids, make them learn investing skills. It should be like learning to walk, swim, or drive.

6. Inflation kills. Assuming an annual inflation of 6% (over long term), in 40 years you need $11 for every $1 you have now to have a comparable lifestyle. 7. Diversify enough. Always spread your money in 5-7 different types of investments (bank deposits, tech stocks, broad market index, bonds, etc.). 8. The Rule of 72. If you have put your money in an investment earning 9%, how do you calculate when your investment doubles without a calculator? There is a simple rule of thumb. Just divide 72 by your interest rate and that gives you the number of years it takes to double your investment. Thus, if your investment gives 9%, you will double it in 8 years (72/9).

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Why is Gold so Precious?

The world needs some currency system to handle trade. It can be anything (stones, metals, water, food, etc.). So, why gold? Gold was used by almost all major civilizations in the world. Can the whole world be crazy for thousands of years? Here is why gold is golden: 1.It is extremely dense. This means it is easier to carry and handle than a sack of rice or a barrel of oil. In fact, anybody could put their entire familys wealth in a small bag and carry it away (in times of crisis, disaster, or migration). 2.It is quite inert and doesnt corrode. This means it doesnt lose value. Thus, generations could hand over their gold to their next ones. Can you do that with paper or iron? Can your grandma give her savings in some crumbled notes to you (that her great grandmother gave her)? Unless you are a philatelist or a history student, those notes will have no worth to you. 3.It is very easy to test the purity of gold anywhere in the world at almost no cost. How easy is it to test a foreign counterfeit note? How easy is it to value land or diamonds?

There is a reason why gold is so celebrated among the metals.

4.The supply of gold is stable across centuries. Very unlikely to produce new mines any time soon. How easy is it to print currency & debase value? How likely is it to find a newer mine for another metal? No government can cheekily steal your savings value by increasing production. 5.Gold has only one grade and thus single pricing. This means it is very liquid. If you were to trade in diamonds or oil, you would have to deal with a myriad of grades and qualities. Can you get the same value for your diamond ring if you were to sell it now at the price you bought it? 6.Gold is recognized all over the world. This means flexibility and trust. No other material is this recognized across the world. Will your Yuans or Rupees or Reals work this way? 7.Unlike silver or platinum, gold has very little industrial use (only about 100 tons annually used in industries such as semiconductors). Thus, you are not taking away a valuable industrial commodity for trading. 8.Its the most malleable of all metals, making it easy to handle and manipulate.

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How ETFs Work?

An ETF (Exchange Traded Fund) is a type of fund that, like a stock, is traded on an exchange. What makes ETFs essentially different from mutual funds is that they can be traded (bought and sold) during a regular trading day. Most ETFs track an index, and hold a collection of securities (stocks or bonds) or commodities. The market price of an ETF is heavily influenced by the forces of supply and demand for the ETF, and not just the net asset value of its holdings. This means that ETFs can trade for more or less than the price of their underlying holdings. The benefit of ETFs is that they allow investors to diversify their investments over a whole sector, index, segment, or even country. Lets go through an example of how an ETF is created. An investment bank wants to create an ETF that tracks the Natural Gas sector. That investment bank will submit details of the fund they create (to track the Natural Gas sectors performance) to the SEC. They will also identify which stocks will be part of that fund. Once the SEC approves the fund, the investment bank will contact other firms or funds that hold the stocks that will also be included in the ETF they have created. These stocks are then grouped together and delivered to a custodial bank. ETF shares are created. The firms can now sell their ETF shares on the market.

Stock market is a weighing machine that collectively engages in a guess work.

How Do Stock Markets Work?

In the short term, the market is a voting machine. But, in the long term, the market is a weighing machine. - Ben Graham Part 1: Basics of a Stock Market History: A long time ago, humans ran businesses with just their money. The businesses they ran were small and they grew their businesses only with their own profits. However, not all businesses can be built with ones own money. What if you wanted to build a new factory that costs more than a million dollars? B anks wont lend money to young companies and your probably friends wont have that much. In the 15th-16th centuries, as the Europeans started exploring Asia and the Americas, the big explorers felt they needed a lot of money but their kings were not providing them anymore. The wealthy guys demanded a lot of interest. They felt they needed to raise money from a bunch of common people. Therefore, in 1602, the Dutch East Indian company became the first company to issue shares of its company in the Amsterdam Stock Exchange and get traded on a continuous basis. What is a Stock? Stocks in a company provide you a share of the companys future profits in return for the capital invested. For instance, if you buy one stock of Apple now, you will be assured one-billionth of Apples profits in the future (as there are almost a billion such stocks that Apple has issued currently). Listing: In a stock market, 1000s of companies are listed and these companies (called public companies - as they have given out their shares to the public) pay a fee to the exchanges, along with a promise to provide all important information to the markets. In return, they get an opportunity to put their company on the stock markets board and have the ability to get money from people visiting the market. The first time a companys stock appears on the stock markets board is called an IPO (Initial Public Offering).

Brokers: Conceptually, a stock exchange is similar to eBay. They allow companies to be listed and connect buyers and sellers. Since millions of people trade in the market and it is practically impossible for these exchanges to deal with all these individuals, they have assigned brokers who act between the exchanges and the individuals. Part 2: How does one value a stock? Basic Terminology: We will use a term EPS (Earnings per share), which is exactly as it sounds. EPS is the profits of the company divided by number of shares. For instance, Apple has $41 billion in profits and about 950 million shares, giving an EPS of about 41000/950 = $44/share. Thus, if you own a share of Apple, you are entitled to 44 bucks of Apples profits this year. Calculating Share price: To evaluate how much you need to pay for that one Apple stock, you need to do a simple addition of all the earnings you will get Stock Price = EPS in Year 1 + EPS in Year 2 +... Now, you know that a dollar earned 10 years from now is not the same as a dollar earned now because there is an interest rate i involved and money you get in 10 years is less worthy than the money you have now. Therefore, you need to adjust that formulae. Stock Price = ((EPS in Year 1)/1+i)+ (EPS in Year 2/(1+i)^2) +... Now, there is a whole bunch of math involved (starting from the compound interest formula) and for the sake of simplicity, I will get you to the final results and reduce the stock price to two cases:

Stock Valuation is an art with some science behind it.

1. In the case of a mature company that doesnt grow: Stock price = EPS/Interest rate The expected Interest rate is relatively easy to calculate and depends on how risky the company is, how risky the market is, and the current long-term interest rate of government bonds. For many mature utility companies, this interest rate comes to about 10%. Thus, utility companies that dont grow much are generally traded at about 10-15 times the EPS (insert in the formula above). The stock prices of these companies are very smooth and change only when there is a change in long-term interest rates, the risk profile of the company can change when hurricanes such as Sandy hit, or when market risk changes (e.g. 2008 financial crisis). But on a regular day, there is not much action here. Let us move to the second category of shares. 2. For a growing company: Stock price = EPS of next year / (interest rate - expected growth rate of the company) Let us use a simple example. If you assume Apples next year EPS will be $48, the expected interest rate for such a risky company at 15% and an expected annual growth rate at 5% will get you: $48/(15%-5%) or $48/10% or $480 as the ideal stock price for the company. Where did I get this magical 5% number from? Getting the growth inputs: Now, we need to find the growth rate of the company and figure out what the company will earn in the next year, the following year, and so on. This is not an exact science and no one has a perfect answer to this question. This is why we need stock markets. Collectively, we all pool our intelligence to figure out the future growth of the company and thereby its current price.

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To do this collective prediction, we constantly get new inputs and project that to the future. For instance, if the company management gets new hot-shot engineers, then we predict the future will be bright. What are other news that investors typically use? 1.Periodic financial results of the company that gives us a view into the companys workings and its financial position. 2.Periodic results of similar companies that help us guess this companys results. Thus, when Apple sneezes everyone else catches a cold. 3.Changes in the sector. If a new report comes that people are more inclined to using mobile phones, we predict growth of these companies will be high. 4.Changes in the broader market. 5.Changes in the international economy. Market Estimation: In short, we try to use all possible information to guess the future growth of the company, plug that into our formula, and find out the stock price. For instance, if Apple comes out with a report saying people are buying less iPads, we might ding Samsung too as we believe their Galaxy Tabs might sell less too. Estimating growth rate is an art rather than a science, and is collectively done by millions of humans in a place called the stock market. Since we need to constantly adjust the growth rate based on new information, stock prices constantly fluctuate. Main advantages of a stock market: 1. The market allows companies to get money from a large number of people. That means there are more options to get your money for building your business. 2. Spread risk. The stock market lets you spread the risk of your business into a large number of people. Since, each person is investing only a small portion of his/her income in the stock of a particular company, the risk of a single company collapsing doesnt significantly affect investors.

Look for market cues when estimating the stock price. Market Psychology matters too.
3. Collectively estimate value. Summary: Modern corporations require a lot of capital beyond the wealth of a few individuals. Markets help companies raise money from a large number of people and together these investors value their company. The theory is that when a large number of people do their independent valuation, the companys price comes closer to its ideal worth. In the short term, the market is a voting machine. But, in the long term, the market is a weighing machine. -- Buffett

(Disclaimer: This is an answer targeted at beginner-intermediate level investor and not high frequency traders or experts. I deliberately approximated a few things to improve clarity).

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What does GDP mean? How is the Gross Domestic Product of a country measured?
If you follow business news, it is hard to miss this acronym: GDP. It is thrown in almost all economic news. What does GDP mean? How is it measured? GDP (Gross Domestic Product) is a measure of a countrys production or income. You can simply understand this as the sum of incomes of all people living in a particular country. For instance, the GDP of US is $15 trillion. This is the sum total of incomes of 313 million Americans (at an average of $50,000 per person). This is one of the simplest and most intuitive measures to track the economy. If incomes go up, wellness goes up. Thus, most governments prioritize maximizing this measure. The annual growth in GDP is the most used metric to figure out if an economy is going up or going down. How is the GDP measured? The village of utopia has 6 cows (generating 100 liters of milk everyday), 100 acres of wheat field (generating 100 tons of Wheat every year), 100 acres of cotton fields, 1000 sets of clothing (at an average price of $10 each). Assuming that nothing else is produced in the village, the GDP of the village is: 1.100 liters *365 = 36500 at $1/liter. Annual product: $36500 2.100 tons of Wheat at $500/ton. Annual product: $50000 3.1000 sets of clothing at $10 each. Annual product: $10000 The total GDP of this village is: $365000+$50000+$10000 = $96500. (Note: We dont take the value of cotton produced here, as it will be accounted in the Textile production).

GDP measures a regions total production in a year.

When you have millions of people living a country, it can be hard to measure the GDP. Most often it takes a couple of years to fully know what happened on a particular year. Thus, there is a lot of guess work involved in the process to make it timelier. There are 3 ways to measure GDP: 1.Measuring through Consumption: This is the total amount spent and invested by people. Since all money generated in the economy has to be either spent or invested, it indirectly measures the economy. Given that governments have tax collectors all over the nation, it becomes relatively easy to measure how much people spend. Thus, this is one of the best ways to measure GDP. GDP = Spending by people + Spending by government + Investments + Exports - Imports. In the short term, GDP can be increased by increasing government spending, leading to some leftist economist arguing for more government spending during recessions. 2.Measuring through Incomes: Adding wages, corporate profits, taxes, interests, and rents of all labor and facilities. This measure can be delayed given the fact that businesses and people file taxes only the following year. If you subtract the tax component from this, you get the GDP measure: Total Factor Income. 3.Measuring through Production: Calculate the market value of all products and services produced in the economy. You need to make sure that you subtract the value of intermediate goods (such as the cotton from the fields). This is what we did in our basic utopia example. This is one of the hardest ways to measure GDP as you need to track all products and services. If you add all the taxes and reduce subsidies, you get GDP at Producer Price. Due to the various guesswork involved, these three measurements could lead to different results.

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Recessions The annual increase in GDP is called the growth rate. To make sure you account for inflation, you subtract the inflation from the growth rate to get the real rate. When an economy goes through a period of negative growth (wages going down), the economy is said to be in a recession (this is an unofficial use of the term though). Here is the 80-year GDP growth rate of the US. You can see the massive drop in GDP in the 1930s (Great Depression) and in the period immediately post-World War II (1940s). Since then, governments and economists have learned a lot in managing the economy and have taken immediate measures to manage GDP through active intervention (such as government spending).

There are 3 different ways to measure the GDP.

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