[This is a set of questions that my friend was going to have
on a midterm in a class on portfolio's. Here are the answers...]
Ask Mr. Smartass, the Investment Wizard...
Q) Small caps vs Large caps: What can an investor expect from the two
categories? When would you want to invest in one vs. the other?
A) If you want your money to wallow in the sluggish pace of the
over-heated market and be able to talk about stocks with dinner party
guests, invest in large caps. You can feel like a stud, saying you own
Coke or AT&T, and people will admire you for being a savvy investor,
even though you have taken your children's rightful inheritance and sunk
it into a no-growth stock with a P/E equivalent to an average team score
of an NBA game.
If you want your cash to go to work for you and desire the opportunity
to make real money, invest in small caps. With a little bit of
analytical common sense (in other words, don't be a moron), you can
pick up unknown, undervalued companies and watch the price shoot through
the roof as "Wall Street Wizbangs" take their eyes off trendy tech
stocks featured on CNBC and notice these great bargains with great
potential.
The Bottom Line: Large caps are like fat sows - they can't get any
fatter or they will explode, right along with your portfolio. Small
caps are like malnourished sows - as soon as the hungry beast finds the
Wall Street feeding trough, watch your investment expand.
Q) Briefly explain the differences between the Dow, S&P 500, and the
NASDAQ: The nature of the indexes and how they differ.
A)There is a tremendous amount of history associated with the Dow. The
Dow is an index of a 30 industrial giants. It was created by Dow Jones
& Co. during the early part of this century, when much of America still
thought the world was flat. The number has very little meaning except
that it gives the average American a way to feel like they are part of
the excitement of the Market:
Man on the street: "Did you see the Dow today?"
Other man on the street: "Yes, 80 points! Can you believe it?"
Man on the street: "Amazing!"
As you can see from the above stereotypical conversation, neither man
really knows what they are talking about, but the sense of camaraderie is
clearly evident. Also significant is that 9 times out of 10, neither
man owns any stock and is completely unaffected by any change in the
Dow, large or small.
The S&P 500 is a tool created and used by Human Resource Departments at
finance companies to determine the size of the bonuses to tack onto the
6 and 7 digit salaries given to our nation's portfolio managers. This
index of 500 stocks is selected at random by HR representatives though
an interface with their employee tracking systems. They choose the
stocks based on whim or fancy, sort of like our salaries and other
benefits. At the end of the year, when they are deciding bonuses for
fund managers, they take the difference between the return of the index
and the fund manager's performance, and enter it into the following
equation:
Bonus = ([1-{R/4*e-X}+$75*n/6.3mm]/Q-M1*Z]+1/0)
where R = S&P return, e-X is a formulation having to do with the salary,
n = some kind of number, and the other letters are system derived
integers or something. This way, the amount of money given to these
guys for returns that were worse than what a monkey could have done with
a randomly generated portfolio can be scientifically justified.
NASDAQ is an index used to divert the attention of investors in national
market system stocks so they will not notice that the market makers have
stuck a 3/4 point spread into the stock. The wide swings of this index,
often shown on glitzy CNBC primetime "Tech Stock Mania" shows, gets the
NASDAQ investor used to seeing large differences in numbers, such as
between the bid and the ask.
Q) General thoughts on risk/reward trade-offs when constructing a
portfolio.
A) The risk/reward ratio is a direct correlation between the
intelligence of the investor and how much he will have at the end of the
year. It is like getting into a car with a drunk behind the wheel - the
more booze the drunk has guzzled (the less intelligent the investor),
the less chance you will get home with your innards intact (less chance
of having a net worth after the margin collection department gets
through with you). Let's face it - putting money into this overheated
market IS like getting into a car with someone who has had a bit to
drink. Investing smart is picking a driver who thinks O'Doules is real
beer.
Analogous Booze/Stock Chart:
Jack Daniel's = Tech stock featured on CNBC
Vodka = Asian Company (any company)
Red Dog = Mercury Finance, Centennial Technology
Schlitz = Bradlee's
Pabst = Cityscape Financial
Busch Light Draft = Quality Semiconductor
Budweiser = This stuff sucks too much to be correlated to any company
Wine Coolers = USA Detergents, PLC Systems (might make it home on these)
O'Doule's = Cellstar
Play it smart and at the end of the year, you will be able to convert a
few unrealized gains into a few pints of Guinness. And don't forget to
treat a friend.
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