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Creating Your Own Mutual Fund

Lesson Five: How to Buy Stock by Devlin Bronte Rachele

By V. H. EberlePublished 3 years ago 15 min read
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Here we find our investor. He has a $5,000 windfall from an inheritance. He wants to take advantage of the stock market. He has done his research on a stock he has been watching. He looked up its Price to Earning Ratio, its Beta (the stock’s reaction to market behavior,) recent Open and Closing prices; He has been tracking its highs and lows. He has been reading up on the company in various business journals. He is very familiar with the company and even knows its Book Value and various debt and other business ratios in comparison to similar companies or industrial averages. Following his best instincts he believes the lowest price will be at about $10. It hits that and he places his order and the purchase goes through at $10.05 a share. He skips off into the sunset thinking he did great only to see the price slip to $9.50 a share. Then the next day it goes down even further. After a few more nerve wracking days the price rebounds and starts to climb again and our investor is back on the plus side. However, stuck in his mind is the idea that he could have purchased the shares for an even lower price and have made even more money.

Once about twenty-five years ago I was sitting in a stock broker’s office and I had just placed an order. My broker turned to his computer and placed the order from the funds I had deposited with the brokerage. We sat and watched the various transactions being placed. As each purchase had been made the price fluctuated and we watched as the price changed several times a minute. About two minutes later my transaction went through and I saw the price I had purchased it at. The price had changed about ten cents from the time I first placed the order until I actually became the owner of a couple hundred shares. That is a reality of the market. You may want to buy at $10 a share and you may place the order when it is at $10 but the market moves fast with people all over trying to make trades. Especially in the electronic world we live it moves very fast. By the time the order goes through the price could be much higher or lower or right on the price when you made the order.

Very rarely will you ever hit the absolute low even with the best research. But let’s try something slightly different. Let’s say a stock you have been watching has dropped in price and you are certain it is near the price at which it will be bottoming out. Instead of making the full purchase at one shot you decide to spread it out over a period of five weeks. All math may be off slightly due to rounding to the nearest cent.

On the first purchase you take $1,000 and through one of the several applications which allows you to buy odd lots you are able to buy 100.503 shares at $9.95.

For the second purchase a week later you buy 90.909 shares at $11.00.

During the third purchase a week later you get an additional 112.023 at $8.93 a share.

You buy 89.102 shares at $11.22.

Then on the final purchase you acquire an additional 114.050 shares at $8.77 a share.

Looking at your purchase history:

1st Week $9.95 100.503

2nd Week $11.00 90.909

3rd Week $8.93 112.023

4th Week $11.22 89.102

5th Week $8.77 114.050

First thing you may notice is that the price did fluctuate. You may also notice that when the price was down you were able to acquire more shares than when the price was up. If you total your shares you will find you have 506.587 shares. Now take this total and divide it into the $5,000 you used to purchase the shares. This will give you 5,000/506.587=9.87. So the average price of each share you have purchased is not any of the prices listed above. Each share cost you $9.87. This means even if you bought a share at $11.22 if the current price is $9.88 and your average price is $9.87 you have made 1 cent per share if you so choose to sell at that point. So, what happened?

It is simple. When you buy shares this way you will naturally acquire more shares when the price is lower while less when the price is up. In the above example we had bought over 320 shares for less than $10 while we only bought 180.011 shares for more than $10. Of course having more shares at a lower price will have more of a pull on the price per share down than the fewer higher priced shares. This is what is called a weighted average. Let’s look at another example.

Again, you have $5,000 and will invest $1,000 of it over the next five weeks. During the first week you make your first purchase and end up buying 100 shares at $10. You buy 97.561 shares at $10.25 the following week. In the third week when the price hits $10.50 a share you buy an additional 95.238 shares. Another 93.023 shares are bought at $10.75 per share during the next week’s purchase. In your final order placed you receive 90.909 shares at $11 a share.

1st Week $10.00 100.000

2nd Week $10.25 97.561

3rd Week $10.50 95.238

4th Week $10.75 93.023

5th Week $11.00 90.909

In this example the price has steadily increased. As you can see from the results in the table above with each increase in price the amount of shares you have purchased dropped accordingly. We have purchased 476.731 shares. If we divide the shares into the original $5,000 we started with we find that our average price per share is $10.49. Again, the same weighted average worked out to our advantage. If the price stays at $11 we have made 51 cents per share or a total of about $243 if we decide to sell at this moment.

This is what was introduced to me in the 1990’s. I was shopping at a local grocery store and there was this small book titled, “Create Your Own Mutual Fund.” Having just graduated from college armed with a Bachelor’s of Science in Business and Economics I was curious so I bought a copy. After reading it I had learned how to buy stocks. This strategy was what the author called Average Cost Investing. It was based entirely on instead of making large one time purchases and being stuck with that result you can take advantage of the effects of weighted averages by making your purchases over a period of time and several prices.

Now we have seen what happens with a stock price bouncing up and down over a range of a couple dollars. We have seen what happened when we purchased a stock over a period of time which was steadily climbing. So, let’s see what happens when a price climbs steadily and then declines. Let’s do $1,000 a week over 10 weeks for a total of $10,000.

1st Week $10.00 100

2nd Week $10.50 95.238

3rd Week $11.00 90.909

4th Week $11.50 95.238

5th Week $11.25 88.889

6th Week $10.75 93.023

7th Week $10.25 97.561

8th Week $9.75 102.564

9th Week $9.25 108.108

10th Week $8.75 114.286

We find the result to be that over this period we have acquired 985.816 shares. If we divide this into the money we had invested we find that the average cost per share is $10.14. It seems to appear as if you have lost $1.39 a share or $1,370.28 in total. But I will let you in on a little secret about the stock market. You didn’t really lose this amount until you sell your shares for $8.75. Another thing which most people I have talked to fail to realize is that many of the companies which existed before the 1929 crash which sent many investors out their office windows continued to exist after the crash and many continued to exist to this day and all of their stocks rebounded. In other words people who didn’t sell were able to recoup the value or those who were smart enough to take advantage of the bargain basement prices of the crash made a bundle of cash when the market rebounded.

Here is another tidbit of information which most people fail to realize is the stock market has historically increased about 8% annually on average. Also as I have mentioned before the market is ruled by emotions and speculations. If you follow the market long enough you will see the smallest fears such as a recall or the tariff increases against China in more recent news can cause a temporary dip in a stock’s price. As quickly as the fear causes the dip it can pass and the price rebounds. Another very important point to remember is to stick to companies which have been well established. Another good point is that there are industries which do have cycles. As I have mentioned Fast Food restaurants do better business in the summer while business trails off during the winter months. Of course this would lead to better prices in for Fast Food stocks in late summer and early fall when they would report their earnings for the summer months. When a company announces a dividend payment it will cause the price to go up and then drop after the payment. One last thing to consider is sometimes prices drop because of stock splits. This is when a company issues stocks against existing stock to bring the price down making the stock more attractive to investor demand. Of course if you followed the basic guidelines of Lesson One and are investing responsibly with money that won’t make or break you, you should be able to take advantage of lows and wait for the rebound.

Looking back at our last example with all of these tidbits in consideration let’s say you have the guts and take advantage of the lower prices. You have another $1,000 and you decide to purchase more shares and do get 114.286 at $8.75 or a total of 1,100.102 shares at an average cost of $10 a share. Buying additional shares at the lower price has reduced your average cost per share by about 14 cents. Continuing to take advantage while the price is down would result in more shares at the lower prices and a further reduction in the average cost per share. If you have the money and this is a well established company I would suggest you take even more of an advantage while you can. If and when the stock rebounds to even $11.00 a share you will make over $1,100.

Currently, as I had mentioned in an earlier lesson, I had been buying a stock which my first purchase was at about $40 a share. The price continued to tumble and on my respective investment date I bought more shares. I should mention that this is a huge international corporation which produced $26 Billion in net profits last year and was actively dealing with an image issue. About five to six months later the price finally bottomed out at about $18 a share. Continuing to buy as it fluctuated a few cents around this price I managed to reduce my average cost to within 30 cents of the lowest price the stock hit. It rebounded over 35% and I had made over $350 on a stock that was still technically down in price from when I made my first purchase. That is if I chose to sell. The price is currently at $26 which still represents a 35% loss from my first purchase but having bought each month as the price went into a free fall I acquired evermore shares at ever decreasing cost and my average price dropped to the point of producing a potential profit of just over 35% on a stock which if I had made one purchase at the original price would had produced a loss of 35%.

Remember, PANIC KILLS and I can never say this enough, PANIC KILLS! You need to remember that any loss is only in theory until you actually sell. Several years ago my boss came to me and asked me what to do about his retirement plan. His fund was dropping in price and he knew I had a lot of knowledge in the area. I told him that he had not lost a cent and will not lose a cent until he actually sells. He was thinking of transferring his money to another fund. I told him I would increase the amount of my deposits if I could and take advantage of the low price. He told me to put my money where my mouth was. So, right there in front of him I did exactly what I had told him to do. He even personally submitted my allotment form to personnel himself to make sure I really did it. I thanked him. About two months later he came up to me and asked me how I did. I said that I was up about 38% and I followed this up by asking him what he did. He told me he had panicked and did transfer his funds. He had lost 10%.

Again, his story isn’t unusual. Here are some important points to remember:

• Remember you have not lost a cent and will only lose if you sell or transfer. In the same vein if the price had increased you haven’t actually realized the gain until you have sold or transferred the funds. One way to look at this is if you had 100 shares when the price dropped or increased you still have 100 shares. It is just the price has changed and it can change again.

• Prices go up and down. You need to remember that the only thing more skittish than a bank loan officer is a speculator and a speculator will bail on an investment at the first sign of trouble such as a recall driving the price down. However, once the issue has been corrected or passed the same speculators will drive the price back up.

• Prices also go up and down with normal business cycles. For example, the main sales time for fast food is over the summer so prices will rise towards the end of summer and beginning of fall with the release of sales figures for the summer period. Retail sales peak in the holiday season and with the increase in sales and prospect of dividends prices are driven up by speculators.

• Many of the companies (Kellogg, Kodak, MMM, Weis, Ford, American Standard, Bell, and GM just to name a few) which existed before the 1929 crash continued to exist afterwards as well and in fact, many still exist today performing strongly.

• When starting out with this strategy stick with companies which have been around for some time and are doing well such as Fortune Five Hundred. As you gain experience and earn more money through investing you may want to experiment with higher risk investments. We can talk about that more in a later chapter.

• Unless you need the money tomorrow or in the near future why sell? As mentioned in chapter two you should be investing only with money you don’t need in the immediate future. In fact, hopefully while the price is down you should do as I told my boss and take advantage of the lower price.

• More in line with my former boss’s scenario his retirement plan was based on a mutual fund. Most of the mutual funds I have invested in or followed are usually made up of twenty to thirty individual investments. Because of this diversification it would take the failure of all those individual investments for the fund to fail. In most cases if a fund is dropping and the owners are panicking the fund will hire a new manager to get it on track and they do this quickly. In the case with my boss they did turn it around and quickly but not too fast that I wasn’t able to cash in on the low price.

• Though the stock price in our example had dropped 23.9% since your average cost per share in the above example is $10.14 the price of the stock you would realize if you sell at this point has only dropped 13.7%. Again, you will only realize the loss if you cash it in at the lower price.

• Another reason a price of a stock can dropped quickly is splits. This is when a company decides to attract investors by keeping their price low by issuing more stock without diluting control of current shareholders. This is done by doing splits. These can come in many ways such as a two for one split which means that if you have ten shares at $20 each you now have 20 shares at $10 each. I once invested in Harley Davidson (HOG). I had bought 100 shares at an average value of $23 a share. Shortly after that the price shot up to over $50 a share. They did a two for one split and I now had 200 shares for about $25 a share which then shot up again to about $60 a share. Talk about winning the lottery! This amounted to just over a 400% increase in just a couple of months. By the way, this was over thirty years ago.

Biggest thing to remember is that unless the company is going out of business; unless you need the money today don’t sell. You need to think in the long term and in the long term the stock has the potential to increase in value. However, in the meantime if you continue to invest according to plan and take advantage of the stock’s low price you will continue to decrease your average cost per share as shown in the example above. With each cent you decrease the average cost per share of your stock you have actually increased your earning potential.

personal finance
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About the Creator

V. H. Eberle

I have been a student of human nature since I can remember. I hope that you feel free to explore my findings in these short stories and articles. Perhaps you will learn far more about yourself and others.

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