A Home Gamer's Guide to Financial Independence: Stock Trading for Retail Investors

Chapter 1

Introduction

In the Beginning

I first became interested in the world of money and finance when I was a student at Mumford High School in Detroit (made famous by Eddie Murphy in the 1984 movie Beverly Hills Cop). Many of my classmates appeared to be financially well off while I was not. At that young age, I did not understand the power of money and had no idea about how to make it. There were six of us in the family, and we resided in a small, three-bedroom house in Northwest Detroit. Our financial resources were extremely limited with enough to feed and clothe us plus minimal discretionary funds. When I was a high school junior, I started working part time during the academic year and full time in the summers. Thanks to my high mechanical aptitude and visualization abilities, I secured work as a mechanical draftsman at local contract engineering firms around Detroit. By the time I graduated from Mumford, I was already a senior draftsman and making very good money for a seventeen-year-old kid. This type of work continued through the first three years of my undergraduate engineering classes at Wayne State University. By the end of my junior year, I had advanced to the level of senior machine designer and was making serious money. In fact, I was offered a full-time position as a machine designer with a very attractive salary. However, my goal was to become an aeronautical engineer. I completed my bachelor of science degree at the top of my class and went off to MIT on a fully paid fellowship to pursue an advanced degree in aeronautics and astronautics. One year later, I received a master of science degree and decided to go out into the world to find out what it would be like to work as an engineer and have some money in my pocket.

All through high school and college, I continued to unravel the mysteries of money and understand how to accumulate it and make it work for me. Nevertheless, here I was at twenty-two with very little money beyond the bare minimum to live on. Fortunately, because I was an engineer with a master’s degree from MIT, career opportunities were plentiful. My choice of a first career position was as a member of the staff at the Hughes Research Laboratories in Malibu, California. I accepted this position without first visiting the facility. When I arrived in California to begin my career, I experienced complete culture shock. Imagine being a twenty-two-year-old kid from Detroit who had never seen a mountain or an ocean suddenly dropped into Malibu where everyone seemed to be rich. The people were beautiful. The cars were flashy, and the scenery was spectacular. Even though my salary was at the top end of the scale for a rookie engineer, my budget was very tight. I wondered how all these California people could afford fancy cars and lovely homes. I could hardly afford to do anything beyond paying for the necessities of living and working. Money was still a mystery.

Early in my professional career, I realized that working for a company and receiving a regular salary would relieve most of my financial anxiety and allow me to establish a savings account. However, as an employee, my financial opportunities would be limited. I soon started to realize that a significant improvement in my financial situation was going to require some extracurricular activities outside my regular job. It was also clear that becoming professionally independent could enhance the possibility of achieving financial independence. I also started to look for personal investment opportunities that could result in accumulating extra cash.

After three years at Hughes, I accepted a senior engineering position at a military satellite manufacturer in Palo Alto, California. As it turned out, this was a wise and fortuitous move that allowed me to continue my academic career on a part-time basis at a local college that was not familiar to me, Stanford University. After just one year of working and studying, I was offered a fully funded graduate fellowship in Stanford’s PhD program, allowing me to pursue a doctoral degree in aeronautical and astronautical sciences. After two intense years of full-time academics and research, I completed the doctoral requirements and accepted a position as an assistant professor of aerospace engineering at the Pennsylvania State University. As I realized later, this represented a key step toward professional independence by opening many opportunities for financial gains through personal investments and consulting activities while teaching space engineering and carrying out space-related research projects. Thirteen years later, as a full professor, I left academia and became an entrepreneur in serious pursuit of financial independence.

While at Penn State, I became intrigued with the workings of real estate investments and started buying income-producing rental properties. This activity grew rapidly, and I became a managing partner in several rental property ventures. At its peak, there were some three hundred tenants in properties that I managed and partly owned. The success of the real estate business plus space industry consulting activities allowed me to start accumulating some sizable funds that later became the basis for my stock-trading portfolio.

With regard to my personal financial capabilities, much of my technical education included extensive training in mathematics, which helped me to formulate successful strategies for both real estate and stock market investing techniques. This capability combined with a love for teaching and extensive writing of articles and books allowed me to better understand the stock market and to explain my strategies to others. I have now taken this unique set of experiences and interests in combination with the digitization of stock market trading to formulate the successful trading techniques explained in this book. In summary, over the past several decades, I have been an engineering professor, real estate entrepreneur, spacecraft engineer, author, consultant, and stock trader.

I started investing in common stocks in my thirties without any formal financial training and initially made several scattered investments in listed stocks through brokerage houses with little success. In those days, a stockbroker had to execute any stock transactions for retail investors. The transaction fees were high, and the quality of stock selections by brokers was low. For retail investors with limited funds, it was difficult to get a good return. All that has changed thanks to online brokers such as Fidelity, Schwab, E-Trade, and others. Today, there are no stock transaction fees for buying and selling shares through most online brokers. Furthermore, the convenience and speed of today’s transactions have made it possible for retail investors to realize returns that are comparable to those of big investment firms.

I have learned many lessons through practicing the art and science of individual stock investing. After decades of studying the stock market and experimenting with different approaches, I can now make important recommendations to others regarding methods of achieving financial independence. My first recommendation to readers who want to self-manage their portfolios is to buy individual stocks only after thoroughly understanding the contents of this book. In the meantime, I suggest investing only in a savings account, index fund, or a mutual fund. This can be done through your bank or other financial institutions such as online brokerages, such as Fidelity, Schwab, etc. For those who do not want to personally manage a portfolio, I suggest the use of a certified financial advisor (CFA). However, always be aware that you love and respect your money much more than any financial advisor. So consider educating yourself on making your money work for you. Read and understand the ideas and guidelines presented here, and you should be armed with important knowledge regarding your financial potential. Regardless of your path forward, this book is designed to offer important and lasting information and advice.

Home Gamers

A home gamer is a retail investor who has some money to invest, wants to control the investment selections, and has a goal of reaching financial independence—the status of having enough financial assets and income to pay living expenses for the rest of your life without having to be employed or dependent on others. If you are such a person, you must be willing to work with numbers, commit to learning how the stock market works, have patience, and be tenacious. With every investment activity comes some level of risk. Many people think stock investments are associated with high risks. Wise investors avoid high risks and realize good returns. The techniques explained in this book have associated risks, but the use of my methods allows home gamers to trade stocks at low-risk levels while promising to deliver high rewards.

As a retail investor, you must accept the fact that stock markets and stock prices go up and down. When prices go up, all is well. When prices go down, you will have to deal with the potential of some red ink. The simple truth is that the stock market always tends to go up over long periods of time. Furthermore, some stocks appreciate while others depreciate. The objective here is to make money by first selecting the right stocks, then buying and selling them such that you make a net profit. This does not prevent making mistakes. You may lose money from stocks that do not perform advantageously. While no one can always select stocks that will perform as expected, the objective here is to select more winners than losers. Follow the guidelines presented here, and you should expect to experience significant financial gains over a period.

One important fundamental guideline for new home gamers deals with the level of funds needed to start trading individual stocks. While you are accumulating cash that is to be used for stock trading, take advantage of this book to start developing your personal trading strategies. Also, build up at least $10,000 of investable funds. By the time you have these funds, you should have selected an online broker and opened a standard brokerage account that allows you to buy and sell common stocks. Before using that cash, practice buying and selling through theoretical paper transactions. Your broker will be happy to help you with this. Once you are comfortable with the mechanics of a transaction and have some confidence in a stock selection, go ahead and make that first trade but only use a small part of the cash available. As you gain trading experience, you may want to slowly increase the amount of cash invested in stocks.

The primary reason for waiting while accumulating at least $10,000 is simply that the needed research and time spent to pick winning stocks cannot be justified until some threshold of capital becomes available. Once your investible funds have reached $10,000, the potential financial gains are sufficiently large to justify the work of selecting and trading stocks. Start with a single basic stock market account at a large online broker. Later, you may want to add other accounts that offer tax advantages, such as an individual retirement account (IRA) or a Roth IRA account. All these accounts allow you to buy and sell individually listed common stocks that are traded on public exchanges such as the New York Stock Exchange (NYSE) and the Nasdaq. Ultimately, you will probably want to maintain both taxable and tax-advantaged accounts because these will give you significant financial flexibility in your retirement trading activities.

I mentioned using a brokerage account because individuals cannot directly buy or sell publicly traded common stocks. A few decades ago, all such transactions had to be conducted through brokerages such as Goldman Sachs, JP Morgan, and several other old-line banks. Today, home gamers are best served by the new generation of online brokerages such as Fidelity Investments, TD Ameritrade, and Charles Schwab because their transaction fees have been waived and they have vast research capabilities through their websites. These brokerage firms have access to the trading floors of the stock exchanges, and they can execute transactions quickly and easily.

The New York Stock Exchange (NYSE), sometimes referred to as the Big Board, is a United States stock exchange located in the Financial District of Lower Manhattan. It is the best-known exchange and one of the world’s largest. The average daily trading value of stocks at the NYSE is well in excess of $100 billion. The Nasdaq Stock Market is another United States stock exchange based in New York City. Nasdaq was initially an acronym for the National Association of Securities Dealers Automated Quotations. In 1971, this exchange began operations as the world’s first electronic stock market.

To summarize, for the purposes of this book, home gamers are individual nonprofessional retail stock traders who buy and sell common stocks. The focus here is limited to common stocks, even though other securities may also be traded on the stock exchanges. The reason for this limitation is to maintain a relatively simple and understandable philosophy toward succeeding in the financial markets. Professional traders and financial managers have much more sophisticated strategies that involve higher-risk trading methods with complicated financial entities. The methods and strategies explained here are entirely sufficient for the needs of the home gamer. Even novice home gamers can conduct investment activities through either traditional brokerage accounts or through retirement accounts or both. Retail investors purchase stocks for their own personal accounts and often trade in small amounts as compared to institutional investors who manage large financial entities such as mutual funds, pensions, and insurance companies.

I hope it is clear that home gamers should use online brokerage accounts because stock transaction fees are waived and many brokers offer full services at no charge to account holders. Here are a few additional thoughts that will help to define and guide home gamers.

Nonprofessional stock market participants who invest smaller amounts in stocks as compared to institutional investors.

Encouraged to establish trading accounts with online brokerages that do not charge transaction fees and provide free research services.

Do not trade individual stocks until they have accumulated at least $10,000 in investment funds.

Trade only common stocks that represent ownership in public corporations.

Do not use borrowed money to buy stocks.

Retail investors make up a major part of the investment community and thus have a significant impact on market sentiment. Some critics say small investors do not have the knowledge, discipline, or expertise to properly research their investments. It is the goal of this book to not only educate home gamers but also to show how to outperform many professionals. Small investors have also been accused of undermining the potential performance of financial markets through uninformed trades and panic selling. Follow the lessons presented here, and you should be sufficiently sophisticated to avoid major mistakes.

Unlike institutional financial managers, retail traders are more likely to invest in stocks of smaller companies because those stocks tend to have lower share prices and thus allow home gamers to buy many different securities in numbers that assure diversified portfolios without high risks.

As a new retail investor, you will undoubtedly find many new terms and acronyms in the following chapters. Simply refer to the glossary for explanations.

The United States Securities and Exchange Commission

The United States Securities and Exchange Commission (SEC) is charged with protecting retail investors in order to ensure that financial markets function in a fair and orderly manner. This government agency helps retail investors by providing education and enforcement of regulations that ensure the integrity of investing in the stock market.

Nevertheless, retail investors must be vigilant. The SEC does not provide timely warning to investors regarding the health or adverse activities of individual companies. Thus, home gamers need to be aware that holders of common stock can experience partial or complete loss of value if the underlying company of a publicly traded stock enters bankruptcy. In other words, in the event of a corporate liquidation, common stockholders in that corporation have rights to the company’s assets only after bondholders, preferred shareholders, and other debtholders are paid in full. In such cases, common stockholders generally lose most or all of their investment in that corporation. This in effect means the risk is limited to the investment in such cases.

To reiterate, the retail investment market in the United States is significant in size and scope. According to a recent SEC statement, American households own $29 trillion worth of equities, more than 58 percent of the United States equity market. Approximately forty-four million United States households hold at least one retirement or brokerage account.

Clearly, the information age has enabled retail investors to have access to more financial information, investment education, and trading tools than ever before. Many brokerage fees have all but disappeared, and mobile trading now offers investors the option of managing their portfolios from smartphones and other mobile devices.

The Magic of Time

Time is a key parameter in your investment strategy and in your potential for success. Young investors can use time more advantageously than older investors. The more years ahead of you, the more options you have in building your investment portfolio. Young investors can survive more risk because they have time to grow out of losses and gain important experience and knowledge at the same time. Older investors have shorter time frames in which to grow a strong portfolio. Thus, the level of acceptable investment risk should decrease as age increases.

Most investors are not wizards at mathematics. The truth is that you need only be good at the basic arithmetic functions to be a smart investor. If you hate math altogether, you may want to reconsider self-managed individual stock investing. As you probably realize by now, time is critically important for your long-term financial appreciation through stock market investing. In fact, the best single step to financial independence is to start investing regularly as early as possible because the stock market is an appreciation machine. I can demonstrate this by simply referring to figure 1-1, which illustrates the growth of the Dow Jones Industrials Average (DJIA) over the past fifty years. This indicates an annual average appreciation of about 8 percent. If you had invested $10,000 a half-century ago in a DJIA index fund, today, that original investment would be worth about $470,000. This example effectively illustrates the power of time when it comes to building a retirement fund.

Figure 1-1. The Dow Jones Industrials Average over the past fifty years.

Next, consider a realistic example involving an average investor who manages a personal account. Assume this home gamer is twenty-five years old and has $5,000 each year to invest until the retirement age of sixty-five. Careful stock selections should yield at least an average annual rate of return of 10 percent; thus, that annual $5,000 investment will become roughly $5 million at retirement. Even if this investor adds only $1,000 each year for forty years, at retirement, this account would be worth about $442,600. In this latter case, the investor would have invested a total of $40,000 but would realize more than eleven times the investment. These examples again illustrate the magic of time and its effect on wealth. If you can take advantage of starting to invest at a young age, carefully select stocks and make wise adjustments to your portfolio as needed. Then just let the time factor make money by compounding your returns over many years.

Time is more value than money. You can get more money, but you cannot get more time.

—Jim Rohn

The Value of This Book

Many stock investors follow the old philosophy of buy and hold for long periods. This is not surprising because the stock market has been steadily appreciating over the past half-century and the buy-and-hold philosophy has been successful for many investors. Unfortunately, associated financial returns have generally been limited by overall market appreciation. If the market goes up 10 percent in a year, stagnant stock portfolios tend to advance by about the same amount. It is generally also true that if the market drops 10 percent in a year, then these portfolios tend to go down about the same amount. The following chapters describe a more aggressive method of stock investing while maintaining limited exposure to risk. My underlying philosophy is not to maximize the portfolio value because no one can accurately predict when stock prices will peak or bottom. Instead, my fundamental stock trading objective is to earn a small percentage of profit on each trading day and not to focus on peaks and troughs. Simply put, my goal is to achieve an average return of between 0.1 percent and 0.2 percent on each trading day. Since there are approximately 250 trading days per year, my target yield for each year is between 25 percent and 50 percent.

Based on this and without adding any new money, you should be able to double your portfolio within every three-year period. Of course, it is not realistic to expect a 50 percent gain each year, but it is reasonable to expect some average return such as 37.5 percent. At this rate of return, over a twenty-five-year period, your initial investment would grow by about 2,868 times its initial value. If that investment was $10,000, after twenty-five years, it could grow to about $28,680,000. If you start with $10,000 and add $1,000 each year with an annual 37.5 percent return, the amount you could realize after the quarter century is over $36,000,000. This return is based on a total investment of $35,000. Of course, I cannot guarantee that you will achieve this level of success, but if you properly apply the knowledge offered in the following chapters, it is entirely possible you will reach a comfortable level of success.

Most retail investors will be earning income from career jobs. Hopefully, this will provide that initial $10,000 in a reasonable time frame for funding a beginning stock portfolio. Once you reach this goal, do not stop investing part of your paycheck on a regular basis. Think of this as paying yourself before you pay other bills. Do it every payday until you can retire as a financially independent person. This approach should assure that your retirement fund is more than sufficient for your needs.

Remember, the earlier you start saving and investing, the more money you can expect to be available for retirement later. One important metric that you can use to keep you incentivized is the amount of time that it takes to double your portfolio. If you think in terms of percentage yield from investing, then you can use the Rule of 72 to approximate the time to double your portfolio. Assuming my method of stock trading yields about 37.5 percent annually, simply divide