Investment Course Snapshots

The following information is provided to prospective course members to gain an insight into the topics covered in the investment course. Only the first few paragraphs of each main topic area are provided here. Please refer to the Investment Table of Contents for a more comprehensive list of subject headings covered within each topic area. 

Chapter 1 – Financial Markets

Financial markets provide a mechanism for a broad range of financial products to facilitate the flow of funds from savers or investors to borrowers or entities that need to raise capital for business operations.

Financial markets can therefore offer market participants a variety of different financial products that possess a range of different attributes in the areas of risk, return and liquidity.

Financial products that are of a contractual nature are referred to as financial instruments and are made available to investors through financial markets in two phases:

• The primary issue phase, or primary market: when a corporation offers equity securities to the market for the first time, or needs to issue new financial instruments to raise money for new projects, it will issue them directly to investors through the primary market; and
• The secondary market: the secondary market provides for the subsequent trading of those financial instruments based on market forces such as supply and demand in an organised marketplace or exchange.

Most of the financial instruments available in today’s financial markets are transferable, meaning they are able to be transferred from one investor to another on a centrally traded exchange.

If you are looking to buy and sell existing debt and equity instruments, you would use a stock exchange.

A stock exchange is an association of stockbrokers formed to facilitate the trading of financial instruments, such as equity securities (shares). Trading on a stock exchange is regulated by the rules of that exchange. These rules also extend to regulating the conduct of the members (i.e. stockbrokers) of that stock exchange.

The majority of industrialised countries have a national share market or stock exchange. You may have heard of share markets like the London Stock Exchange, New York Stock Exchange, or the Tokyo Stock Exchange. These organisations each perform essentially the same role, providing capital raising services by operating the primary market, and trading facilities by operating the secondary market.

Chapter 2 – Financial Market Regulators

ASIC

ASIC has responsibility for the regulation of Australia’s financial markets in two important areas:

• Financial services (together with APRA and the RBA); and
• Australia’s 1.2 million companies.

The function of ASIC is to enforce and administer corporate law and consumer protection law throughout Australia for:

• investments
• life and general insurance
• superannuation, and
• banking.

The key principles underlying ASIC’s approach to its function is market integrity and consumer protection.

ASIC actively supervises the activities of the ASX as market operator and a listed company and is charged with enforcing and regulating company and financial service laws.

ASX

The ASX operates the main equities market in Australia on a near monopoly basis.

Since its recent merger in 2006 with the Sydney Futures Exchange, it now also operates one of the world’s largest derivatives markets.

The ASX has the following obligations set down in the Corporations Act 2001:

• To ensure that the ASX stock markets are orderly and fair;
• To monitor and enforce compliance with the Market and Listing Rules;
• To monitor the conduct of stockbrokers and stockbroking firms;
• To notify ASIC of certain supervisory matters; and
• To have adequate arrangements to investigate complaints.

As a licensed market operator, the ASX seeks to ensure that all users can transact with confidence in a market of integrity. A market should be able to attract capital, transfer risk and create the potential to generate wealth across the economy fairly, efficiently and at the lowest possible cost.

In order to maintain a market of integrity, there is a high level of regulation and supervision by the ASX of its market. The Corporations Act 2001 and ASX Market Rules and ASX Listing Rules, which together regulate the operation of listed companies and brokers in their dealings on ASX markets, are regularly updated and enforced with the co-operation of government regulatory authorities, including the Australian Securities and Investments Commission (ASIC).

Chapter 3 – Investment Risks

Investment risk in financial markets

The key motivation for investment in financial markets is profit. However, there is always the risk that an investment will fail to perform as expected due to economic and market factors, or factors specific to an industry or an individual company.

This risk means that the investor could lose some of their expected profit, all of the funds invested, or even property used as security for borrowed investment funds. The major risk, however, is the loss of opportunity for profit-making as a result of the investment’s failure to perform as expected when compared to other investment options. In other words, the investor may find that choosing a different investment could have provided greater returns.

Investment risk is therefore the risk of not achieving one’s long term financial goals and includes the risk of being out of the market, or the risk of doing nothing.

The risk/return trade-off

Often investors want the highest possible rate of return, but do not want to take on too much risk to reach their financial goals. As a result there is often a mismatch between the level of return a person expects from an investment and the level of risk that person is willing to take on. The returns investors seek are just not available from investments that fit with their tolerance for risk.

A diversified portfolio may reduce the risks inherent in investing in the stock market and provide a more consistent return from year to year.  By investing across a range of asset classes which experience good performance at different times, the high returns you receive from one type of investment can offset lower or negative returns you may be experiencing from another.

Stock market risks

The main risks associated with investing in the stock market can be categorised as follows:

• Market risk
• Timing risk
• Risk of poor quality advice
• Currency risk
• Interest rate risk
• Credit risk
• Liquidity risk
• Business risk and
• Regulatory risk.

These are just some of the main risks that are associated with an investment in the share market. Learning about risk and its effect on your investments is crucial. You should clearly understand the risks associated with any investment you are considering.

Chapter 4 – Risk Profiles

Everyone has a different tolerance for risk and this provides for different investor risk profiles. Taking the time to identify your own risk profile will help you choose the best investments for your portfolio. There are three main risk profiles commonly used by investors to determine their tolerance to risk:

1. The Conservative investor
2. The Balanced investor
3. The Assertive investor 

Investors should be aware of the risk/reward relationship that exists with any type of investment. In order to receive a return on money invested you need to be prepared to ‘risk’ that money. Generally the greater the risk associated with an investment the greater the rate of return investors can expect.

Chapter 5 – Asset Allocation

The investment process involves a number of steps. Once you have determined the amount of funds to invest, your timeframe for investment and risk profile, you next need to work out what proportion of your total capital you should invest in different asset classes to achieve your short term and long term financial and investment goals.

This is called asset allocation and is often considered the most important part of the investment process. The correct application of your investment funds across the range of different asset classes is critical to the success of your investment strategy.

The different asset classes available to invest in may include:

• Australian and international shares;
• Listed Investment Companies and managed funds;
• Property and infrastructure assets;
• Fixed interest and hybrid securities; and
• Cash.

Each asset category should be weighted in accordance with the state of the current market (i.e. do we have normal market conditions or an abnormal market) and the present economic situation (i.e. are we in an economic boom or a recession). This helps to gauge an asset categories future investment prospects for income and capital growth and serves to reduce volatility and risk in an investment portfolio.

By including asset categories in a portfolio with investment returns that move up or down under different market conditions, an investor can protect against significant losses. This is because usually the returns of the major asset classes do not move up or down simultaneously.

Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category you reduce the risk of consistently losing money inside your portfolio and have a better chance of smoothing out your portfolio‘s investment returns over time. This is why diversification is so important.

Chapter 6 – Introduction to Financial Products

The definition of financial product under the Financial Services Reform Act 2001 (FSR Act) is very broad and is defined as a facility through which, or through the acquisition of which, a person:

• makes a financial investment;
• manages a financial risk; and/or
• makes non-cash payments.

Financial products refer mostly to financial instruments of a contractual nature. A financial instrument is a legally enforceable agreement between two or more parties expressing a contractual right, a right to the payment of money, or a document evidencing a monetary transaction between parties.

With the exception of most exchange traded options (ETOs) and futures contracts (otherwise referred to as derivative instruments), financial instruments traded on the ASX are defined as securities and come under one of the following categories:

• debt securities;
• equity securities; and
• hybrid securities.

Chapter 7 – Investments in Cash

Cash is an asset class that offers investors two main features:

• a return in the form of interest income; and
• a secure short term investment option.

The cash investment sector includes many different financial products, mostly available in the short term money market where traders, using screen based information and trading systems, conduct a market that does not rely on any particular exchange. 

Some of the cash and money market investments providing both fixed and floating rates of interest include:

• bank accepted bills;
• term deposits;
• at call accounts;
• certificates of deposit;
• building society deposits; and
• cash management accounts and cash management trusts.

Chapter 8 – Equity Securities

Equity represents an ownership interest in an asset. A company that issues equity securities allocates a proportion of ownership in their entity to an investor or purchaser of their equity securities. The investor or purchaser thereby obtains a membership interest in the form of a shareholder right in the issuing company and in effect becomes a part owner of that company.

Ordinary shares are an example of a basic equity security conferring ownership rights on the holder of ordinary shares.

There are several different types of equity securities. These include:

• Ordinary shares;
• Bonus shares;
• Rights issues;
• Preference shares; and
• Company options.

Equity financing allows a company to raise money from the general public and institutional investors by offering shares to finance its business operations, rather than borrowing money. Equity securities or shares representing a proportion of the ownership interests of the company are given to these investors in exchange for various entitlements. These entitlements normally involve:

• a right to the income of the company (if any) in the form of dividends, and
• a right to vote in the management decisions of the company.

A share is therefore a right to a proportionate share in the profits and ownership of a company. These rights are usually equal between all shares of the same class. A company may issue several different classes of shares. The differences between shares of different classes may include such things as:

• rights to dividend entitlements;
• voting rights attached to shares; and
• the right to participate in capital distributions on the eventual winding up of the company.

The major securities created by company equity financing are ordinary shares. Ordinary shares represent the vast majority of shares issued by companies in Australia and shares are the major form of equity ownership in Australia.

Shares exist as a cheap way of raising finance for an entity. Issuing shares provides corporations with an alternative to raising finance through debt. A corporation listed on the stock exchange may issue a prospectus offering shares to the public through a stockbroker in order to raise equity finance.

Note: Unlike debt, funds raised by a company through the issue of equity securities or shares do not have to be paid back later by the company.

Chapter 9 – Debt Securities

Debt securities are essentially interest rate products of various types and represent a borrower and lender relationship. The issuer of a debt security (or the borrower) is invariably a corporate or government body. The lender (or purchaser) of the debt security could be a corporation, superannuation fund, financial institution, government, small business or individual.

Debt securities, or interest rate securities as they are often referred to, represent a contractual claim against the issuer. In Australia, the main types of debt securities issued by the government and various corporations include:

• Treasury or Government bonds;
• Corporate bonds;
• Fixed rate bonds;
• Variable rate bonds;
• Debentures;
• Unsecured notes;
• Convertible notes;
• Floating rate notes; and
• Collateralised Debt Obligations (CDOs).

Bonds in general

Bonds are loans issued by corporations or governments to raise long term debt capital, usually for specific projects. Bonds are often called fixed income securities, although the term is somewhat misleading given you can purchase both fixed and variable rate bonds.

Essentially, a bond is a formal promise by the issuer to repay a loan to the bondholder. Bonds are issued at a nominal amount called the face value of the bond (usually $100) and may carry a fixed rate of interest (called the coupon rate), which is often printed on the bond instrument. Unlike buying shares, which makes the buyer a part owner in a company, buying bonds makes the buyer a creditor. In the event of liquidation, bond holders have a preferential claim on the assets of the issuer to retrieve their invested capital before equity security holders.

The purchase price or gross price of a bond after issue includes two components:

• capital price; which is the price of the bond estimated by the market, based on a number of variables including interest rates, maturity date, ranking and credit quality; and
• accrued interest; which is the amount of interest accumulated on a bond since the last coupon payment (the bond price increases daily by the amount of interest accruing).

Coupon or interest payments are made regularly, typically at quarterly or semi-annual intervals throughout the life of the bond. The final coupon payment amount and face value of the bond are usually repaid to the investor on the maturity date. The time to maturity can vary greatly, although in Australia it is typically between 2 and 20 years.

Chapter 10 – Hybrid Securities

Since the Australian Government starved both amateur and professional investors of government bonds, the hybrid market has been thriving.

Hybrid securities have the characteristics of both debt and equity and the enormous growth of hybrid securities in today’s marketplace can be best explained by financial markets seeking financial instruments of varying risk and reward.

Large companies, including financial institutions, life insurers and general insurers are the dominant issuers of hybrid securities, filling the vacuum left by the government. In a sense they have become a replacement fixed interest investment for people who a decade or so ago may have held government bonds.

What makes hybrid securities so attractive to investors are the numerous combinations of payments, rights and obligations available in the hybrid marketplace.

Examples of hybrid instruments include Convertible Notes and certain preference shares. Convertible Notes are a type of interest paying debt security that convert to ordinary shares (equity) in the issuing entity on maturity. Convertible preference shares and redeemable preference shares are an example of a hybrid security that may be considered by the ASX as equity when first issued, but offer investors dividends that resemble interest or coupon payments and therefore resemble debt securities.

Chapter 11 – Listed Investment Companies (LICs)

Listed Investment Companies (LICs) provide investors with exposure to a professionally managed and diversified portfolio of assets. These assets may include Australian shares, international shares, fixed income and hybrid securities, property and infrastructure assets and unlisted private companies.

An investor’s exposure to an LIC is very similar to that of a traditional managed fund – but with some important differences.

LICs are companies listed and traded on the ASX whilst managed funds are predominantly unlisted trust structures accessible directly through fund managers.

There are listed managed funds available, called ASX Exchange Traded Funds or ETFs, but the majority of managed funds currently offered to investors are available outside of a traditional stock exchange environment.

Being a company rather than a trust structure, there are features of an LIC that make them especially attractive to investors, particularly SMSF investors.

Investors in LICs own shares in the LIC and can achieve capital growth from holding the company’s shares as well as receiving dividend income like any other investment in ordinary shares of a company. The level of dividends paid out to shareholders is set by the investment manager and may contain imputation credits, which serves to reduce the level of income tax payable by an investor based on the tax already paid by the LIC.

Managed funds on the other hand, because they are mostly trust structures and therefore not liable to pay tax on their income, must deal with that income differently.

Managed funds issue trust units to investors and are legally obliged to distribute to investors all surplus income (after fees and charges) in the form of distributions in the year they are received based on the underlying investments in the trust. These distributions can include both income and capital gains components with investors paying tax on distributions at their marginal rates of tax.

An important feature of LICs that distinguish them from most managed funds is that they are what we call ‘closed-ended’ investments. The closed-ended nature of an LIC means that, unlike the majority of managed funds, they do not regularly issue new shares or cancel existing shares as investors join and leave. The share capital is restricted with a set amount of money raised from investors through a prospectus.

Once fully subscribed, the issue is closed. The investment manager then invests the money raised in line with the objectives of the LIC. Investors can then buy and sell shares in the LIC on the ASX through a stockbroker.

Occasionally, however, the manager may issue new shares to increase the size of the portfolio, or buy back and cancel shares in order to reduce the size of the portfolio. These decisions are made at the discretion of the investment manager. 

The closed-ended nature of an LIC also allows the manager to concentrate on investment selection without having to factor in the possibility of money coming into or leaving the LIC, which can significantly affect how the portfolio is invested. This capital stability assists those managers who take a long-term approach to investing.

Chapter 12 – Property Investments

Property is as an asset class on its own and investors can choose direct property investments in land and buildings (bricks and mortar), or investment vehicles that offer investors with an exposure to property. The most popular form of direct property investment for individual investors is residential property.

However, rather than invest directly in property, which often requires large amounts of capital, investors prefer to access property assets for inclusion in their portfolios through the use of property based investment vehicles called property trusts.

The most popular property investment vehicles are Listed Property Trusts (LPTs).

There are over 100 LPTs on the ASX, split into several main categories:

• industrial;
• office;
• commercial;
• car park;
• residential;
• hotel and leisure; and
• international.

LPTs have provided investors with high yields, capital growth and relatively low levels of volatility and have proven to be a popular investment for Australians. Their rapid expansion has led to over 12 percent of the world’s listed real estate assets now residing on the ASX through international exposures.

Investors gain exposure to both the value of the real estate the trust owns, and the regular rental income generated from the properties. Returns from LPTs are generated from income and capital growth with regular income of 6-10% per annum from rentals a common feature of LPTs.

Chapter 13 – Infrastructure Investments

Infrastructure investments are an important part of any investment portfolio and particularly attractive to SMSF portfolios because of the nature of infrastructure assets as an investment option.

Infrastructure comprises the provision of essential economic or social services, such as roads, airports, telecommunications networks, schools, hospitals and public housing, which tend to be single purpose in nature and exhibit the characteristics of natural monopolies.

As a result of these characteristics, infrastructure assets tend to be subject to varying degrees of government regulation, depending largely on the degree of natural monopoly. This is not necessarily to the detriment of investors in infrastructure, as it provides a level of surety regarding the income streams that will likely flow from the asset.

Although infrastructure assets vary in terms of the level of regulation they face, this regulation generally results in capital values that exhibit low growth. To compensate investors for this, infrastructure investments tend to be higher yielding than equity investments. In terms of capital values, this stable, high yield results in infrastructure assets displaying a lower level of price volatility than equity investments over the longer term.

Infrastructure also acts as a support to the price of infrastructure assets in periods of poor returns in the broader equity market. As such, infrastructure is often referred to as a 'defensive' asset that should provide a steady return throughout the economic and investment cycle.

Both listed and unlisted infrastructure investments are typically of long-duration, which makes them particularly well-suited to superannuation and retirement funds.

Infrastructure assets in the earlier stages of construction will generally exhibit larger amounts of risk, higher potential growth and lower yields and so may be better suited to younger or more risk tolerant investors. More mature infrastructure investments tend to display lower growth and very high yields, which may be preferred by investors seeking a stable income over time, such as self funded retirees.

Chapter 14 – International Share Investments

International shares have in the past outperformed Australian shares on various occasions, although recently with Australia’s resources boom the trend has been the opposite.

This out-performance potential has prompted Australian investors to look for opportunities and investment vehicles that can give them access to the potential growth that investing in international shares can provide. Aside from the obvious diversification benefits, international share investments can also provide investors with exposure to industries and assets not ordinarily represented or available in Australia.

Unfortunately for most Australian investors, direct access to international share investments in various sectors of different countries around the world poses a number of problems. These problems include:

• lack of access to information available on companies in another country for the purpose of making informed investment decisions;
• political and social instability of some countries and the unpredictable actions of foreign governments affecting a company’s share performance or market liquidity;
• regulatory restrictions to investing in foreign share markets; and
• currency fluctuations such as the rise and fall in the Australian Dollar that may negatively impact the value of the investment and its returns.

To mitigate these risks, investors would need to have extensive knowledge of different share markets across the globe and the range of different companies within those global markets to have any real sense of which companies to invest in.

Going it alone and investing directly in international share markets is often fraught with danger and has prompted investors to seek out professional investment managers to do their investing for them.

If you want an international share exposure inside your investment portfolio that is hedged against foreign currency fluctuations then you may want to consider using the services of an international fund manager. You must, however, be prepared to pay the necessary higher management fees to international share fund mangers to give you that exposure.

Chapter 15 – Derivative Instruments

Derivative instruments come under the definition of financial product and are financial instruments that derive their value from, and whose return is dependent on, the price of an underlying financial instrument, foreign currency, index or commodity (referred to as ‘the underlying’).

The underlying for a derivative instrument could be a physical commodity (such as gold, oil or wheat), a financial asset or liability (for example shares or bonds), an index (such as the ASX200 Share Price Index), or a currency (such as the Swiss Franc or Euro). Existing debt and equity financial instruments, indices, commodities and currencies are used to construct these derivatives.

Derivatives can be traded on or off an exchange and do not represent ownership claims, but a promise to give ownership.

The main derivative instruments traded on the ASX consist of options, warrants and futures. Financial innovation has created more exotic and complex types of financial instruments, which are often a combination of the basic derivative instruments with different terms and conditions.

Generally, derivatives are used to hedge against or manage risk within an investment portfolio, but are fast becoming attractive to traders and speculators looking for profit and ‘arbitrage’ opportunities. Arbitrage is the simultaneous purchase and sale of the same type of financial instruments in different markets to profit from unequal prices.

Arbitrage takes advantage of pricing anomalies in financial markets with a view to profit.

However, the value and returns that come from the use of derivative products are contingent as they depend on what happens to the price of the underlying.

Chapter 16 – Portfolio Management

Many investors put considerable time and effort into the initial planning phase of their share portfolio and choosing the right type of securities to buy to meet their financial goals, but fail to put the same time and effort into monitoring and managing the performance of their portfolio once it has been established.

The regular review of your share portfolio at key times during the income year is vital to establishing whether your investment and financial goals are being met. However, because many investors lack the market knowledge and information necessary to make informed investment decisions, they are often forced to behave reactively to market news and when market conditions change. As a result, they may end up losing significant amounts of money. The regular practice of tracking the performance of your portfolio will give you the chance to plan ahead and to take advantage of new opportunities as they arise. 

This approach is often the best practice to adopt because investment markets such as share and property markets move in cycles that often resemble booms and busts as the economy reacts to various macro economic factors such as interest rates, inflation, government spending, unemployment and economic growth.

Portfolio management is all about rebalancing the securities in your share portfolio to address securities that are underperforming and incurring losses, or alternatively, selling down securities that have significantly outperformed the market and are now inappropriately represented against other assets of the same asset class in your share portfolio.

Many investors tend to fall into the trap of adopting a ‘buy and hold’ strategy for securities in their portfolio that can leave them with:

1. Poor returns when markets are depressed during the bad times; and
2. Negative returns when the market is experiencing a severe downturn after having gone through a sustained period of growth during the good times. 

This so called ‘buy and hold’ strategy advocated by so many investment advisers is basically tantamount to doing nothing, regardless of how markets have performed. For many investors, doing nothing cost them dearly in 2008 as the gains of the latest bull market were wiped out. Investors who placed up to $1 million in superannuation before 30 June 2007 to take advantage of the federal governments super simplification changes have paid a heavy price for such a strategy.

As an investor you need to be ready to act quickly to rectify problems with any securities that may be underperforming in your portfolio because the opportunity cost of not having funds invested in other assets that are doing well can have a significant impact on your overall portfolio returns.

Securities that have reached significant new highs after a prolonged and sustained increase in price from low levels due to a strong bull market should also be monitored closely. The reason for this is because their weighting against other assets in the same asset class can be out of sync and will need to be brought back into line to restore balance. Securities in this situation are also at high risk of experiencing major price reactions when boom cycles end, so it is often prudent to stay on top of any securities that are outperforming the market.

As a general rule, if a stock you have invested in has increased in price over the course of a bull market run and is now at risk of shedding some of its gains due to a bear market now taking hold, you may decide to sell all your shares or a significant amount of your holdings in that stock if the price retraces by 20% from its recent high. A simple exit strategy like this could have saved some investors from losing large sums of money on their unrealised profits, especially considering that most stocks in the ASX have now retraced in price by over 50% since the highs experienced in October 2007.   

Chapter 17 – Fundamental Analysis

Fundamental analysis involves identifying the 'value' or 'growth' potential of a company using a range of statistical methods and performance measures. By analysing factors such as the company's financial characteristics and performance, the market in which it operates and general economic conditions, fundamental analysis endeavours to understand the primary drivers behind a company’s share price.

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects. This intrinsic value can be compared to the current value of the company as measured by the share price. If the shares are trading at less than their intrinsic value then the shares may be seen as undervalued and therefore a good buy.

Fundamental analysis looks for certain characteristics of a company that make its shares attractive to buy for capital growth and dividend income purposes in comparison to other companies. These factors come under the banner of balance sheet and ratio analysis and include factors such as:

• An experienced and well-qualified management team;
• Strong cash flows and profit margins;
• Balance sheet strength;
• Attractive financial performance ratios;
• Favourable sector comparisons; and
• Shareholder strength.

Fundamental analysis can also takes into consideration Australian and global economic factors which may have a marked impact on a company’s performance, although the impact of these factors is often more difficult to measure. Some of the broad economic factors that may impact on an Australian company’s share price include:

• Rate of economic growth;
• Unemployment levels;
• Consumer confidence and spending levels;
• Inflation;
• Economic policy;
• Interest rates; and
• The value of the Australian Dollar.

Chapter 18 – Technical Analysis

Technical analysis is an alternative method of share market analysis to fundamental analysis. It is an analytical approach that is designed to forecast future share price movements based on past share price behaviour. By studying the historical performance of stocks and analysing statistics based on time, price and volume, technical analysis seeks to identify patterns of future performance through the use of trading charts.

Technical analysis is therefore best characterised as the study of the actual share price movement and time frames over the life of the stock, not the fundamentals of the company. It assumes that a stock’s historical pattern will re-emerge overtime (i.e. history will repeat itself). The rationale behind this theory is that the value of a company’s share price is primarily a function of supply and demand for it. These factors will cause patterns or trends in the market to appear and reappear over time.

History of technical analysis

Technical analysis goes back quite a long way but it is widely accepted that the founder of modern day technical analysis was Charles H. Dow (1851-1902). Dow was a journalist, the first editor of the Wall Street Journal and co-founder of Dow Jones and Company. He published several articles on technical analysis trading techniques between 1899 and 1902.

His approach to analysing the market and individual stocks was refined after his death by others and was eventually referred to as Dow Theory by his followers, even though Dow himself never used the term. The Dow Jones Industrial Average (DJIA) stock market index still bears his name.

Other well known technical analysis trading techniques, including Elliott Wave Theory and Gann Theory, are loosely based on Dow’s initial editorials.

Although Dow Theory covers a number of technical analysis trading techniques, its main thrust was that major market trends are composed of three phases: the accumulation phase, the progression phase, and the distribution phase.

During the accumulation phase astute investors are actively buying stock in contrast to the general market, which is liquidating or selling stock. During this phase, the stock price changes little because these investors are just a small part of the market and are in the process of accumulating their positions. When the market wakes up to these activities and realises what is going on, (i.e. the stock has entered a strong uptrend or bull market) the general public begins to participate and a rapid price rise takes place based on demand outstripping supply. This phase, called progression, is often referred to as the public participation phase and relies on the assumption that markets are dominated by mass psychology that continues until rampant speculation occurs resulting in large upward price moves and volatility at new or extreme highs. At this point, astute investors begin to distribute their holdings in the market (the distribution phase) by liquidating (selling) their positions and taking their profits before a major change in trend occurs and a new market cycle (i.e. a strong downtrend or bear market) begins.

In the sections on Dow Theory and Forecasting we will be concentrating on these key phases of the market in conjunction with cycle analysis in order to learn how to invest intelligently in the market.

Chapter 19 – Cycle Analysis

The share market reflects the state of investor and public confidence in the various commercial sectors of the economy. The cyclical nature of the economy, evidenced in the recurring peaks and troughs experienced by different sectors, is the basis for different theories concerning the frequency and length of time the share market remains in a particular cycle.

These theories are used as a basis for decisions regarding what to invest in and when to do so at any given point in time so as to maximise investor profit. A common belief is that the share market usually runs through a cycle of economic growth or economic downturn over a three to five year period. The recent bull market in Australian shares ran from 13 March 2003 to 1 November 2007, a period of approximately 4 ½ years.

Some investors in the share market who follow the cyclical school of thought believe that each specific share has an inherent value which can be predicted and used as a basis for forecasting when to buy and sell shares in a particular company. These investors are known as ‘chartists’ because they buy and sell shares according to prior performance and predictions of future performance based on the cyclical rise and fall in share values over time.

From a technical analysis point of view, much of the commentary written about cycles in the market can be traced back to Elliott wave theory and Gann analysis. Elliott wave theory talks about wave sequences in a market using the Fibonacci series of numbers, whilst Gann analysis focuses on sections of the market using the percentages of previous moves.

Without going into an in-depth discussion of Elliott Wave theory or Gann Analysis, both observed that stock markets move in a series of rhythmic patterns which are based on a natural progression of shifts in mass investor psychology. As market participants fluctuate between greed and fear, price patterns develop. These price patterns are called ‘waves’ or ‘sections’ of the market.

The basic premise behind Elliott wave theory is that markets tend to move in a FIVE ‘wave’ sequence, followed by a THREE ‘wave’ sequence during the course of a bull or bear cycle. Gann analysis talks about a market moving through a series of THREE or FOUR ‘sections’ during a bull or bear cycle.

Chapter 20 – Dow Theory for Direct Equities

In this section of the course we are going to concentrate on developing an investment plan for investing in direct equities. Direct equities are predominantly the ordinary shares of companies listed on the ASX such as BHP Billiton (BHP), National Australia Bank (NAB), Telstra (TLS), Woolworths (WOW), Wesfarmers (WES) and QBE Insurance (QBE).

The investment techniques we are about to discuss are not appropriate for other types of securities we have talked about that are deemed suitable for the investment portfolios of SMSF trustees, such as fixed interest and hybrid securities. The reason for this is that bonds and preference shares are not growth securities but income securities meaning their market price rarely deviates from its par value or face value. The only times that an income security like a corporate bond or preference share will deviate significantly from its issue price is when the entity responsible for its issue is either:

• in serious financial trouble meaning that it may not be able to meet its dividend or interest obligations to investors. This may result in a sell-off of the security well below its intrinsic value (par value or face value plus interest or dividend earnings); or
• doing extremely well and reporting strong financial results. If the security is structured in such a way that allows for equity upside, (which is the case with some preference shares) then the security value may become significantly higher than its intrinsic value.

The investment techniques we are about to explore are therefore generally suitable to the more active or volatile securities listed on the ASX, such as ordinary shares.

Chapter 21 – Forecasting

Forecasting future price moves and the timing of those price moves over both minor and major share market cycles is one of the most challenging aspects of investing in the stock market that any trader or investor can undertake. However, there are several forecasting techniques that anyone can master to identify possible price targets and time frames for a change in trend.

In this next section of the course we are going to focus on how to best utilise these forecasting techniques over both minor and major cycles in the market. This will enable us to make predictions about price levels and dates to safely enter and exit positions in the market so as to avoid leaving significant profits on the table when a market for a stock has a severe pull back or reaction.

In the section on Technical Analysis we studied several different types of chart patterns for investing purposes such as 1-2-3 bottom formations, double bottoms and narrow sideways channels.

In our forecasting discussions we will examine forecasting techniques that will enable us to safely trade these chart formations during the different phases of the market (accumulation, progression and distribution) in order to maximise investment returns.

The basis of these forecasting techniques is to look for patterns in the market to repeat in terms of both time frames and price magnitude over both short term and long term time frames.

This means you will need to be looking for not only equal time frames and price ranges to emerge, but also key percentages of these time frames and price ranges so that you can make predictions about when and at what price a market is most likely to give a top and/or change in trend.

Obviously you would like to enter a market when it confirms an uptrend and sell out of the market before a downtrend develops, so let’s have a look at the best way to go about this for a bull market situation. These techniques also work well in the opposite direction when you have downward trend or bear market.

Chapter 22 – The Art of On-line Investing

As an investor you have two methods of buying shares in a company. The first is through a float or capital raising in the primary market where you don’t pay any brokerage, and the second is through a stockbroker in the secondary market where brokerage applies. Stockbrokers act as agents in the share market to buy and sell securities on behalf of clients for a fee because shares cannot be bought and sold directly with the ASX.

There are two main types of stockbroking firms, full service brokers and discount brokers, with the level of investment advice and brokerage fees they offer being the key differences between the two.

Advisory broking service (full-service brokers)

A full service broker provides research recommendations and personal advice on buying and selling shares including information on mergers and acquisitions. They may also offer investments through capital raisings or IPOs to their clients and can provide a priority of access service to certain stock offerings. Brokerage fees are generally higher for advisory broking services as they often use a commission grid to charge clients, rather than a flat fee per lot or transaction, often used by discount brokers.

Some full-service brokerage firms also offer the ability to trade via their internet trading platform, usually for a lower brokerage fee. It is always worth discussing your trading, reporting and data needs with a full service brokerage firm as many can provide substantial value-added services to traditional stockbroking through an online trading platform.

Non-advisory broker (discount brokers)

Non-advisory brokers (who are typically phone or internet brokers) usually offer no recommendations or advice to their clients. These brokers are generally based around an 'execution only' service, where they simply provide a transaction service for a flat fee to trade in the stock market. However, some discount brokers are now also offering full service advice, IPO information and company research to their clients.

As the name implies, discount brokers' fees tend to be a lot lower than those of a full service broker. With the advent of the internet, most non-advisory brokerage firms offer their execution only service via a comprehensive internet trading platform.

Choosing the right broker

Most SMSF investors prefer to have the best of both worlds when it comes to trading and investing in the stock market by having a discount or online broking firm to carry out the bulk of their share transactions, and a full service stock broking firm for investment advice purposes and as a back-up to execute trades that are difficult to get away online. Given most SMSF investors are buying well known and trusted blue chip stocks for their investment portfolios anyway, they can probably operate quite well without personal advice. After all, you don’t need advice from a full service stock broking firm to buy Commonwealth Bank (CBA) shares if you want these shares in your portfolio and they suit your investment needs. 

The majority of SMSF investors will establish a relationship with a full service broker because of the range of services they can provide, which are quite extensive and can be advantageous to SMSF investors looking to access company floats (IPOs) and capital raisings. Although you will need to open and maintain an account with a full service brokerage firm to gain access to their services, you don’t always have to use them to take trades on reputable stocks and pay the higher brokerage fees. 

Using an online broker

Millions of people use online brokers to trade share markets and invest in shares. As there are quite a few online brokers offering a range of different services, you need to do your homework to find the right one for you. Most investors, however, just want a fast execution service with the ability to act immediately when they see a trading opportunity come up on their computer screen.

Aside from fast execution services, some of the other more important considerations that you should also investigate when looking for a suitable online broker are:

• the range and quality of customer service;
• whether you can speak to a real live stockbroker to place your trades with if  their online trading platform becomes unavailable; and
• their fees and charges to take trades.

Good service includes the provision of trading and research tools and other related company data to assist your decision making. You'll find some trading tools and research data extremely useful and others not so good – just keep exploring the various sites out there and use whatever suits your trading or investment style.

Some of the key areas you should be looking for in an online broker include:

• having access to real time depth screens that show you the depth of the market for different stocks (i.e. live ‘bid’ and ‘offer’ quotes in priority order);
• being able to use charting software with technical analysis tools and trading indicators; and
• the ability to manage your portfolio based on your CHESS holdings to keep track of your trades and share positions.

One of the most important aspects of customer service is access to a fellow human being when you need help. Though online investing is supposed to make it easier and cheaper to interact with a brokerage firm and make trades, unusually high volume on the site (often caused by unusually high volume in the overall market) can mean delays in taking trades online. So it is sometimes important to have the option available to you of being able to contact a human broker who will actually take your call when needed. Most discount brokers have this capability, it just costs a little bit more to have a real broker conduct the trading for you because they are effectively taking on the execution risk associated with placing the trade.