Should an Investor Use Credit Cards?

Ask SmallIvy

Dear SmallIvy,

I’ve heard that paying off credit cards is part of a good financial plan.  Is this the case?  Should an individual looking to build wealth use credit cards?

Thanks a lot,


Dear Mark,

Let’s talk about the credit card agreement.  If you read the agreement you will notice that it talks about interest rates, late fees, and yearly fees.  You will first note that the actual rates that will be charged will never be disclosed, but rather linked to some other interest rate like the prime rate.  The reason is that the rates will range from 12% to 25% or more.  If one payment is missed or comes in late for that card, or any other card, the rate can rise to 35% or more.  That will not be for just new charges, but even existing charges. 

You’ll also notice that there will always be a clause that says something like:

These terms can be changed at any time at our discretion by sending notice to the card member within 15 (or 10 or 30) days of the change.  If the card is used after that point the card member agrees with the terms.

That statement is basically saying that no matter what we’ve told you, we can change the terms at any time, charge you whatever we feel like charging you, and unless you have the cash ready to pay us off immediately you’ll need to abide by the new terms.  Who would agree to something like that?  A lot of people, apparently.

But what if you pay off the balance every month?  I was doing that for about 15 years on a few credit cards I kept.  One month, on a credit card from CHASE that I had held for about 5 years and paid in full each month, I had monthly charges for $1759 or something.  In the number box I wrote $1795.  On the payment line I mis-wrote “One-Thousand, Ninety five,” leaving out the “seven hundred.”  Rather than calling me to say that I’d mis-written the check, CHASE cashed the check for $1095, said nothing about it until the next statement.  They then charged me interest on the remaining balance and the balance for the next month.  They agreed when they looked at the check that it was just a mistake in how I wrote the check, but they refused to refund the interest.  I cut up the card and no longer use credit cards. 

The lesson here is that even if you pay off the bill each month you’ll slip up somehow and they will get you when you do.  They make the rules and are too good at what they do.  It is better not to even play the game.

But what about the rewards points?  Studies have shown that people spend more when using credit cards than when using cash.  If you don’t believe this, take out cash each time you go to the grocery stores each month, without putting a limit on your spending, and compare how much is spent compared to a month when a credit card was used.  Do the same thing when going out to dinner.  The pain of spending money is not felt when a credit card is used.  If you spend 10% more everywhere on stuff you don’t really need, is 1% cash back or in free airline miles you can never book really worth it?

So the answer is, no, there is no place in the wallet of a person who wishes to grow wealthy for a credit card.

How to Reduce Your Risk when Investing in Stocks

The title of this article is actually something of a misnomer.  The reason is that if one is taking substantial risk, one is not investing, but rather speculating or trading.  In investing, while one is putting money at risk the odds are substantially in the investor’s favor.  With speculating the odds are slightly in one’s favor.  In trading the odds are even or maybe stacked against the trader.  Just like gambling, trading and speculating are obviously more exciting than investing, and many simply fool around with stocks for the entertainment value.  Those who are serious about making money in the market, however, would want to put the odds in their favor since this both increases the chances of growing one’s wealth and reduces the amount of time required to manage the accounts.

The two factors three factors that affect risk are diversification, stock selection, and time period.

One way to reduce risk is through diversification.  Because things can happen to single stocks (scandals, lawsuits, bad management) it is safer to buy several different stocks rather than concentrating all of ones funds in a few stocks.  Diversification also reduces the impact of poor stock choices.  If one buys three different stocks, the poor performance of one of the companies can be offset by good performance in the other two.  Diversification into more than one industry also reduces risk since good performance int he retail sector can offset downturns in the technology segment, for example.  Finally, diversification into different types of investments, for example, buying stocks, bonds, and real estate investment trusts (REITs) reduces risk because the different sorts of investments may perform differently from each other so market conditions that cause one type of investment to decline in price may cause other types to increase in value.  When this is the case the two types of inc=vestmebnts are said to be “uncorrelated.” 

Diversification is a two-edged sword, however.  By buying several stocks or different types of investments one also limits one’s possible gain to the gain of the markets in general.  While this is fine when one has a large account and is simply trying to keep up with inflation and generate a some income, for the investor just starting out who does not have a lot of money it may be worth taking slightly more risk for the possibility of faster gains.  In general it is best to concentrate positions yet never hold more in a  single position than one is willing to lose.  An investor with a large account might therefore hold 50-100 stocks, or a set of mutual funds that invest in hundreds of stocks, while the investor starting out may only hold 3-5 stocks. 

Even the beginning investor can reduce her risk, however, through the type of stocks she selects.  By purchasing the stocks of companies that have shown a history of steady growth over long periods of time – and that still have room to continue to grow – she can reduce risk by planning to hold these stocks for long periods of time.  In that way even if market fluctuations cause short-term declines in stock prices, eventually the growth of the company’s earnings will cause the stock price to rise.  There is therefore no market timing required – just hold onto the shares and chances are in one’s favor that the price will increase.

This would mean avoiding cyclical stocks – those that do well in good times and poorly in bad – and look for stocks that are able to generate increases in earnings each quarter.  These stocks tend to be in areas such as retail, restaurants, hotel chains, and technology (particularly software and computer sales).  Areas to avoid would be airlines, semiconductors, and basic material producers.  Large companies that have already completed growing and now are simply holding market share and paying out dividends would also not be appropriate because they lack the growth capability of smaller growth stocks.  

Finally, time horizon affects risk.  Investing for short periods of time is more difficult because short-term pricing of stocks is unpredictable.  Stocks sometimes go up or down for no apparent reason, mainly due to the trading activities of various individuals and entities.  A stock that sets record earnings but misses people’s expectations by a penny could fall several percentage points.  Likewise, a company that lays off hundreds of employees can shoot up in price.  If one selects the type of companies described above and holds them for significant periods of time (many years), the effects of these seemingly random factors will be mitigated.  Stocks are also affected by interest rates and other economic factors that are unpredictable.

If a company increases earnings at a 15% rate per year over long periods of time the price of the stock will grow by about 15%.  There may be times when it grows faster or times when it grows slower but stock price will follow earnings given sufficient time.  It is therefore much easier, and less risky, to find stocks that reliably grow earnings and hold them then try to predict stock behavior over short periods.  This leads to boring trading, just buying stocks and almost never touching them, but if one really wants to invest to grow wealth rather than just be entertained, that is the way.

To ask a question, email or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Important Considerations in Short Sales

After investing a while many people get interested in short selling.  In short selling, one borrows shares and sells them, collecting the proceeds from the sale.  Later on the shares are repurchased.  If the stock has gone down in the mean time one will make a profit.  If the stock has risen in price one will suffer a loss.  It is very similar to buying stocks long, except the order is reversed.

There are some unique aspects of short selling of which one must be aware.  These are:

1) Losses are “unlimited,” in that a short position gets bigger and bigger as the stock goes up in price.  One cannot limit losses as one can do when buying stocks long.  In practical terms it is unlikely that a stock will rise more than 20-30% in a very short period of time as long as one does not try to short stocks that are very low in price.  One must definitely pay closer attention to short sales than long positions, however.

2) For taxes, all short sales are considered short-term capital gains, regardless of the time period held, and therefore are taxed at a higher rate. (Always check with a CPA before believing tax advice, but this has generally been the case.)

3) The cash received from a short sale must remain in the account until the position is closed or one may end up in margin and be charged margin interest.  If the stock price rises above the price at which it was shorted additional cash must also be placed in the account to avoid a margined position.  If the stock rises far enough a margin call may result where one will need to put additional funds into the account or the short sale will be closed by the brokerage house regardless of the loss the the investor.  Note that margin can be a very dangerous tool and short selling without a large amount of cash available can lead to a margin situation.

4) When one shorts a stock one must pay any dividends that a company  pays while the short position is open.  Shorting stocks that pay a significant dividend is therefore not recommended.

Given these aspects I would generally recommend against shorting stocks.  The natural flow of the market is upwards, so when one goes short time is against you rather than on your side.  The only exception is when the market in general or a certain segment of the market is clearly in the late stages of a bubble.  In this situation the stocks have risen so high that there is not much room for them to rise higher.  For example, in 2008 the home builders, banks and thrifts, and oil stocks had completed a long run-up in price and it was unlikely that they could climb much further.  For that reason selling some stocks in those segments short as a hedge against declines in other long positions was a reasonable strategy. 

Even in that case, however, some stocks rose quickly in price.  For example, Golden West Financial was purchased and jumped in price by about $10 per share in one day.  The company that bought them later realized their mistake and even accused Golden West of misrepresentation of their financial position, but that would be little consolation to the short seller who suffered a severe loss when the buy-out was announced.  Maintaining a sizeable cash position to allow one to absorb such losses is therefore recommended even when shorting frothy stocks.

To ask a question, email or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

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