Why Common Stocks are a Good Investment for the Small Investor


When a company needs to raise money to manufacture widgets, rent offices, and hire employees, they generally have two choices. The first option is to borrow the money by issuing bonds. The second option is to sell off a portion of the company – and its future earnings – by issuing common stock. 

When a company decides to sells of shares of stock, called “going public,” an Initial Public Offering (IPO) is held in which a specified number of shares, representing a certain percentage of ownership in the company, will be sold. The IPO is handled by one of the large security firms who is responsible for publicizing the IPO and gathering an initial group of investors. Typically the IPO price is set by valuing the company, based on the perceived value of the company as determined by current and potential earnings, and then dividing that value by the number of shares to be offered. Once sold through the IPO, the shares are then traded among individuals and the price will rise or fall depending on future earnings of the company.

Each share of common stock represents a fractional ownership stake in the company. Each holder of common stock therefore has a say in how the company is run and gets a share of the profits. The amount of the say and the size of the share of the profits is determined by how many shares are held. For example, in voting on propositions individuals typically get one vote per share; therefore, if an individual owns a majority of the shares she can control the outcome of the vote and therefore the direction of the company. Likewise, dividends are issued on a per-share basis so the more shares you own the mgreater your share of the profits.

After the IPO, additional shares of the company may be sold in what is called a secondary offering, either from the portion of the company retained by the company (for example, if only 30% of the control of the company was sold during the initial offering, the company could issue shares representing control of another 10%) or by further dividing the value of the company. In this latter situation, the majority of the shareholders must approve of the issuance of further shares since each share will then be worth a smaller percentage of the company after the secondary offering. Because the company receives additional funds which can be used for acquisitions, expansions, and other activities, however, the actual value of each share may not decrease (each share is worth a smaller percentage of the pie but the pie is bigger).

Common stocks are generally more risky than bonds and other investments like bank CDs since the investor is assuming an ownership stake in the company and therefore there is no guarantee of returns. This means that if the company loses money, the value of the ownership, and therefore the value of each share of stock, will decrease.  If a company continues to lose money there will be no profits to split.  Despite stocks being more risky than many investment options, there are good reasons to hold stocks. Among these:

1) Stocks can beat the rate of inflation, leading to growth in capital. Of the various investment options, stocks are one of the few that provide enough of a return to beat inflation. If you are saving for retirement, the dollars you invest today in money market funds, treasury bonds, and the like will be worth only a fraction of their value when you retire. Real estate (that you buy fully for cash) will on average just track the level of inflation (although there are special situations if you are investing in specific properties and know what you are doing). Common and preferred stocks hold a nice place in the risk curve where you can beat inflation but still put the odds in your favor.

2) Long-term holding of stocks allows compounding through the delay of taxes . Capital gains taxes on stocks do not come due until the stock is sold. This means that investors who hold stocks for long periods of time get to enjoy the benefit of compounding for years without paying taxes on the capital gains until the shares are sold. Warren Buffett and Bill Gates have paid very little in the way of taxes, despite their enormous wealth, because most of their wealth is in stock in their companies. Because they sell only a few shares each year, their tax bill as a percentage of their wealth is very small. Warren Buffett will actually never pay taxes on the bulk of his wealth because he donated it to the Bill and Melinda Gates Foundation.

By contrast, those earning a paycheck see 25-35% of their earnings taken by state and federal income taxes and another 15% taken by payroll taxes before they even see it.

3) Investing in stocks requires much less effort than some other types of investments. Real estate can be a great investment if you know what you’re doing, but you often need to have it as your hobby. If you want to buy, renovate, and resell houses, count on spending many hours at the house doing a lot of the work. Even if you contract the work out, losing much of your profit, you will rarely find someone with as much commitment to the project as you do since it is not their house.

With long-term investing in stocks, you simply need to spend a little time finding stocks to purchase, call a broker or enter trades on a website, and then monitor the stocks once in a while. Because good investing is long-term and based on the business, rather than on the short-term fluctuations in price, it really doesn’t require a big time commitment.

For even less care and feeding, a set of index mutual funds can be purchased. In that case, the only maintenance required is to rebalance the money in the funds once a year. As retirement nears, more and more of the funds are sold to raise the cash needed for living expenses.

While other investments deserve a place in one’s portfolio, common stocks, either bought directly or through mutual funds, definitely deserve a prominent place for money that will not be needed in the next 5-10 years.

 Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Budgeting while Building your Pipeline


In a previous post I discussed the difference between being a bucket carrier and building a pipeline.  Everyone starts out a bucket carrier – at least those who weren’t fortunate enough to be born with the name “Hilton” or “Heinz.”  Those who make and spend all of their income from carrying buckets, however, will toil their whole lives and end up with little to show for it.  They also put themselves at great risk because if their ability to carry buckets stops – through a job loss, an illness, or another event – their income will stop.  Those who spend some of their time building pipelines – buying assets – will be able to eventually stop carrying buckets without seeing their standard of living decline.  Carrying buckets is easy when you’re young but it gets more difficult as you age.

Building the pipeline is done by directing a portion of your income to purchasing assets such as common stocks.  Because assets provide income to you, as your assets grow your income will grow as well.  It is often difficult to stay on track and continue to invest, however, since the increased income will be very little at first and seem to take forever to grow.  One also may fall into the trap of being too aggressive in building assets and never take the time to enjoy life at all.  

Building a pipeline is particularly difficult when married and one of you is a spender by nature as is nearly always the case (opposites attract).  Indeed, investing can become a great source of tension in a marriage when one individual would like to spend money as it comes in and the other wants to save and invest.  In any marriage a budget is a critical process to allow both individuals to agree on priorities.  Adding the pipelines to the budget can be a good way both satisfy the spender that building assets has merit and prevent the saver from overdoing it and never enjoying life. Here’s how:

1.  Each month, a budget should be prepared that lists all expected income from work and other sources.  Each dollar of that income should then be allocated to one of three categories:  expenses, savings, or giving.  It is during the preparation of the budget that agreements are made as to how much will be spent or saved on various things.  After the budget is made and agreed upon, a pact must be made that the spending and saving will follow the budget.  If there is a critical need to change the budget due to an unforeseen expense, it must be revisited and revised such that the source of the additional money is identified.  This forces both parties to see the effect of the change.

2.  For each of the pipelines, the expected annual amount of income provided should be determined.  It should then be agreed upon how much of that income should be reinvested and how much should be spent during the year.  The additional amount to be spent should be tracked each month and allocated as needed.  This will show the spender that the addition of assets is in fact increasing the available income and prevent the saver from never using any of the additional income.  For common stocks, an average income of 10% should be assumed.  For bonds and other interest paying assets the actual income to be received should be assumed.

3.  The projected increase in earnings from the addition of pipelines should also be tracked using the assumptions stated above.  This will provide a direct link between investing and an increase in income.

For example, let’s assume that a couple has $10,000 in common stocks and a net income of $60,000 of $5,000 per month.  The budget without the pipeline income might look like the following for the first month:

Income $5,000

Expenses (itemized) $4000

Investing $600

Giving $400

Note that every dollar is allocated somewhere.  Given the pipeline balance of $10,000, an average annual income of $1,000 could be assumed.  Note that the actual income on any given year will vary wildly – this is just a long-term average.  Let’s assume that the couple agrees to reinvest 70% of the income, or $700, and spend 30% of the income, or $300.  Let’s say during the second month that the couple wishes to buy a new chair with $200 of the pipeline income.  The budget would then look like:

Income $5,000, Pipeline Income $200, Pipeline Closing Balance $100

Expenses (itemized) $4200

Investing $600

Giving $400

At the end of the first year, assuming that $600 per month was put into common stocks and a 10% return was realized, the pipeline will have grown:

Total = Initial ($10,000) + Gain($1,000)  + Additions($7200) – Withdrawals($300) = $17,900.  This means that the assumed income from the pipeline for the second year will now be $1,790.  By seeing this income increase from year to year, the spender will see the value of investing and the saver will realize that some money can be withdrawn as the assets begin to provide income without seriously affecting one’s financial future.

By adding the income from the pipeline to the budget, a better picture of one’s financial state can be gained that will both motivate the continuation of savings and prevent saving too much and enjoying life to little.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What You Should Know About Investing Before Going to a Financial Advisor


As with any professional, most people would choose to use a financial advisor since they would not have the particular knowledge needed to plan their own finances.  This is similar to going to a car mechanic when one does not know how to fix the car oneself.  Of course the car mechanic does have more experience, does the repairs everyday, and probably has some special tools that the do-it-yourselfer would not have, so it can make sense for an individual to take the car in even if one could make the repairs. 
Likewise, it can make sense for an individual to use a financial advisor even if one does understand finances.  There may be aspects of finance like life insurance, stock investing, or tax planning that are outside of one’s comfort zone.  Also, as with auto repair, while one might be able to change one’s own oil or replace one’s own brakes, one may not wish to spend the time.  As is discussed in The Millionaire Next Door,  the rich tend to spend their time at their chosen profession or with their families instead of doing things themselves to save the cost of hiring a professional.  They figure they can make more money doing their profession than they can save by doing things themselves.
As with car repair, however, if one knows nothing about investing, one is left at the mercy of the financial planner.  Unfortunately there are unscrupulous financial planners out there just as there are unscrupulous auto mechanics.  The following are competencies one should have to allow one to ask the right questions of their financial planners:
1.  A basic understanding about the different types of assets and their behaviors.  The Money Book of Finance is a good place to start.
2.   An understanding of the effect of diversification, volatility, and time frame on investment risk.  See Stock Trading and Investing Tips for Beginners.

3.  An understanding of the risk and reward for different asset classes.  For example, see the post Understanding risk and reward.
4.  An understanding of what type of investing is appropriate for different stages of one’s life.  For example, see the post The Stages of Investing.
5. An understanding of the role of growth assets and income assets in a portfolio, commonly referred to as “stocks and bonds.”  
6.  An understanding of the different types of mutual funds (open funds, closed funds), the different fee structures (load, no load), and the different investment strategies (momentum investing, value investing).
7.  An understanding of the effect of frequent trading, called churning, on fund performance (basically, a lot of activity drives up fees).  Also, an understanding of appropriate levels of fees (funds with fees below 1%, ideally below 0.50%, are best).
Some of the classic books on investing will help provide a good foundation.  For example, A Random Walk Down Wall Street, One Up On Wall Street, and The Warren Buffett Way are all excellent.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.