Investing Strategies for the Individual Investor

I’ve been spending a lot of time this past week working on the final edits for the book.  Hopefully I’ll be able to get it out and available for purchase early next week.  In the mean time, please enjoy this “classic” SmallIvy Post from last year in case some of you missed it.  (Yes, I know it is just like a lousy clip show when you’re waiting for a new episode, but please bear with me.  The book will be worth the wait.)

Different stock picking methods have been popular through the years.  Some people try to buy stocks they consider cheap and then sell when they get expensive.  Others try to buy stocks that are going up and then step out before they reach a top.  The first technique, called value investing investing, is buying low and selling high, the second technique, called momentum investing, is buying high and selling higher.

Today I thought I’d review a few of the strategies and plusses and minuses of each:

Momentum Investing:  In momentum investing an individual looks for the hot stocks of the day – those that are going higher and everyone is talking about – and buys them.  He then tries to jump ship before it reaches a top and fizzles.  This is sometimes called “building castles in the clouds” since the support for these types of stocks is normally fairly weak and eventually they come crashing back to earth.  The advantage is that the stocks to buy are fairly obvious – everyone is talking about them, like Apple until recently – and gains are generally made fairly quickly.  The disadvantage is that one risks buying into a stock that is overpriced near a top.  Usually the hot stocks come crashing down at some point.

Value Investing:  In value investing, an investor finds stocks that are cheap relative to their “fair value,” which is calculated based on earnings and other factors.  He then buys them while they are cheap and sells them when they start to get overpriced.  The advantage is that he is buying low-priced stocks which may not get beaten down as badly during a market fall.  The disadvantages are that one need to be very patient since it may take a while for the stock price to turn around and this strategy can be risky because some stocks are beaten down for a reason.  Buying companies that go bankrupt is more likely with this strategy.

Buy and Hold:  In this strategy, recommended by this blog, stocks are bought in companies that show potential to grow for long periods of time.  These stocks are then held regardless of stock price until the fundamentals of the company change or the position becomes too large and a portion must be sold for safety.  The advantages are that it is easier to find stocks that will do well over the long-term than it is to find those that will do well over short periods of time and one has a chance of picking a stock that will provide a very large return (in some cases turning a few thousand dollars into hundreds of thousands or even millions of dollars).  A disadvantage is that one can also lose a lot of time and potential profits if one chooses a stock that does not do well.  Another disadvantage is that when one does make a large profit, much of the value of the stock may be profit, resulting in a lot of taxable income when the stock is sold.

Dollar-Cost Averaging:  Rather than a way of picking stocks, this is a way of buying stocks in which an equal dollar amount of a stock is bought at a regular interval – say every month or twice a year.  Because an equal amount is purchased, more shares are bought when prices are relatively low than when they are high, resulting in a profit even when the overall price of the stock is fairly flat over the period.  This is a good strategy for buy-and-hold investing and generally works best with a stock that has a dividend reinvestment plan that allows purchases of stock since one can therefore avoid most brokerage fees.  The disadvantage is keeping track fo your cost basis for taxes.  This could be eliminated with the passage of the Fair Tax.

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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.

Ways to Delay Capital Gains

One of the main advantages in long-term investing is the ability to delay capital gains taxes.  This allows the money you would have been paying in taxes to compound and grow more income for you.  This is true even in a taxable account.

Even if you do sell stocks and pay capital gains taxes regularly, there is a tax advantage to holding stocks for more than a year.  While this rule changes from time to time, currently you will pay between 0% and 20% in capital gains taxes for long-term gains and ordinary tax rates for short-term gains.  Note that for some reason it is thought that those who invest for long periods of time are helping society and therefore deserve a lower rate than those jumping from stock-to-stock, or perhaps politicians are trying to encourage people to invest for longer periods of time since this is a good thing to do.  In any case, there is currently an advantage to long-term holding, meaning holding stocks for a year or more before selling and realizing a gain will lower your taxes.

But what if you buy a stock and it shoots through the roof in a couple of months?  Maybe you planned to hold it long-term, but now the price is so high that you worry it will sit there for years, waiting for earnings to catch up or perhaps even fall back to earth once the excitement dies down.  Or maybe you need the money in a year, but know your income will be a lot less next year than this year, so you want to move the gain by a few months and reduce your tax burden.  (Note, all of this could be avoided if the Fair Tax were enacted.  Please read my posts on the Fair Tax and support it so we can get back to worrying about investing instead of taxes.)  In general the best thing to do is to just sell the stock since the price can easily drop enough to wipe out any tax savings you would have had.  Nevertheless, today I thought I would provide some ways to delay the realization of capital gains.

As with anything tax related, please check with a CPA or do your own review of the rules at the IRS website, rather than believing some guy on a the internet.  These rules change all of the time. 

Using Put Options to Insure Your Gains

The first method to prevent a loss is to buy a put option on the stock.  This is an insurance policy that guarantees that you can sell the stock for a certain price, called the strike price, on or before a certain date, called the expiration date.  For example, let’s say that you own 1000 shares of IBM, which is currently trading for about $180 per share, and wanted to hold it through next December to put your gain into 2015 instead of 2014.  Looking at the options for IBM, you could buy an IBM January 2015 Put Option with a strike price of $180 for about $1200 per 100 shares, or about $12,000 for all 1000 shares, valued at $180,000.

This would allow you to sell your shares to whomever sold you the put option for $180 per share no matter the price at which the stock was trading.  You could do this anytime between now and the third Friday in January.  At that point, if you did not sell the shares using the put option, the option would expire worthless (you are paying for an insurance policy).  If the stock went up to $250 in the mean time, you could just hold onto the shares and sell them for $250, letting the put expire.  If the price fell to $100 per share, however, you could still sell the shares for $180 each in January by exercising the put option.  If you wanted some protection but didn’t want to pay $12,000, you could also buy the January $170 puts for $8.00 per share, or about $8,000 to cover the 1000 shares.  This would allow you to sell the shares for $170 per share, which would result in a little more of a loss if the share price did fall, but would allow you to keep more of the gain if the share price held up between now and January.  This is kind of like having a higher deductible on your car insurance, which means you pay more if there is an accident but you save money when there is not.

Selling Short Against the Box

A second method is to do what is called selling short against the box.  In this strategy you tell your broker you would like to sell short against the box the same number of shares as you hold long.  You would then keep both positions open until the point at which you wanted to realize the gain, at which point you would tell your broker you wanted to liquidate the position.  He would then cause the two positions to cancel each other out and you would effectively have sold the shares.  (Note that this has no reason for existence other than to delay capital gains for taxes and some lawmaker may have changed to rules to disallow this transaction; therefore, check with your CPA and/or your broker before trying this maneuver.)

As an example, let’s return to our holder of 1000 shares of IBM.  He would tell his broker that he wanted to sell short 1000 shares of IBM against the box.  His broker would borrow the shares and sell them, putting an entry for 1000 shares of IBM short in the investor’s account.  From that point if the stock went down in price, the short sale profit would exactly cancel the growing loss on the shares held long.  Likewise, if the stock went up in price the loss on the short sale would be cancelled out by the gain on the shares held long.

There are issues and a cost to this strategy as well.  Selling the shares short will result in additional commissions and fees that the investor would not need to pay if he just sold the shares instead.  The short sale would also result in a possible margin position.  For example, if the stock increased in price and there was not sufficient cash in the account to cover the value of the short sale, the brokerage firm would start charging margin interest for the uncovered value of the short sale.  If the stock rose high enough the brokerage firm might make a margin call, forcing the investor to come up with more cash to cover a larger portion of the amount of the short sale or close the position early.

As said before, it is usually best to just sell the shares and pay the taxes.  If the tax savings will be large enough, however, such as for someone in the top tax bracket where the income taxes would be around 40% for a short-term gain versus 20% for a long-term gain, using one of the above strategies may be worth consideration.

Contact me at, or leave a comment.

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. 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.

Why Don’t People Want the Fair Tax?

Since posting this entry, I’ve had a couple of people rate the entry as “poor” instead of leaving a comment.  I’m thinking they’re actually rating the Fair Tax as poor rather than the post and I’d love to know why.  Please leave a comment and let me know why you don’t like the Fair Tax if this is the case.  If you can’t express a reason, maybe you need to rethink your stance.

I’ve made a few posts in the past about the Fair Tax.  In a nutshell, the Fair Tax would replace all of the existing Federal income taxes, including the Federal Income Tax itself, Social Security Taxes, and Medicare Taxes.  It would be a consumption tax on new goods and services (meaning your yard sale items wouldn’t be taxed, nor would your used car).  It is estimated that the tax rate would be about 20% if tax revenue levels were left the same.  Compare this with income taxes, which are around 10% for those in the middle class, Social Security taxes, which are 6.5% for the employee and the employer, meaning about 13% total, and Medicare taxes, which are about 4% between the employee and employer.  This means your paycheck would increase by about 27% in exchange for paying a 20% sales tax.  Sounds good to me.

But wait, there’s more.  Because businesses would no longer be paying corporate income taxes, and because they would no longer need to maintain a huge staff to handle payroll deductions, tax deferred accounts like 401k accounts, and planning to avoid corporate income taxes, their costs would go down.  This might increase profits a little for the shareholders if the company retains some of this savings, but most of that savings in the cost of providing goods and services would go to lowering their prices and raising salaries.  It is estimated that most of the 20% sales tax would be offset by the reduction in the prices of goods, meaning that the actual price you pay may be about the same, even including the sales tax.

Having less of a paperwork burden would also make it easier for people to open businesses.  If all you had to do was hire people and hand them a paycheck, rather than needing to have an elaborate accounting system to figure out tax withholding and all of the other corporate taxes, more people would be willing to start a business.  This would mean more competition for both customers and workers, meaning more selection, lower prices, and higher wages.

The tax is also not regressive because there is a prefund.  With the prefund every American would receive an electronic deposit from the government at the start of the year or the start of each month to cover part of the sales taxes.  For example, if you wanted the first $20,000 of spending to be tax-free to help low-income earners and the Fair Tax was 20%, you would send a prefund of $4,000 per year to each citizen.  This means that even if a person at the low end of the income spectrum spent their whole paycheck, they would not be paying any taxes.  If they saved a bit they would be getting a supplement to their income.

I’ve created posts on the Fair Tax before, but have gotten few responses.  I also am not seeing the activity needed to get one enacted.  Understand that politicians like the current income tax because it both gives them some control over their constituents and allows them to give special favors to big donors, which in turn helps get them re-elected.  If they want you to buy special windows or certain cars, they can create a tax deduction for those items.  Likewise, they can create special exemptions for coal companies, farmers, or sugar importers and in exchange get donations from those groups who want to keep the special tax break in place.  They even use Social Security to control seniors since all incumbents need to do to defeat a challenger that might restore some fiscal sanity to federal budgets is say she will cut Social Security or Medicare and get the seniors out in mass against her.  To replace the income tax with the Fair Tax, which would take all of the power away from the politicians and take away all of the ability of the IRS to stoke fear in the hearts of taxpayers, would take an enormous ground-swell of people demanding it be enacted.  It might also require some incumbents who enjoy the power they weild and wealth they gain with the existing tax system be replaced.

So my question is, why so little interest?  Do you like paying $100 to buy TurboTax each year or $300 to hire an accountant to help with your taxes?  Do you like to live in fear of an audit?  Do you like to save all of your receipts for business expenses, medical expenses, and write down the mileage from your car odometer after each business trip?  Do you like to keep seven years’ worth of tax returns just in case you get a call wanting you to prove your home office expenses from 2008?

I think it would be wonderful to get my whole paycheck rather than what is left after all of the taxes are removed.  I think it would be great to just throw out those receipts and not worry about what price I paid for a stock back in 1982.  I would love to not need to worry about making deposits to an IRA account before a certain date or worry about the limits for deposits to an HSA.  So what am I missing?

Please leave a comment with your reasons for not wanting the Fair Tax if there is something I’m missing.  If you support a Fair Tax, how about leaving a comment saying that so others could see this is not some crazy idea.  And if you do want the Fair Tax, how about writing a quick email to your Representative and Senators (just search for the US House of Representatives and the US Senate in Google and you’ll get the contact information in a few seconds).  And when politicians come calling or the political parties come asking for a donation, how about expressing your desire for a Fair Tax to them.  Maybe 2014 could be the last year where you’ll need to file income taxes.

Contact me at, or leave a comment.

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. 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.