Instead of Trading Stocks, Invest


Many financial advisers and personal financial pundits will say that you should not invest in single stocks. You need a large amount of diversification (the holding of a lot of different stocks) to lower your risk. Investors should therefore only hold mutual funds, which buy a large number of stocks.

They are right that investing in mutual funds is the safer way to go. History is littered with examples of companies that collapsed, leaving the investors with large losses that they could never make back because the company they had invested in was no longer there. Generally if your company files bankruptcy, you can expect to get nothing for your shares. Management, the workers, other creditors, and the bond holders will take what they can, so there will be a couple of pennies on the dollar leftover for the shareholders if that.

There has never been a holder of a mutual fund who saw his whole investment wiped out, because that would mean hundreds of companies failing at once. If that happened, the whole economy would be imploding and you’d be out hunting squirrels in your backyard to eat. (By the way, this is why the argument that having people invest for retirement with individual accounts in mutual funds rather than having the government-run Social Security program because investing in the stock market is too risky is a really stupid argument. If the mutual funds imploded, there would be nowhere for the government to raise the money to pay Social Security payments either because no one would be working and there would be no corporations anymore!) In general, if you just hold on after a market downturn, you’ll see your investment recover within a year or two. Even better, invest more at these times since the markets generally overreact and under-price things, allowing you to swoop in and get shares in good companies for a great discount.

Still, holding only mutual funds limits your potential investment return. Having a portion of your portfolio in stock mutual funds makes sense since it virtually guarantees you a great, inflation beating return that has ranged from 10%-15% over long periods of time since people have been keeping track. It is where your 401k retirement funds belong, and where your individual IRA funds belong if you don’t have a 401k available to you. Having a portion in bond funds and income funds also makes sense as you are nearing the time when you’ll need the money since then you can generate regular income and not need to rely on selling stocks and capturing capital gains when you need cash.  This is important since you really can’t predict what the markets will do from year-to-year.

Individual stocks, however, can return far more than the markets. Look at companies like Microsoft and Home Depot. If you invested a few thousand dollars in either of these companies in the 1980’s and just locked your shares away in a safe deposit box, you’d be a multimillionaire today. If you put that same cash in a set of mutual funds, you’d have maybe half a million dollars over the same time period. The difference is that a small company can double its earnings and become far more valuable many times over as it grows and matures. An entire market, that includes stocks that grow and become big, others that fail and disappear, and still other that just grow to a certain level and then stagnate, cannot do the same.

The issue though is that many people start to think they are high-power Wall Street Traders and try to beat the markets by shifting from company to company as they hear news, see some movement in the price of a stock, or get a tip from a friend at work. One of the silliest commercials on television today shows a father who talks about the “rush hour” in their home at 6:30 as his kids and wife get ready and head out. He, on the other hand, just sits down at his computer to trade stocks for the day, still dressed in a long sleeve white shirt and slacks to make him appear like someone in high finance.

The truth is you will never be able to beat the markets over the long time by moving in and out of stocks, taking profits and limiting losses. Every piece of news that you hear causes the markets to react before you get a chance to click a button on your computer or call your broker. There are thousands of others out there ready to pounce on the same news. You also won’t be able to find some pattern in the price movements of the market and deftly jump in and out before major events. Most of the time, charting stocks just tells you where you are rather than where you are going. Any reliable pattern indicator that does show something like an inefficiency in the markets that can be exploited is soon discovered and eliminated as everyone piles on. The only way you can actually take advantage of market inefficiencies is through arbitrage, where you find the same stock on two markets at different prices and buy on one market and sell on the other, but professional trading firms with lightning fast computer quickly exploit those opportunities.

The way you outperform the markets is to start thinking like an investor instead of a trader. In other words, thinking like an owner of a company instead of just a stock holder. You find companies that are managed well in markets where they have the potential to grow and make lots of money in the future. You then buy into these companies with the intention of holding them as they grow.

This isn’t a short-term thing where you’ll sell out once you’ve made 20% or doubled your money. This is a long term commitment where you’ll hold on through think-and-thin since you know that brighter things lie ahead. In down markets you know that your company will be able to take market share and become more efficient while competitors go out-of-business. In boom times you can enjoy watching your company grow and expand, but you know that it will get even bigger and more profitable in the future.

This is what it means to be an owner. Instead of acting like someone who bought a few shares on E-Trade, you act like you put $5,000 into your cousin Evan’s garage start-up. You know that you may not get the money back, but you have confidence in Evan and know that he has a great idea and the return you could get would dwarf your investment.

In the next post in this series, I’ll discuss how investing like an owner changes the kind of companies you pick.

I’d love to hear your comments!  Please use the comment form and let me know what you think, especially if you disagree.  You can also contact me at vtsioriginal@yahoo.com.

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.

What is Money?


dollarsThis is a long post – way more than the 1000 words recommended for a blog entry, but please take time to read all of the way through since I think it will be well worth the effort.  I’d also love to hear some comments, particularly from people who disagree.  If you have a way to make a living wage work, I’d love to hear it. – SI

From some of the ideas of how to help the economy, or how to help working people, it is clear that many people don’t understand the fundamentals of money.  When we were young, no doubt we admired the pretty pictures on paper currency and liked the shiny coins that stacked and clanked so nicely.  We were taught that money was something to obtain and guard and value, but what exactly is money?

Money is essentially an “IOU” for work.  You spend an hour doing something useful for someone like picking crops or building a house, and they give you an IOU that you can give to someone else in exchange for them fixing your car or cooking you lunch.  Ideally you should be able to work harder than you need to just meet your present needs when you are young and full of energy, saving up a few extra of these IOUs each year, and then spend them to have others provide for your needs when you are old and unable to work anymore (or just don’t want to work anymore).  If you die before you get all of your labor repaid, you can give the IOUs to your children so that they can receive an equivalent amount of labor as you contributed in the past.  Maybe this is why it is so sad when someone squanders an inheritance, since the person who gave you that inheritance worked so hard.  Read How to Invest a $100,000 Inheritance to learn how you can put that gift you’ve been given to more productive use.

Before money existed, we used barter.  You wanted a new wagon and were a farmer, so you found a wagon maker or someone who owned a wagon they were willing to sell who wanted a load of corn and traded them for it.  The trouble was finding someone who had what you wanted who wanted to trade for what you had.  You might need to trade several times with several different people to finally get what you wanted in the first place.

To make it easier for people to trade for what they wanted, trading posts were established.  There, you could trade whatever you had for the wide variety of things the trading post owner had.  (Note that the free enterprise system was working here – people saw a need for an easier bartering system, so they created trading posts.  They did this to become wealthier, but the way you do this in a free enterprise society is by taking care of the needs of others.  The more people you help, the wealthier you become.)  Owners would quickly learn what their customers needed regularly, so they would make sure to have regular deals with suppliers of those things.  The trading post owner would trade things that were a little less valuable than the things he received so that he could make a small profit to feed his family and provide for his needs since he was managing the trading post rather than out growing food or maintaining his property.  The value he created to his customers from creating and managing the trading post, however, more than made up for the differential in the value of the trade.  They knew they could get just what they needed from the trading post, rather than scouring the country for people who had what they wanted and would trade it for what they had.  The trading post owner created convenience and a time savings, which was valuable to the customers.  If it wasn’t worth the price they were paying, they would have not patronized the store and just traded directly with others.  People would also open other trading posts if they felt the existing ones were too expensive and they could take business away through slimmer margins.

At some point the trading posts probably found the need to issue IOUs rather than trade goods directly.  Maybe the farmers would trade their crops in the fall, but then wait until spring to pick up seed and tools.  Maybe regulars started keeping an account of credit at the stores so that they could come in when convenient and get goods rather than getting everything right when they traded their goods.  Maybe there were also things that were available only during certain times of the year, so people didn’t have things to trade for them when they came in.  People probably started swapping these IOUs with each other when there was something they wanted from someone directly.  That was likely an early form of money.  At some point people probably wanted an IOU that they could use at many stores, instead of just the trading post that issued a particular IOU.  At that point, they may have started using something like pretty shells or bits of gold.  It just had to be something that couldn’t be found everywhere that people knew would hold its value.  It also had to be something that people would work for to obtain even if they didn’t trade it for something else.

At some point precious metals became the standard.  These worked well because they were limited in availability and people wanted them for jewelery and adornment, so people knew they could always trade them.  Countries started shaping these metals into coins and standardizing the quantity of metal in each coin for convenience, but it was still the value of the metal in the coins that made them worth something.  If you wanted, you could always melt the coin down and recover the metal.  Gold was used for larger amounts, silver for medium amounts, and copper for small amounts.  (Note sometimes people would shave a little of the metal off of the coins before they spent them.  This was kind of like counterfeiting since now the coin you exchanged was not as valuable as its face value.)

At times it became difficult to carry around a lot of coins.  To remedy this situation, countries began issuing paper notes that would allow the holder to exchange the note for a specified amount of gold or silver.  This was called The Gold Standard and was very effective.  Because the amount of precious metals were limited, and because the amount of effort required to dig them up and refine them more than equalled the amount of labor the coins and notes represented, the value of money was relatively fixed.  In the US the value of the dollar stayed almost exactly the same from about 1800-1920.  This means that you could work an hour, save up a dollar note, and then trade it to someone 80 years later for the same amount of labor.  There was no inflation!

This all changed in the 1930s in the US when the country needed to repay its debts from WWI.  Rather than cutting government spending and raising taxes, and thereby raising the money legitimately, the government stopped guaranteeing the ability to trade notes for precious metals.  This allowed them to print money without needing to actually go through the effort to procure something of equal value to back it up.  They also confiscated most of the precious metals in the US so that people who held these metals wouldn’t suddenly realize a bonanza, since they knew that those metals would suddenly be worth a lot more dollars than they were in the past if the government started printing money that was not backed up by gold or silver.  When they spent these new greenbacks, there was now currency on the markets that had not been traded for an amount of work equal to its value, but that could be spent and traded for goods and services just like the legitimately earned dollars.  Because there were now more IOUs out there than there were goods being produced, the value of each dollar decreased and the value of gold in dollars increased.

This is called inflation.  To understand the effect of inflation, realize that the dollar that was worth exactly what it was a hundred years before in 1930 is worth one-tenth the amount it was worth in 1930 today.  If you worked ten hours to earn that dollar in 1930, you could now only trade it for one hour of equivalent labor today.  Inflation really is thievery by the government, or at least another tax levied on everyone who holds cash currency (or even money in savings and other bank accounts, since they don’t pay a high enough interest rate to overcome inflation), since it decreases the value of everyone’s money and they therefore lose part of the work they performed in the past.

And this is why the you can’t expect the government to just cover everyone’s needs, or even a few wealthy individuals.  The government could send out lots of checks, but without someone putting forth the labor to cover the value of those checks, the dollars they create decline in value to the point where thousands of dollars must be traded for a loaf of bread.  To put it another way, for every loaf of bread, house, or shirt that someone purchases with the money the government hands out, someone needs to put forth the effort to make that item.  In a functioning economy, you can either have most people working enough to cover their own needs with a few working extra to cover the needs of those who don’t provide for themselves, or you need to have a few people working really hard to cover then needs of a lot of people.  In the latter case, at some point those who are working really hard will just throw in the towel since they are getting nothing in return that comes anywhere close to the value of what they are producing.  They will just produce what they need for themselves.  As more and more people do this,  the amount of goods and services available declines.  You can then have a fist full of dollars, but it won’t buy you anything.

What about rich people?  Can’t they just cover everyone?  Well, people get rich by just getting a little more back than they provide from a lot of people.  They employ people and get a maybe $5 for every $100 worth of goods and services each employee produces.  They trade goods and services to others, and maybe get $2 for every $100 worth of good they sell.  The reason that they become wealthy is that they employ a lot of people and they sell a lot of items.  They become wealthy by providing a lot of jobs and meeting a lot of needs.  If a lot of the workers started receiving more than they produced, (through a minimum wage that was too high, for example,) and if a lot of the people started receiving the items for free, (because they receive dollars from the government to buy things but don’t provide the labor needed to earn those dollars), the wealth the rich person had would quickly disappear.  There would also be no one to take his place because there would be no incentive to put in the hours required and go through the hassle of opening a business and employing people.  You might as well just provide for yourself and do the minimum and enjoy your free time.

So, dollars are only worth something if people are doing something to earn them.  Remember that they are IOUs for goods and services you provided in the past and not some magic thing that governments can just produce at whim.  You also can’t produce $10 worth of goods per hour and recieve $15 per hour just because you need $15 per hour to pay for expenses.  Maybe a few people can, but on average everyone needs to be producing at least as much as they are paid, plus a little extra to cover the business owner and make it worth his time.  The government can produce the paper and the coins, but they can’t produce the loaf of bread or the house.  That takes an effort.

Contact me at vtsioriginal@yahoo.com, 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.

How to Build a Mutual Fund Portfolio – Part 2


Ask SmallIvy

In How to Build a Mutual Fund Portfolio – Part 1 I discussed the basics of mutual funds.  In a nutshell, when buying into a mutual fund you’re pooling your money with other small investors and buying a large basket of stocks.  By doing so you’re spreading out your money so that bad news for one company will not sink your whole portfolio.

Today I’ll discuss how to use mutual funds to build a portfolio.  Let’s assume that you have just started investing and just raised enough money to make your first investment.  With mutual funds, that is between $3000 and $5000.  Let’s also assume that you have a long time to invest – like 20 years or more.

The first step is to select a good stock mutual fund.  Probably the best first fund will be either a large cap stock fund, such as an S&P 500 fund, or a total stock market fund.  When choosing between funds that invest in the same things, select the ones with the lowest fees.  Because mutual funds are buying a lot of different stocks, they end up with about the same portfolios.  Over long periods of time, the ones with the lowest fees will therefore provide the greatest return since you’ll be getting the same markets returns but paying less of your money out in fees each year.  The funds with the lowest fees are index funds since they do not need to pay managers to select investments and they do not trade stocks very often.  To buy into the fund, just send a check to the fund company or send money through electronic transfer online.

Buying into your first fund is just the beginning.  To build wealth, you’ll want to keep contributing money and buying more funds.  Think of it as planting a money tree with dollar bills as leaves.  You could spend your cash from your salary now, but if you plant a few bills and let them grow into a tree, you can harvest the leaves for ever.  You can only harvest a certain number of the leaves each year or the tree will die, but with time the tree gets bigger and you can harvest more.  If you then take some of the leaves from the trees and plant those also, you’ll grow more and more trees and be able to harvest more and more leaves.  You can earn your money once and then spend it forever.

Your initial investment is just the beginning.  Start saving $300-$500 each month.  If you have bought into a total stock market fund, just add money to the fund as you go until you have about $10,000 in the fund.  If you bought into a large cap fund, when you have saved up another $,3000-$5,000, you are ready to buy into your second stock mutual fund.  This time put the money into a small cap fund since that will provide diversification.  Sometimes the large caps will do better.  Sometimes the small caps will do better.  Over long periods of time, the small caps will best the large caps since they have more room to grow.  Which will do better over a period of a few years, however, is anybody’s guess, so you want to bet on both horses.

Once you have about $10,000 in domestic stock funds, it is time to think about diversifying out into other types of assets.  This will help reduce the ups and downs that you see in your portfolio value.  More important, it will ensure you have at least some money in the areas that are hot at any particular time.

If you are nearing the time when you’ll need the money for life expenses, or you just want to have a less volatile portfolio, you should start to put some money into income producing stocks and bonds.  The higher the percentage of growth stocks you have, the greater the level of fluctuations in the value of your account will be, so adding income assets will tend to reduce the heart-dropping falls and help you sleep better when the markets are going south. You will also find that you can have a lot more volatility for not a lot greater return if you have a large percentage of growth stocks.

A rule of thumb for a stock-to-bond ratio, which is really a growth investment to income investment ratio, is to invest your age in bonds.  In other words, if you’re 20, put 20% in bonds.  If you’re 80, put 80% of your money into bonds.  If you don’t like the market fluctuations, add more bonds than you age.  For example, if you’re 40 but worry a lot, have 50% or 60% bonds.  If you don’t mind the fluctuations and want a higher return, invest less in bonds than your age.  In fact, if you are several years out from needing the money (like 20 years or more), you might want to have a very small portion of bonds in your portfolio since that portion of your portfolio will not perform as well as the growth stock portion, so you’ll be giving up several percentage points of return.  Realize, however, that you can expect some large fluctuations in the value of your account, on the order of 40% or more, during big moves in the market like the 2008 housing crash.  You need to have the intestinal fortitude to just hold on for the ride if you choose not to include bonds.  The closer you get to needing the money, the more dangerous being in all stocks becomes since you could lose half the value of your account and take five to ten years to recover.

To add bonds/income assets to your portfolio, you can buy a total bond market fund or perhaps a growth and income fund.  You can also find a managed fund that lists its objectives as “preservation of capital while providing some growth,” since this type of fund would contain a lot of defensive stocks and bonds. Again, however, managed funds would have higher costs, which would affect your return.

Once you have invested enough into a bond fund or an income fund to provide the growth/income ratio that suits your personal taste for volatility, you would continue to add to both positions.  At some point (perhaps when you have about $50,000), you should also consider adding international stocks.  The US is not always the best place to invest, and as I said before, you want to always have some of your money in the places that are doing the best at any given time, so adding an international stock fund to your portfolio is a good move.  Personally I would invest somewhere around one-quarter to one-third of the stock portion of my portfolio in an international stock fund.

Once you have US stocks, international stocks, and a bond fund you could then stay with that mixture of funds your whole life.  You would just add money to the funds as needed to maintain the ratios of stocks to bonds and US to international stocks that you desired, perhaps selling some shares of one and buying shares of another if things got too out-of-balance.  This should be done rarely, however, since it can trigger taxes and also reduces your return because you are driving up costs for the fund.  Some funds also limit the number of transactions an investor can make to dissuade people trying to time the markets.  Really, making a shift once a year at most is fine, while directing new money into the fund that needs propping up the rest of the time.  As you move closer to retirement, shift money into the income funds and/or sell outright and build up a cash position for near-term spending needs.

You can also add some other types of assets to your portfolio as it grows.  See this more as fine-tuning than a necessity.  A Real Estate Investment Trust (REIT) fund diversifies you into real estate, providing both income from rents and capital appreciation from increases in the value of the properties.  You can also invest in convertible securities, which provide both an income and a growth component.  Finally, you can put a small portion of your account into an aggressive growth fund, which will invest in start-ups and other high risk/high reward ventures, or an emerging markets fund, which invests internationally in companies in third-world nations transitioning into second-world nations.  These types of funds will do great some years and really bad during other years.

Probably the biggest thing to remember is that it doesn’t matter all that much.  If you invest in at least a couple of funds that invest in different things, keep your costs relatively low, and generally leave things alone, you’ll do just fine.  The most important thing is to invest regularly and don’t pull the money out to pay for something that will not improve your finances in the future.  Every dollar you invest in your twenties will be hundreds of dollars in your sixties.  It is just a matter of letting it grow into a big money tree rather than pulling it out with the roots when it just starts to bear fruit.

Contact me at vtsioriginal@yahoo.com, 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.