How to Not Lose Money when Investing, Part 2


River2In the last post we talked about how you can use bonds to provide a steady income and to provide stability while using stocks to participate in the markets and get some growth.   You buy enough in bonds such that the interest you receive from the bonds will be enough to offset any losses you may see in the stock portion of your portfolio.  This is how you create the “risk-free” portfolios you see some companies promote.  The difference is that if you do it yourself you’re not limited to the 5% maximum returns in the stock markets that they advertise.  You also don’t have the big company backing you up, however, meaning you don’t have a company able to pay out some money in the down years so that you don’t see a drop in your portfolio value during those years like you will if you create the portfolio yourself.  In the long run, however, you’ll be better off going it on your own, but you’ll have a little more volatility over short periods of time.

Today we’ll go into the strategy more fully and see how to put things into practice.  First, let’s talk about the behavior of stocks and bonds.

Stocks:  As stated previously, when you buy a stock, you are taking an ownership position in a company.  After you buy it, it’s value is determined by what someone else is willing to pay you for it in the future.  While you can look at the long-term return for stocks and draw some conclusions about how they will probably perform in the future, there is no guarantee of any rate of return over a given period.  Furthermore, the shorter your time period, the more unpredictable your returns will be.  Almost all periods of five years have positive returns, while 1-year returns are about 70% positive and 30% negative.

Despite the uncertainty involved (or really, because of it), stocks are an important part of a portfolio.  Stocks provide a long-term return that is better than bonds and other fixed-income assets, and holding stocks will allow you to protect your money from inflation.  While single stocks can (and do) become worthless from time to time, it would be very unlikely that you could lose everything if you held several different stocks.  If you have money you need in a short period of time (five years or less), it should be in cash assets.  If you have money that you don’t need for ten years or more, it should be in stocks to protect against inflation and increase returns.

Bonds:  Because bonds provide a fixed income, their return is more predictable than that of stocks.  This is not to say that the total return of a bond can be predicted exactly, and in fact the price of a bond can change dramatically if interest rates change or if a company gets into financial difficulty.  Losses can therefore still occur if the price declines and the investor sells out of the position.  Provided bonds are held until they mature, the fluctuations in price of bonds is not important since you’ll get the full coupon price of the bond when it matures.  In fact, you can gain a little extra return by buying bonds that are at a price less than their maturity price and then holding to maturity.

Holding single bonds can result in a loss of your entire investment if the company goes bankrupt and is unable to repay the loan.  Because of this, several bonds should be bought at once to reduce the damage caused by the loss of any single bond.  Again, buying bonds through mutual funds is a good way to accomplish this.  Also, bonds should be held for long periods of time, as should bond funds, so that the interest paid by the bonds and the effect of bonds maturing has the ability to reduce or eliminate short-term losses caused by price fluctuations.

Setting up a (nearly) limited risk portfolio:  Now that we’ve discussed the behaviours of bonds and stocks, let’s see how to use them to make gains when the stock market goes up but limit or eliminate losses when the market declines.  The trick is to use bonds to provide income and stability, while using stocks to benefit from market gains.  The more bonds you buy, the less declines in the market will decrease your portfolio value, but the less gains you’ll make when the markets go up.

You should therefore use a percentage of bonds tied to the amount of risk you’re willing to take and the amount of time you have to invest.  For example, let’s say that bond funds were paying an interest rate of 5% and you had $100,000 to invest.  You want to take almost no risk of a decline in your portfolio value, but you want to participate if the stock market increases in value.  Let’s also assume that you don’t need the money for at least five years.  (If you have a shorter time period and you really need the money, you should just be in CDs because even bond portfolios can decline given less than five years).

If you put 60% of your portfolio in bonds through a bond mutual fund, you would get a return of $3000 per year from your bonds in interest.  If you then invested the remaining 40% ($40,000) in stocks through a stock mutual fund, the interest from the bonds would make up for almost an 8% decline in the value of your stock portfolio.  If the stock portfolio increased 10%, you would gain $4,000 from the stock gains and still have the $3,000 from the bond interest, providing a $7,000 total return, or a 7% overall return.

Now if stocks fell more than 8%, or if interest rates went up and your bond portfolio went down in price, you would see a loss temporarily.  You would not see this from the commercial products because the company covers these losses.  (Note, they also generally require you to hold for a specified period of time since they know it is very unlikely that you will see a loss in either the bond or the stock portfolio if you holld for at least five years.)  When there are big gains in the portfolio, however, they keep a good portion of that gain.  You would therefore do better on your own since your gains will more, but you may need to see an account value decline a little in a given year, especially really bad years.

Note that you’ll often do much better than an investor who is fully in the stock market during down years if you hold bonds as well.  For example, in 2008, many pure stock investors saw 30% declines in the value of their portfolios.  Bond investors actually saw the price of their bonds go up as stock investors sold and bought bonds to try to gain safety (note, this is exactly the wrong thing to do, but we’ll talk about that another time).  If you had the portfolio described in the example above, you would have seen maybe a 5% gain on your bond portfolio just due to the price going up (+$3,000), a 30% loss in the value of your stock portfolio(-$12,000), and then your normal 5% interest return on from your bonds (+$3000).   You would therefore have seen a decline of only $6,000 in your portfolio, or about 6%, when others were seeing a 30% decline.  Most years are not that bad, so even a 6% loss would be rare.

If you had then held the portfolio for another year, allowing stocks to recover, you would have ended up gaining about 20% on your stock portfolio (+$5600), plus another $3,000 in interest from your bonds in the next year.  After year two, you would actually be up $2400 from where you started at the beginning of 2008.

The issue with increasing bond percentage further is that you are giving up return.  And if you go to an all bond portfolio, in fact, you end up increasing risk since now you’ll not have a counterbalance to a decline in bond prices due to rising interest rates.

Your investing questions are wanted. Please leave them 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.

 

How to Not Lose Money when Investing, Part 1


Coffee money

Ever see those ads where you can invest and get returns from the stock market, but you’re guaranteed to never lose money and wonder how they could offer such a product?  If you wanted to, you could do the same things with your portfolio by using the right mix of stocks and bonds, and holding your investments for a long enough time period.  You’ll actually make more that way than you will with one of the “guaranteed” investment products because you won’t be paying out a lot of money in fees.

Let me first say, despite the claims, there is absolutely no way that you can never lose money when investing.  You can just make the chances of losing money very low by making the right investment choices.  The companies may claim that you can never lose money, but they would simply go bankrupt or look for a government bailout if everything went bad at once.  They also have a little more protection than you do when investing on your own since they have a larger pool of money to work with.  As long as everyone doesn’t want their money back at once (and they’ll usually protect against this by charging huge fees if you redeem early), they can usually wait for the stock market to recover.  This is actually what you should do as well, but you’ll see a loss for a while until it does.

Also, understand that the less chance you have making money, the lower your returns will be.  In investing taking prudent risk is how you make greater returns. (Note that term, “prudent” in there.  If you take stupid risks you won’t make bigger returns, except maybe for your broker.)  Part of protecting your money is to invest in some things that make a lesser return, but are more stable and have a more predictable return.

To understand how things work, you need to understand how stocks and bonds work.

Bonds:  A bond is a loan to a company.  In exchange for making the loan, they will pay you a specified amount twice a year.  At the end of the loan period, the company will pay you the money you loaned them back.  At this point, the bond is said to have “matured.”  The company can also pay you back early, which can be an issue since this normally happens during a time when interest rates are low, leaving you with few options to get a good rate of return with your money.

So with bonds, you get a specified rate of return (for example, $500 per year or a 5% initial return on a $1000 bond) and at a certain date the company should pay you your money back.  Of course, things can happen at the company and they may declare bankruptcy.  If that happens, you’ll be first in line to get paid but you’ll be lucky to get a couple of hundred dollars back for your $1000 investment.  If you’ve been collecting interest payments long enough before this happens, you’ll have made money.  If not, you’ll take a loss.  You need to therefore invest in bonds in such a way that you almost guarantee you will not take a loss.  Do this by:

  1.  Invest only in the bonds of companies that are financially strong and unlikely to go bankrupt.  These are bonds that are AAA or AA rated by the rating agencies.  You can buy a few lesser-grade bonds provided the interest rate they are paying are suitably high, but understand a percentage of these will go bankrupt before they mature.
  2. Invest in several different bonds in different companies rather than investing in just one or two.  Think of how unlikely it is that ten or twenty high-quality companies will go bankrupt within the next ten or twenty years.  Having one go bankrupt is  more likely.  Really, investing through bond mutual funds that buy a set of dozens of bonds for you is usually the way to go since you then don’t need to find all of the bonds yourself.
  3. Try to buy bonds that are below their maturity price.  The price of a bond will fluctuate during its life depending on the health of the company and interest rates.  Try to buy bonds that cost less than $1,000 per bond (most bonds are worth $1000 at maturity).  This way, you’ll get a little extra return when they mature since you’ll get paid $1000 per bond then.  If you buy bonds above their maturity price, you’ll lose a little in each bond.
  4. Buy bonds you can hold to maturity.  Your plan is to hold these bonds to maturity so that you won’t care about what happens to the price along the way.  If you have ten years, don’t buy bonds that don’t expire for twenty.

Stocks:  With common stocks, you’re buying an ownership stake in the company.  This means that if the company does well, the value of your ownership stake will increase.  There is no guarantee, however.  If your company doesn’t do well, you’ll lose money, possibly your whole position.

Stocks provide the opportunity to make a greater rate of return than you can receive with bonds.  The value of a company will also keep up with the rate of inflation.  If you invest only in bonds, you’ll see your spending power decrease over time. Remember that at the end of the life of a bond you only get the $1000 you loaned the company back – you don’t get $1100 to account for inflation.  Conversely, Over long periods of time the price of stocks will increase just because of inflation.  Even if the company you buy never makes a higher profit, the price of the shares of stock will increase just because of inflation.  Also, the company will be able to charge more when dollars are worth less, so their profit will increase in absolute dollar terms even if they don’t in real dollar terms.

So the underlying philosophy is that you buy enough in bonds such that the interest you receive from the bonds will be enough to offset any losses you may see in the stock portion of your portfolio, plus give you a little but of money each year.  That way, you “eliminate” the chance of losing money, yet still have the opportunity to make returns from the stock market.  Note that the word, “eliminate” is in quotes because there is still a chance of losing money if things go really badly or you do something silly like see your position after a drop in the markets  before it has a chance to recover.

In the next post we’ll go into the details of how to use a combination of stocks and bonds to build a “risk-free” portfolio.

Your investing questions are wanted. Please leave them 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.

 

Why Just Raising Wages Won’t Help the Economy


SpiderYou know the argument:  If we legislate an increase in wages, we’ll add $100B more to the economy.  Gee, that sounds great.  Why not raise wages by ten times as much and we’ll see an increase of $1T instead.

The issue with this idea is that it ignores what is going on when someone is paid for work they are doing.  You see, when you work for an employer, you are doing something that is needed in order for your employer to do something for other people.  For example, if you work at McDonald’s, you are helping your employer feed hungry people.  If you work in construction, you are helping your employer to build shelter for people.

In exchange for what your employer is doing for these people, they do something that someone else needs of equal value.  Before they walk in the door of McDonald’s they have, perhaps, made a pair of socks for someone else.  They are trading the pair of socks they made for that quarter pounder with cheese and a drink that the McDonald’s employee makes for them.  You just don’t realize it because they trade the socks to someone else who gives them a voucher, called money, that they can trade to McDonald’s for the food.  When they give the voucher to the McDonald’s employee, it only has value because McDonald’s did something to earn it – they provided food to the customer.  They created something or did something that was worth that voucher.

To see it more clearly, imagine if there were two farmers and each one grows corn.  For some weird reason, rather than just eat their own corn, Farmer A gives Farmer B a bushel of corn that he grew.  In exchange, Farmer B gives Farmer B a bushel of corn that he grew.  They are exchanging things of equal value.  Neither one feels cheated, and neither one would squawk at working to grow another bushel and exchange again in the future.  In actuality they would be exchanging different things, but the point is that they are exchanging things of equal value and each needs to do something for the other.

Now what if Farmer A needed to be paid 2 bushels the next time for the bushel he was giving Farmer B because the government forced Farmer B to pay Farmer A more?  Farmer B would rightly feel cheated.  Before he would trade again, he would raise his prices to two bushels per two bushels so that the trade would be fair.  This would mean that Farmer A would be paid more, but now prices would be higher so he would not be getting any more spending power.  If Farmer B could not raise prices, he would probably choose to just eat his own corn and not trade since what he had to trade was worth more than he was receiving in exchange.

If wages are artificially raised, such that the same amount of work is done but the employees are paid more, the same thing will happen.  If a worker at McDonald’s now gets paid $15 per hour instead of $7.25, you’ve now given him a voucher for two more Big Macs per hour.  The trouble is, someone needs to produce those two more Big Macs in order for him to use those vouchers.  But those Big Macs were never produced – a voucher was just printed.  Instead of the emplouyee now being abel to buy more for each hour he works, the price of Big Macs will double.  And so will the price of clothes, rent, and everything else.  Soon, everyone will be right back where he started.

But what if you link the minimum wage to inflation, where wages increased when prices went up?  Well, because you would now be asking the employer to pay more than he was receiving from the work that was being done, the result would be the same as when the farmer decided not to trade and just ate his own corn.  In the real world, an employer must make enough money from having employees to justify the cost of hiring them and dealing with them.  If wages are artificially high, an employer may choose to do work with fewer employees or maybe just work the business himself and not expand if wages are required to be too high.  What sense would it make to grow bigger if he was losing money with every employee he hired?

Got an investing question? Please send it 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 do you think?  Please leave a comment?

Contact me at vtsioriginal@yahoo.com

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.

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