How to Grow Rich Slowly


Everyone has seen the late night advertisements.   There is a guy standing in a large backyard by a sky-blue pool with tropical flowers and a large stucco-roofed house in the background.  Perhaps he has a woman 10-20 years younger than him lounging next to him in a bikini, enjoying the sunny day.  They are both probably wearing sun glasses – wealthy people are always wearing sunglasses.  He says that he is ready to share the secrets to building great wealth and obtaining economic freedom.

He then proceeds to tell you that you can make a fortune while you keep your day job using his system.  It may be a real estate trading scheme.  You may be buying and selling penny stocks.  Perhaps you are doing multi-level marketing — a technique only a hair different from a pyramid scheme.  Maybe you are selling products over the internet for them.  All you need to do is set up an account and then check each day to see how much cash you made.  Just sign up for their seminar, which conveniently is coming to the Holiday Inn near you.  The price is never mentioned.

Unfortunately, wealth will not come to you from some scheme.  If there really were a scheme that could create untold wealth, why would they share it with you?  Why not just sell the real estate themselves?  Why wouldn’t they set up their own websites to sell their products?  If the individuals in the commercials actually are wealthy (and they didn’t just rent out a house for the commercial), you can bet that they got that way off of the fees for their seminars and classes, not from the scheme they are presenting.

 

The Compound Effect

Getting wealthy through starting a business, which is the fastest way, requires time, risk taking,  hard work and long hours.  Getting rich through investing luckily doesn’t require as much hard work, but it requires sacrifice,  prudent risk taking,  time, and discipline.

Sacrifice is required.  You don’t buy a new car every few years; you buy a 3-4 year-old car every 5-8 years.  You don’t buy a boat; you rent one during the few occasions you actually go boating during the year.  You don’t eat out every night; you learn to cook and eat out perhaps once a week.  You set a budget and stick to it, and that budget has less money going out each month than is coming in from your job.  You understand that by waiting and buying the toys later for cash and from the gains from your assets, you can have both the money and the toys.  Buy them now, on credit, and you’ll end up spending twice as much for them as the sticker price.  Plus in five years, they’ll be old and broken and you’ll still be making the payments!

You take prudent risks.  This does not mean going to Vegas and betting on red.  It means investing your money in places where the odds are in your favor, but that grow faster than the rate of inflation.  Things like stocks, real estate, ETFs, mutual funds, and bonds.  These investments allow your money to earn money and compound, growing as you work so that eventually your portfolio is providing more income than your job.  This is when things really start to happen.

 

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Growing wealthy requires time.  Do some calculations on compound interest and you will find that very little interest is made in the first few periods, but huge amounts are made during the last few.  Try this experiment: start by placing a penny in a jar.  The next day place two pennies, the next day four pennies, and so on, doubling the amount each day.  See how much you will be putting in the jar by the end of thirty days.  (If anyone does this, please write a comment telling everyone what happened).  Be patient and let your money compound.

Finally, discipline is required.  Money needs to be put away every month into investments.  It doesn’t matter if the market is up or down, put some money away.  If the market falls through the floor, buy all you can.  If the market seems really pricey, perhaps hold back a bit on the side in a money market account, but put some in anyway in case you are wrong.  In any case save some money each month from you earnings.  Consistency is the key.

Learn how to use mutual funds from the founder of Vanguard:

 

 

 

 

 

 

 

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in 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.

The Stock Price is All About the Dividend (Even When They Don’t Pay One)


A couple of years ago I got into a lengthy discussion of stock pricing with a reader.  Unfortunately the exchange ended up being by email (I’d much rather readers post comments to the blog – I get so few of them).  I contended that stocks are priced based on the dividend they pay, or actually, based on the potential future dividend.  The reader basically said that I was incorrect and that stocks are based on a lot of factors, the dividend being a very minor one.  (In actuality, we’re both right, and I’ll explain why in a minute).  In any case, he cited Apple as a company that would never pay a dividend; therefore, the idea that it was priced based on potential future dividends was ludicrous.  A few days after our debate, Apple announced that it would start paying a quarterly dividend of about 2%.

How is he right?  Stock pricing isn’t like pricing at the supermarket.  You don’t walk in, pick up an item from the shelf and see a price sticker on it.  (Yes, I know that we’ve gone to bar codes now, and the price (might) be on the shelf, but bear with me – I’m from the 80’s.)  Prices fluctuate constantly and for a wide variety of reasons.  Some people look at earnings and decide what a stock should be worth.  Some look at how likely it is for the stock to have an earnings surprise and bid the stock up accordingly.  Some people sell shares and don’t care what the price is because they have a large profit and just want to unload it, or they need to pay for their daughter’s wedding.  Some people see a stock go up or down in price, and buy or sell it because it went up or down in price.  They figure that if the price is going up, they’ll be able to sell it at a higher price.

Very few of these people are probably thinking about the dividend that the stock is paying.  Heck, a lot of these stocks may not even have a dividend.  So I must be wrong, right?

Well, even though all of these people don’t know it, they are basing the price they pay on the projected future dividend.  Note that the “projected future” part is very important.  Note also that there are fluctuations int he price – the dividend just sets the price range.

 

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You see, the amount that people are willing to pay for a stock depends on its potential future return.  This return must be enough to justify the risk that is being taken on.  If one can get a 5% return from a bank CD, one wouldn’t even think about buying a stock unless one thought a 8% return or greater was possible.  Why trade a certain return of 5% for a possible return of 6%?  You wouldn’t.  You would drop the price you were willing to pay for the stock until the potential return was at least 8%.

Also, the more uncertain the return, the greater the return must be.  If you are buying shares of McDonalds, for example, you can assume that the amount of traffic at their restaurants won’t change by that much during any given year.  It isn’t like everyone is going to swear off Big Macs at once.  You can therefore predict with reasonable certainty how much the company will earn during the next year (or the next five years), and therefore you know about what the price will be.  (Here you’re also assuming that the price to earnings ratio will remain about the same, which isn’t too bad an assumption.)

On the other hand, if you are buying shares of a silicon chip maker like Cypress Semiconductor, the future becomes far less certain.  You don’t know if research and development won’t pan out, or the Koreans will dump a bunch of cheap chips on the market, or what.   You also don’t know if interest in electronics will remain, or if manufacturers will choose Cypress chips or one from their rivals.  Because they are somewhat of a commodity, the fortunes of a company can be pinned to a few cents savings per chip made.  Because of this uncertainty, shares of Cypress are priced cheaply relative to shares of a company like McDonalds.  Note that the PE ratio for Cypress is 17.5, while that for McDonalds is about 18.5.  People are willing to pay a little more for more certain earnings.

But wait, that’s earnings, and I was talking about dividends, right?  Well, let’s say that a company never, ever paid a dividend.  What return would a shareholder receive?  Another way to look at it is, what value would the company be to the shareholder if he never received any share of the profits?  True the company might be making a lot of money, but the investor would never see a cent of that.  Without a dividend, there is no return to the shareholder.  He would not even see capital gains because no one would be foolish enough to buy the shares from him. (OK, someone would be, but that’s beside the point).

 

 

Learn how to use mutual funds from the founder of Vanguard:

So, when people are buying stocks, they are trying to figure out what the future dividend will be, and what their return would be based on that dividend, and then pricing the share price accordingly.  Granted, this is a Ouija board-type of pricing where people may not even know they are pricing it based on the dividend, but they really are.  The reason that people pay more for shares with growing earnings is that if the earnings of the company are higher, they will be able to pay a bigger dividend.  Many who price stocks based on earnings forget this fact, but that is what they are doing (that is why earnings matter at all).  It is kind of like how the main reason people paint houses is because if they don’t the wood will rot, but they are probably thinking more about how the house looks than wood rot when they decide it’s time to paint again.

Note also that the piddling 2% Apple is paying may seem small, but if you bought the shares back a year ago when the price was half of what it is now, you would now be receiving a 4% dividend on your investment.  If you continue to hold the stock and the dividend continues to increase, you effective yield will continue to climb.  You might be making 8%, 12%, or 20% in five years.

So, dividends do matter, even if many people have forgotten that fact.  When it comes to pricing, it’s all about the dividend.

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in 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.

Should You Invest a Lump Sum All at Once?


There was an interesting article in Money magazine this month about dollar cost averaging.  Typically, this is where you would buy investments at regular intervals, for example putting $500 per month into a mutual fund over a period of several years.  The idea is that then you buy shares both when prices are high and low, buying more shares when they are low (since you’re putting in a fixed amount of money each month).  Buying more shares when prices are lower means that you’ll get a cost basis lower than the average stock price for the period over which you were buying, so even in a flat market you’ll make a small profit.  Dollar cost averaging is a great idea since it 1) does get you a good price and 2) gets you putting away money regularly, which is the secret to becoming financially independent.

What the article was really talking about, however, was whether it was better to invest a lump sum all at once, or invest a portion of the money each period over several periods.  For example, if you got a $1M inheritance or a big lump sum payout from a pension fund, should you invest it all at once or maybe put in $50,000 per month for a couple of  years.  Their conclusion was that it is better to just drop it all in at once.  I’m not sure I agree.

        

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They cited a study by Vanguard that showed that you’d be better off 2/3rds of the time just investing all at once than spreading it out over several periods.  This makes sense since the market goes up about 2/3rds of the time.  Their reasoning for doing so despite what happens the other 1/3rd of the time – when the market declines after you invest – is that if you plan to put 60% in stocks and 40% in bonds, for example, you’re already investing to manage risk.  It therefore makes little sense to hold back cash and go against your investing plan.

The problem I have with this plan is psychology.  It would be devastating for most people to invest the $1 M they’ve gathered up all of their lives in their pension plan and see a 40% loss as we saw in 2008.  It would be even worse to see another event like the market crash of 1929 where 90% of the value was wiped out and it was more than 15 years before people were back to even.  Many people would simply cash out and go into T-bills and bank CDs after suffering through such an event.  As we saw in 2009 and 2010, this is often exactly the wrong thing to do since markets have almost always recovered fully from such events within a year or two (1929 being the exception).  If someone invested just $100,000 of a $1 M lump sum right before the drop, hopefully they would see it as an opportunity and continue to invest in regular increments.  Even in 1929 they would have made out like bandits this way because it is right after large drops that the market is on sale.

Learn how to use mutual funds from the founder of Vanguard:

 

 

 

 

 

 

So yes, statistically it is better to invest all at once, but psychologically it is better to wade in slowly. The consequences of dropping a large sum into the market right before a major event are also so severe that a 66% probability of doing better just really isn’t worth the consequences of being wrong.

Even when building up  position in a stock I tend to wade in, rather than taking the plunge all at once.   For example, if I wanted to build up a 1000 share position in BJ’s Restaurants International (a company I usually have a big position in and which I have on now), I wouldn’t typically just put $40,000 into it to buy 1000 shares at $40 even if I had the cash sitting around.  Instead, I might buy 200-300 shares, gather up more cash over the next month or two, then buy another 200-300 shares.  If the stock drops in price, I might use the opportunity to buy more shares at once.  Doing so actually makes drops in share price a good thing that I look forward.

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in 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.

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