The Three Keys to Successful Retirement Investing, Part 2


BikeAs stated in the last post, successful investing in retirement really comes down to fundamental principles more than finding the right mutual fund.  Utilize these principles to drive your decisions and you’ll be successful.  I’ll call these the Three keys to retirement investing.    These are:

  1. Contribute early and regularly
  2. Take appropriate risks
  3. Delay withdrawals as long as possible

In this series of posts, we’ll look at each of these keys and why they are important.  Today we’ll look the second key, how to take risks appropriate for you investment horizon and personal risk tolerance.

Key #2: Take appropriate risks

The first aspect of investment risk is volatility.  Let’s start there.

Volatility

Most of the time when people talk about investment risk, they are talking about volatility.  This is how rapidly the value of your investment changes. In other words, how much of your money you can lose in a relatively short period of time.  Things that are volatile like individual stocks can go up or down in price by 50% easily within a year, and can sometimes do so within a period of a few days or weeks.  In fact, stocks tend to make fast moves in one direction or another as news breaks, followed by a period where they change in price little.

Volatility is often measured by the term, beta, which can be thought of as the volatility of an investment compared to the whole market.  Stocks that have a beta of 1.0 have a volatility level equal to that of the market.  Those with a beta of 2.0 have twice the volatility of the market.   High beta stocks move up and down more than low beta stocks.

Investments that are more volatile are considered to carry more risk than those that are less volatile because their return is less predictable.  If you put $100 in a bank CD yielding 1% per year, you’ll know that it will be worth $101 in a year.  If you invest $100 in a stock index fund, it might be worth $140 in a year, or $60 in a year, or anything in between.  Stocks are very volatile when compared to bank CDs.  Because volatile investments have more risk, you want to only buy them if your potential for reward is greater.  If you can get an assured 1% in a bank CD, why would you buy a stick if the potential return were the same?  Maybe you would want to get a 50% gain from an individual stock when things work out to make up for the times when they don’t.  Let’s say that four times out of five your return is 0%, where it is 50% the other time.  By buying many stocks, you can then nearly assure yourself of getting an average 10% return overall if you can get a 50% gain when things go your way.  If the gain in stocks was only 5% when successful, you would be making the same return as you could with the bank, so it would not be worth the risk.

The return you receive is based on the price you pay when you invest.  If you’re buying an  individual stock, you need to pay a low enough price so that when earnings come in and meet expectations, the value of the stock will move up enough to give you the 50% return you desire (just to use the numbers we’ve been using).  Luckily for you, while there are some random fluctuations in price, on average stocks (and other investments) will already be priced appropriately for their risk levels due to the behavior of the market.   If you buy at several different times, as opposed to simply dumping your money in all at once, the random fluctuations will smooth themselves out and you’ll pay a price that is appropriate for the risk.  Over long periods of time, the average return on a portfolio containing a large number of stocks has ranged from about 10 to 15% per year.  This is significantly better than the returns of bonds (which range from 5-10%) and bank investments (which range from 0-5%).

So in summary, higher volatility leads to higher returns, but high volatility can also cause losses.   The trick is to use two other factors, diversification and time, to manage that risk and make it so that you are almost guaranteed to make a great return.  Let’s look at each of those aspects.

Diversification

Diversification, where you invest in more than one thing,  reduces volatility risk.  If five stocks are moving randomly, if you buy shares in all five the movements up in some will cancel out the movements down in the others most of the time since the movements are random.  This is the same as throwing a hand full of coins – you don’t know which ones will be heads and which will be tails, but you know that the result will be somewhere between 30 and 70% heads a lot more often than it will be between 90 and 100% heads or 90 to 100% tails simply because there are a lot more combinations in the 30-70% heads range than there are at either extreme.   Because the average price for stocks has a natural tendency to increase (because companies become more efficient and grow, and make more money), if you buy a group of stocks the random fluctuations in the value of the group will cancel but the overall average value will increase.

The other form of risk that diversification eliminates is the risk of bad management or random events.  If you just buy Coke stock and the Coke CEO makes a bad decision (like introducing New Coke in the 1980’s), you could see the value of your investment crater even though people are still drinking soft drinks and cola stocks, in general, are doing well.  If you buy stock in both Coke and Pepsi, however, while one of the companies may make a bad decision and cause their stock to drop significantly, it is unlikely that both will do so at the same time.  In fact, a misstep by one might provide an opportunity for the other.  It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.

It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.  The easiest way to add diversification is to buy mutual funds, index funds, or ETFs, all of which allow you to make one investment but get investments in a large number of assets.  If you buy shares in an S&P500 index fund, for example, you’ll be invested in 500 large US companies. but at a cost far lower than it would be to actually buy shares in all 500 companies.  In 401k accounts, mutual funds and index funds are normally the only choices.

There will also be times when an entire market declines.  For example, investors may be worried about an election and decide to sell their shares in US stocks.  In this case, shares of all US stocks may decline – both the good and the bad.    Note this is really the time to buy more shares since they are effectively on sale, but if you have money invested that you need soon, you may not be able to wait for prices to recover.  To guard against this risk, you can diversify into more than one type of asset.  For example, buying both stocks and bonds, or buying both US and international stocks.  In general, you try to find investments that aren’t tied to each other so that they don’t move together.  This can be difficult, but having investments in stocks, bonds, and REITs is not a bad combination, in part because the interest payments and rental income paid by bonds and REITs, respectively, help to keep them from declining in price as much as stocks when the market declines.  Of course, for short-term needs (like within five years), cash is the appropriate investment.

Time

Time frame is often forgotten when looking at risk.  Time frame will also reduce risk since you don’t need to be right about the timing for an investment to do well if you have a lot of time to wait, you just need to wait until things start to happen.  If you have a lot of time, you can reduce your diversification (but not eliminate it since single stocks or bonds can disappear entirely), since you can just wait out a market downturn or wait for the product lines of the companies you’re investing in to catch on.  In general:

Risk is proportional to:    (volatility)/(diversification x time)

More volatility causes more risk, but time and diversification both reduce risk.  In addition to reducing risk, however, diversification reduces your reward potential.   When looking at buying single stocks, adding more investments means some won’t perform as well as others.  If you just buy Coke and Coke increases in share price by 100%, you’ll do better than if you buy both Coke and Pepsi and Coke goes up 100% but Pepsi only goes up by 10% over the same period.  Diversifying into other markets also reduces your potential reward.   Because lower volatility investments like bonds don’t provide the same long-term return as higher volatility investments like stocks, diversifying into bonds will reduce the level of fluctuations in your overall portfolio value but also reduce your long-term return.

It is, therefore, better to use time to reduce risk than diversification if you have time available.  If you can stay invested for a long period of time and can just wait out market declines, it is better to hold more stocks than bonds.  As you get closer to needing the money, you then add diversification closer to equal percentages of growth investments like stocks and income investments like bonds to reduce risk since you no longer have the luxury of time.

Using appropriate risk

So to use appropriate risk when investing in a retirement account, do the following:

  1.  When you don’t need the money for a long period of time (like 20 years), concentrate more in higher volatility assets like stocks since they have a higher return.  A rule-of-thumb is to put your age minus 10% in income assets like bonds and the rest in growth assets like stocks.
  2. If volatility scares you, add more income assets that will reduce volatility (and don’t look at your portfolio value too often – a couple of times per year is fine).
  3. When you start to get close to the time when you’ll need the money, add lower volatility assets like bonds and REITs that pay out cash and have a more stability.
  4. Assume that your stocks may be up or down 20% in five years (and 50% in one year) and that your bonds may be up or down 10% in five years (and 15% in one year) and decide if you can take that risk.  For money you really, really need to have within five years, go to cash assets like bank CDs and money market funds since those are the only things that don’t go down in value.

 

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.

Why (Index) Mutual Funds are More Likely than Individual Stocks to Provide Gains over Shorter Periods of Time


In Using Investing to Build Up Cash for Large Purchases  it was recommended that mutual funds be used instead of individual stocks to build up money for an eventual large purchase.  This may seem an odd choice since the potential returns from individual stocks are much higher than those from mutual funds, meaning you would have the opportunity build up a balance faster invested in individual stocks than you would invested in mutual funds.  It also seems to go against the serious investing concept cited in other posts where funds are concentrated when you have little money, and therefore growth is more important that preserving your investing funds, and then diversified out into more and more stocks as balances grow because prevention of a large loss is needed to avoid losing ground once you actually have something to protect.  Indeed, a big advantage that individual investors have over mutual fund managers is the ability to select a few great stocks rather than buying everything.  This provides the possibility for individual investors to beat the markets while the mutual fund manager can match index returns at best before fees.

The difference in this case, however, is that the investor was trying to build up cash in a relatively short period of time.  True investing is a long-term proposition.  If you’re buying individual stocks you want to find companies that are well run and have room to grow.  You then need to buy in and prepare to hold them for years as the company grows and expands its business.  There are all kinds of fluctuations in the price of the stock as other individuals trade the shares based on different strategies, hopes, fears, and events in their lives.  There will also be good and bad news for the company related to the ups and downs in the economy.  There were a lot of great companies that lost seventy-five percent of their value in 2008, only to come back to their former levels in 2009 and 2010.  These kinds of fluctuations are unpredictable and part of investing.  It is the long holding periods that put the odds in the favor of the investor and make individual stock investing profitable.

In this case investing was being used to magnify what could be built up through hard work and saving with the goal of getting a large amount of cash in four, five, or maybe six years.  This could be the down payment for a home, or some cash for a new (preferably two to four year-old) car, or maybe some cash to supplement other savings for college expenses.  As discussed in the previous post, this is not true investing since the time period is not long enough to be assured of a good (or even positive) return, but instead being opportunistic and waiting for the value to increase due to a l-timed move up in the markets, then using the opportunity to sell.  This could occur in a short period of time or it may take a few extra years.  You are just giving yourself the opportunity to shorten the amount of time it will take to raise the money through work and saving alone by using stocks.

The issue in using individual stocks in this scenario is that there is a lot of volatility in the price of individual stocks.  This means that a portfolio made up just a few individual stocks will change in value very rapidly, possibly doubling or quadrupling in value, of falling by 75% or more, in a single year.  It is also very possible, and probably more likely, that a portfolio made of just a few individual stocks may do nothing in a given year, not really changing in value at all.  This is because individual stocks grow in spurts, shooting up tens to hundreds of percentage points in a period of a few weeks to a couple of months. It may then sit there for several months or maybe even a couple of years before making any other moves.

As an example, I’ve held shares of Home Depot since the mid 1990’s, buying in at prices ranging from the $50’s to the $20’s, building up a fairly sizable number of shares.  While there were fits and spurts, the stock went nowhere all through the 1990’s and 2000’s.  (For a long-term chart of the share price, go here.)  Then, in 2011, the stock started to shoot up.  At this point the stock is around $115, meaning about a 200% increase from my cost basis.  This is a rate of return of between 8 and 10%, with things currently looking bright for future gains in share price.  This compares with a rate of return of about 5% for the S&P500 index over the same period of time.  This is a good return, but it was along wait before anything happened.

Buying index funds instead, the ups and downs would have been less severe.  More importantly, the natural drift of the markets is up, so if I had kept buying shares in an index fund as I went, I would expect to see at least some positive gain within a few years since I’d be buying during both peaks and troughs in the value of the index fund.  Over long periods of time, I could do better by picking stocks and holding them (assuming I am a good stock picker) that I would do invested strictly in mutual funds.  Over shorter periods of time, however, I am more likely to have a positive investment return, adding to my work and savings, if I invest in index funds than if I were to pick individual stocks.

Got something to say?  Have a question?  Please leave a comment or 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 Kind of Return Can I Get From Stocks and Mutual Funds?


Yearly Returns for the Vanguard Mid-Cap and Small-Cap Indices, from Prospectus

Yearly Returns for the Vanguard Mid-Cap and Small-Cap Indices, from Prospectus

Certainly you can get much better returns from stocks and mutual funds than you can from bank accounts.  Over long periods of time stocks have averaged 12-15%, compared to 6-10% for bonds and maybe 1-3% for bank assets like CDs and money market funds.  The reason is that you are taking a bigger risk by investing in stocks than you are in the bank, so stocks are priced so that when things do work out you make enough to justify the risk that you took.  After all, if I asked you to loan me a thousand and you knew that there was a 10% chance I would not pay you back at all, and maybe a 35% chance that I would just pay you back the $1000 after a few years without any interest, you wouldn’t loan the money to me unless you knew there was a chance I might pay you back $1500 in a year or two.  That way, if you had enough people like me and you made enough loans, you could be assured of making enough from the ones who paid you the $1500 to make up for the few that just kept your $1000.  You’d need to make enough from those who did pay you interest to counterbalance even for the cases where you just get your money back and no interest, since otherwise you’d be better off just putting your money in the bank and earning 2% than to loan to those people and get no return.  The trouble is, you don’t know who is who at the start.

And that’s something you really need to understand when looking at returns from stocks and even bonds.  The returns stated aren’t regular, consistent, or predictable.  In any given year, stocks may be way up or way down.  You can’t plug 12% into a compound interest calculator and predict what your account balance will be in 1, 3, or 5 years.  To see this, look at the table below that gives the annual returns for the Vanguard Small-Cap and Mid-Cap Index Fund ETF Shares (taken from the Vanguard Prospectus) for the period from 2005 through 2013:

 

Total Return
Year Small-Cap Mid-Cap
2005 7.53% 14.03%
2006 15.79% 13.69%
2007 1.27% 6.14%
2008 -35.99% -41.79%
2009 36.31% 40.49%
2010 27.89% 25.57%
2011 -2.68% -1.96%
2012 18.22% 15.98%
2013 37.80% 35.15%

A graph of these total return numbers are shown at the start of this post.

Presented below are the values of an initial investment in the Small-Cap and Mid-Cap index of $10,000 in 2004, the total return for the full, 9-year period, and the annualized return for that 9-year period.

Value of $10,000 Invested in 2004
Year Small-Cap Mid-Cap
2005 $10,753 $11,403
2006 $12,451 $12,964
2007 $12,609 $13,760
2008 $8,071 $8,010
2009 $11,002 $11,253
2010 $14,070 $14,130
2011 $13,693 $13,853
2012 $16,188 $16,067
2013 $22,307 $21,715
Total Return 223.07% 217.15%
Ann Return 9.32% 9.00%

Note that over the 9-year period there were some very good years and some very bad years.  If you had invested in 2004, but then needed the money in 2008 and sold the shares of your fund to raise the cash, you would have actually lost a couple of thousand dollars.  You would have done even worse if you had invested in 2007, losing 40% of your investment over the next year.  On the other hand, if you had invested after the drop in 2008, you would have done spectacularly well, increasing your portfolio value by more than 150 % in the next five years.

In total, you made an annualized rate of 9.32% in the Small-Cap fund and 9% even in the Mid-Cap fund, meaning that you would have ended up with the same amount of money at the end of the period investing in these index funds as you would have received if you had put the money in a fixed income security paying a straight rate of 9.32% and 9% per year, respectively.  The way you earned that return, however, was very unpredictable and truly a wild ride.  This period of time, with the housing bubble burst causing a large decline in stocks in 2008 was certainly more volatile than normal, but there will always be times like this if you invest for a long period of time.

Note also that you would have come nowhere close to 9% if you had timed the market wrong and been on the sidelines during critical periods.  For example, if you had gotten distraught after the collapse in 2008 and sold out, you would have missed out on a 36-40% increase in 2009.  If you had thought that the market moved up too quickly in 2009 and sold out, expecting a pullback in 2010, you would have missed out on a 25% return.  Either one of these moves would have reduced your annualized return drastically.

So the real answer to the question about what kind of return you can get from stocks and stock mutual funds is that you can get between 12% and 15% over long periods of time.  This will come with some spectacular years where you earn 40% or more, and some bad years where you’ll lose 40% or more.  You won’t know during any one-year, or even three-year or five-year period what kind of return you’ll get or even if you’ll get a  positive return.  This is why you should not invest money you’ll need in a short period of time unless you can afford to lose a portion of that money.  For example, if you have $100,000 but really only need $30,000 in three years, you might be willing to invest it and take the risk of losing $50,000 for the chance of making $50,000 over that period.  If you really needed the full $100,000, however, you would be much better off just putting the money in a bank CD where you would know it would be there in three years rather than hoping that things would work out.

If you don’t need the money for 10 or 20 years, however, you really should invest the money in equities since the returns you will get will be far better than you will see in bank CDs or even bonds.  You can also then start to use a financial calculator, plug in an annualized return of 12% or 15%, and get an idea of what you account will be worth in 10 or 20 years.  You just don’t know what the value of the account will be in any given year within that period.

Follow on Twitter to get news about new articles. @SmallIvy_SI. Email me at VTSIOriginal@yahoo.com or leave a comment.

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.

Should I Buy Individual Stocks or Mutual Funds?


Investing involves taking on additional risk in order to get additional reward – income.  While a savings account carries little risk of the account balance declining, the amount of income received is actually not enough to keep up with inflation. Over a period of years your account balance will actually be declining.  Real estate will basically keep up with inflation, although investing in the right markets at the right time can generate returns above inflation.  Renting properties, especially if the house is entirely paid for so that the amount lost to inflation is balanced by the rise in the value of the house and the rents received, minus upkeep and taxes, is a good way to receive income above inflation.

Stocks provide a unique niche in that the growth rate for stocks is above that of inflation, and yet the risk involved is not so substantial.  While there is a possibility that the whole amount invested may be lost, the likelihood is fairly low.  Also, the likelihood of a total loss declines to approximately zero if several stocks are bought rather than just one or two.  This process, called diversification, also causes the amount of volatility in account balances to decline since stocks that go down are balanced by stocks that go up.  Because the economy in general is normally growing, the balance on the account will normally grow with time (10-20 years) and at a rate higher than inflation, typically by 5-10%.

Buying single stocks carries special risk.  While the stock market in general tends to go up over time, individual companies do not always do so.  There are very few companies around today that were there fifty years ago – some are bought out by other companies, but others lose out to competition or other factors and disappear.  Even if the company that one buys does not disappear, the stocks of many companies sit where they are for many years, even if the economy in general is expanding.  If you were to buy a single stock and wait, your rate of return could be much worse than that of the market in general.

For this reason, diversification is used to reduce the risk presented by single stocks.  The difficulty in investing with small amounts is that there is not enough money to buy positions in several companies directly.  To gain substantial diversification in individual stocks would require $50,000-$100,000.

To allow diversification without having a lot of money, many people choose to invest in mutual funds – which are arrangements in which groups of investors pool their moneys together to buy a group of stocks.  Most mutual fund companies have minimum initial investments in the $1000 to $5000. Some will also allow investors to invest less provided that they sign up for automated purchase such that a fixed amount is invested each month.

Another consideration, however, when starting out in investing is that while one does not have a lot of money to invest, the amount that could be lost is also fairly modest.  If an individual only has $2000 to invest, while the entire amount could be lost if invested in a single stock, the $2000 loss could be easily regained through work.  It therefore may be worth the risk for the possible gains.  (Note that a typical position in a stock is 100 shares, so $2,000 would be needed to buy 100 shares at about $20 per share.  Stocks trading at less than about $10 are fairly risky and usually should be avoided.)  If the individual could not afford the $2000 loss, mutual funds should be purchased or the individual should wait to invest when on firmer financial footing.

Perhaps the biggest reason to choose mutual funds over individual stocks is how one reacts to market volatility.  With individual stocks one should expect greater volatility.  It is not uncommon to see stocks rise by 100% or more in a year or fall by 50% or more.  If this type of roller coaster ride makes you worry and keeps you from sleeping at night, investing in a mutual fund where the large amount of diversification will reduce the levels of the fluctuations might be the way to go.  Also, if you invest in stocks for mere entertainment – trying to time the market and buy and sell at just the right times – you would be better off only using a small portion of your portfolio for this purpose and putting the rest into mutual funds where you know you’ll get a steady return.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Which is More Risky, The Stock Market or the Bank?


Ask most people whether it is more risky to invest in the stock market or to put money in the bank and they’ll instantly say that the stocks are more risky.  Obviously you can lose money in the markets, so it is more risky to invest than it is to put your money in the bank, right?  Believe it or not, the answer to this question is, “it depends.”  To understand why, one needs to look at the different types of risk.

It is absolutely true that if one puts $1,000 in the stock market and withdraws it a few days later he is taking a lot more risk than he would be if he put the money in the bank instead.  While he would probably not get any interest over that short a period of time, he could expect with a high degree of likelihood to be able to withdraw his money in a few days from the bank and get back the full amount he deposited (unless there was a fee).

On the other hand, if he put the money in the stock market, the odds are no better than they would be on the roulette table that he would be able to get at least his money back in a few days.  In fact, it is likely that he would have less money in a few days because he would need to pay brokerage fees and other expenses when he bought and sold the shares.  As soon as he put the money into the market he would have less than he started with.

What if a person puts money in a bank account for twenty years, however.  Back in the 1980’s you could get a Coke from a vending machine for 45 cents.  A state college might cost $1500 per semester, and even the private colleges cost only about $10,000 per semester.  If you put $1000 in the bank in 1980, at 3% interest, you would have about $2000 in the year 2000.  The price of a Coke, however, had gone up to a dollar or more.  State schools would run $5000 per semester or more, and private colleges were often $25,000 per semester or more.  Because the rate of inflation is slightly more than the interest paid by the bank, the person would have more dollars numerically but would be able to buy less with those dollars.

What if that person put the $1000 in the stock market?  In 1980 the S&P500 was at $136.  In 2000 it was at $1380.  It had gone up by more than ten times in the amount of time it took money in a bank account to double.

Granted, the 1980’s were a spectacular time for the stock market.  Taxes were lowered and the hyper inflation from the 1970’s was defeated, resulting in a huge expansion of the economy and a big run-up in stock prices.  The 1990’s were also spectacular, despite a short recession from 1990-1992, because of the widespread expansion of the Internet in the mid to late 1990’s.  Still, even during less spectacular times over long periods the stock market has returned between 7 and 12% per year, while bank accounts have consistently had negative returns of about -0.5%, taking inflation into account.

The reason is that while it is difficult to predict the business cycle, over time the value of businesses increases in numerical terms simply because the fundamental value of a business will increase with inflation.  Furthermore, if the business also expands and starts making greater profits, the value of the business, even adjusted for inflation, will increase.  On the other hand, banks will pay an interest rate that is slightly less than inflation, and therefore the money left in banks will decrease in value over time.

So, short-term it is more risky to invest and one should be in cash.  Over long periods of time, however, it is much safer to be invested than to hold cash.  The likelihood of having less if invested in a diversified manner is very low, but you are certain to have less if money is held in the bank.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Against the Standard Advice


Go to a standard advisor, or read an article from a magazine on how to invest, and you will likely get the standard advice:

1) Buy mutual funds (individual stocks are too risky)

2) Diversify as much as possible (to limit volatility risk)

3) Don’t try to pick individual stocks or time the market.

4)  Find stocks with good dividends to supplement growth.

5) Have a portion of your account in bonds (usually a percentage equal to your age, or your age minus 10).

This advice is perfectly good and will nearly ensure that you preserve your money and do better than inflation.  If you properly diversify and rebalance correctly, you should receive around the market average, minus fees on the funds you own.  Long term averages have been around 10% using that strategy.

But what if you only have about $2,000 to invest?  Maybe you’re just out of college, have graduated with no debt and have no credit cards, and you’ve just started your first job.  After a year of careful living you’ve saved up a good, $10,000 emergency fund, and now have a couple of thousand dollars left over for investing.  You’ve also allocated 15% of your paycheck directly into your 401K, which is invested in mutual funds using the standard advice above.  If you put that $2,000 in mutual funds, you would only be able to buy one fund, and then probably only after agreeing to automated payroll deductions.

Let’s say instead that you decided to buy an individual stock with that money.  What is the worst that could happen?  The company you bought could go bankrupt and your $2000 would disappear.  You’d only be left with a worthless stock certificate to frame and put on your wall (if you even sent for the certificate).  You’d have a $2,000 piece of art work.

You could probably re-earn that $2,000 in a few months.  In fact, you could start directing a portion of your paycheck to investing, and come up with a few thousand dollars every 3-6 months.  In that case the loss of the $2,000 would become a distant memory after a few years.  Just a war story to tell.

So what kind of stocks would you buy with your $2000?  Many people get caught up in the dynamics of the market.  If they used that $2000 to buy 100 shares of XYZ stock and $20 per share, they would sell it if it went to $22 per share.  After all, that was a 10% profit.  They might also look at the fluctuations in price, see that XYZ traded between about $18 and $23, and decide to sell at $22.50, hoping the stock would then drop to around $18 so that they could buy the shares back and do it again.  People who did this might make a small gain here and there, but they would never really make a lot of money.  Not as much as they should.

What if you could go find a professional business manager.  The kind who went to a fancy Ivy league school, and invest your $2000 with him.  Maybe with a whole team of fancy managers.  Or maybe you could find someone who has a great idea and invest with him.  Let him take care of running the business.  You’d just be a silent partner.  But wait – those sorts of people are only interested in people with hundreds of thousands of dollars to invest.  They wouldn’t be interested in you and your lousy $2000, right?

In fact, that is just what the stock market allows you to do.  If you stop following the prices and really look at the companies, you can find all sorts of businesses out there to put your $2000 into.  These are all businesses with great ideas and professional, battle-scarred managers.  You could be part of the next Google, or Apple, or Ford Motors.

You’d want to approach it just as you would if you were putting your money into a business.  You would find a business with great prospects and a great management team.  A company that had room to grow for years to come.  Maybe one that had just started to make it big, but was not so big as to be high in price yet.

You would then invest your money and expect to leave it there for years while the business grew.  You would expect up and down years – after all you have no control over what the economy will do or what people will decide to price the company at on any given day.  You would plan to stay with the company though as long as it still has the promise of growth.

Because you could not be sure that your first pick was right – after all, things happen even to great companies – you might want to put your next $2000 into another company.  And then your next $2000 into yet another company.  That way you would have three chances of picking a big winner instead of just one.

Eventually, if you picked the right company, your meager $2000 would be worth tens or hundreds of thousands of dollars, and you’d be receiving a huge dividend.  Maybe you’d get paid back your $2000 every month in a dividend.  Hopefully as the business grew you would have sold off part of your interest.  After all, if you owned $50,000 worth of a company, you’d hate to see something happen and get nothing out of it.  Maybe you’d sell of $10,000 worth every now and then, and use the money to pay your house off early or buy some mutual funds.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Picture Credits: Jorge Vicente, downloaded from stock.xchng

How a Tax Hike for Dividends will Affect your 401K


The current class warfare being stirred may have collateral damage well beyond the targets.  While at first it seems like a good idea to raise taxes on dividends (after all, who but an avaricious, Scrooge McDuck-types would collect dividends?) raising dividend taxes may affect everyone who has shares in a 401K or even a pension plan.

Some background:  As part of the tax cut package of 2003, dividend tax rates were lowered to a flat 15% rate.  Before this point they were taxed as normal income, with rates as high as 38%.  The rationale behind having lower dividend tax rates than ordinary income rates is twofold:

1)  Lower rates encourage investing, which in turn lowers the cost of capital, thereby creating economic growth. 2)  The income received by investors is already taxed at rates up to 35% by the corporate tax.

Currently there is a movement to raise those rates back to where they were before 2003.  This would mean that those who pay the highest tax rate would see their taxes on dividends rise to 38% again (or perhaps even higher, depending on the political mood).  Those paying lower rates – mainly the middle class – would tend to pay more than they are now but would pay a lower rate than the highest earners.  For example, if you are in the 20% tax bracket you would pay 20% on dividend income.

So this would just mean that people would pay a bit of a higher amount on dividends, right?  Well, not exactly.

You see, when an investor buys a stock, the price he is willing to pay depends on the relative return of the investment when compared to other, less risky investments.  For example, if a bank account is paying 3% and investment grade bonds are paying 6%, investors might not buy stocks unless the potential return is at least 9%.

Determining the return for a stock is more complicated than determining that for a bank account.  One does not just look at the current dividend, but at what the dividend may be in the future.  Because the more a company earns, the higher a dividend they can pay, stocks tend to increase in price as the earnings rise and fall when they fall.  A stock that pays a $1.00 per year dividend now, but may see earnings double over the next several years, may see the payout of the dividend double as well.  If the stock price is currently $20 per share, the current yield would be 5% ($1.00/$20).  If the dividend is doubled, however, and one bought in now at $20, one would be receiving an effective dividend of 10% ($2.00/$20) when and if the dividend were raised.  The price of the stock may double as well over that time, but that does not affect the effective yield the investor who bought in at $20 is receiving.

Raising taxes on dividends lowers the effective return.  If you receive a 10% dividend but the dividend is taxed at 40%, you are only receiving a 6% dividend after taxes.  The effect of raising taxes on dividends is therefore to make future dividends less valuable and thereby lower future returns.  Investors react to this by reducing the price they are willing to pay for the stock currently, which will cause the price of the stock to drop.

So that will only affect dividend paying stocks, right?  No, remember that the price investors pay isn’t based entirely on current dividends, but on potential future dividends as well.  This is why investors are willing to buy stocks that pay no dividend at all.  They are hoping that eventually the stock will start paying a dividend, and they will then receive a really great return for the amount they originally invested.  All stocks will therefore drop in price, not just those that pay a dividend (although dividend paying stocks may be hurt more since investors may feel that tax rates may be lowered in the future before the stock that don’t currently pay dividends start to pay one).

So this will mainly affect those who make high incomes, right?  No, because the price of stocks will drop, those who own stocks in 401k accounts, IRAs, individual accounts, and even Pension Plans (which are invested heavily in equities) will see the value of their holdings drop.  States with large pension plans and a lot of workers who are retiring soon may need to divert resources to shore up holes created in their pension plans.  Private businesses that have pension plans may need to cut costs to cover increased pension plan payments.

How much will share prices drop?  Predicting an exact amount is difficult since there are many factors that affect the stock market.  If a tax increase is enacted the same week that peace is declared in the Middle East and oil drops to $10 a barrel, stocks may well go up in price.  The effect of a return to 38% rates, experienced without any other events, however, would probably be to cause stocks to decline by 10-20%.  Note that everyone’s rate would not increase to 38%, and there are institutional investors who hold a lot of the shares.  This would mute the effect of the tax increase.

So, be wary of calls for higher dividend taxes.  The effects may well extend well beyond those who own stocks that pay dividends.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Picture Credits: Thomas Picard, downloaded from stock.xchng

A Solution for the Underwater Loan Issue


Bank of America today announced a new plan by which individuals would turn over their deeds to the bank but then be allowed to stay in the homes as renters.  This idea has some merit and addresses some of the problems that banks face.  For one thing, banks would not have more homes sitting empty, being subject to vandalism and damage from natural events without someone being home to reduce the damage done.

The trouble is, however, that people who cannot afford to pay their payments may not be able to pay the rent.  This might just result in a default in rent and an eventual eviction anyway.  This also creates a renter’s mentality, in which they may not take care of the home.

For those who are unable to pay the payments because of a job loss, there is really little that can be done except wait for the economy to recover.  There are others, however, who could make the payments but choose not to because the house is worth less than they borrowed.  The issue is that there is a perception that one could just walk away and not need to pay back the loan – that one would almost be a sucker to pay the loan in full.  While banks can chase borrowers for the difference if the house is foreclosed upon, many choose not to do so.  This leads to more people walking away, causing home prices to decline, and the cycle continues.

There are really three issues that a plan to solve the issue must address:

1) The plan must remove the incentive to walk away.

2) The plan must lower the payments to a level that the borrowers could afford and give them freedom to refinance and/or move to a different house, and

3) The plan must provide a way for the loans to be repaid in full.

Here is my plan, which I believe addresses all three issues:

Make a deal with the borrower in which their payment would be lowered to an amount they could afford (say 25% of their take-home pay).  In exchange, the borrower would sign an agreement with the bank that the bank would receive all appreciation on the property until the value of the house was high enough to repay the original loan in full.  At that point, the borrower could refinance the house into a standard loan, repaying the original lender.

If the homeowner chose to move, they could do so, but the lender would receive the appreciation on the original house when it sold, plus they would receive all appreciation on the new house until, once again, the loan was repaid.

The advantages to the borrower would be the following:

1) They would be free to move or sell their house if desired.  In the case of a job loss, they would be able to more where there were jobs and better pay.

2)  Their payments would be reduced to a reasonable amount.

3) They would be using the leverage of their home to repay their loan faster than they could with a standard loan.

 

The advantages for the bank would be as follows:

1) They would have people remaining in the homes, taking care of them.

2)  They would have a much better chance of the loans being repaid.

3)  They would not end up with foreclosed homes, with the accompanying cost for repairs, taxes, and sale.

 

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Picture Credits: Thomas Picard, downloaded from stock.xchng

I Can See the Future


I can see the future.  No, I’m not some sort of clairvoyant or something.  I mean that I have the ability to look at current events and predict how they will shape the future.  This has been a very useful gift in investing because it has allowed me to figure out how to invest (and what to invest in).

I’ve found that a lot of people don’t seem to have this gift, because most financially “normal” people, which is most people. tend to make bad financial choices.    They buy stocks that are clearly overpriced then sell those same stocks when they have fallen to the point of being a bargain.  They take out huge student loans then wonder why it is a struggle to pay them back.  They spend money like it is water when they are young and then wonder why they cannot afford basic necessities when they are old.

Actually they probably could see the future if they really looked, but they choose not to.  There is a sense of greed and the desire for immediate satisfaction that drives us all.  There is also a fear that clouds our judgement and causes us not to think about the long-term consequences of our actions.

Today I’d like to summon up my power of prediction and offer some insights about the future:

1.  If you are buying your first house and trying to get one comparable to what your parents have, you will struggle to pay the payments and build up large amounts of debt over time.  Instead, buy a smaller, starter home once you have built up a 20% down payment minimum.  Get a fifteen year fixed loan and pay it off in ten.  Once you have paid off the first home, save up for a couple of more years then find your dream home, using the equity in your starter home to make a huge down payment.

2.  If you take out home equity loans, you will not have any money when you are ready to retire.  If you find the need to take out equity in your home, it means you are trying to live beyond your means.  Even if you do nothing else, if you have paid off your home by the time you are ready to retire you’ll be able to sell and move into a smaller place and pay for living expenses with the left-over equity.

3.  If you are 20 and put all of your retirement savings in money market funds, you will have 100 times less at retirement than you should have.  Money in money market funds and CDs rots with time because of inflation.  If you don’t need to touch the money for a long period of time (more than 5 years), you must invest it just to preserve its value.

4.  Social Security as we know it will not exist in 15 years.  Social Security is a pay-as-you-go program, meaning that money collected today is used to pay benefits for people who are currently retired.  Anything left over is acquired for the general fund and spent.  With the large number of retirees drawing on the system over then next several years, it will quickly become unsustainable and collapse.  This has been accelerated by the recent payroll tax holiday, which reduced the amount current workers are contributing.  There may be some program for the elderly poor, and there may be some benefit that kicks in at a really old age, but it will be inconsequential in most people’s lives.  Don’t plan on receiving anything from the program.  Take that 2% you are saving by not paying the full payroll tax now and put it into an IRA.  If you are young enough, you’ll be able to easily replace the payment you were supposed to receive.  Put away 15% to have a comfortable retirement.

5.  Several states will go bankrupt between 2013 and 2018 and be bailed out by the Federal Government.  Bond holders are likely to receive little if anything when this happens.  Be wary.

6.  There will be a shift from adult toys like motorcycles and gadgets to adult care as the Boomers enter retirement.  This means that stocks like Harley Davidson and Apple will see earnings decrease and stocks that provide healthcare and senior communities will thrive.  Look for a lot of hip and knee replacements over the next 20 years.

7.  Traditional health insurance will be replaced with Health Savings Accounts with high limit, major medical plans attached.  This will be a difficult transition at first, but eventually the cost of healthcare will drop dramatically, largely due to the reduction in the cost doctors need to pay to maintain a staff to file insurance claims and the reduction in the amount of unneeded procedures performed.  Expect a very rocky start as health insurers collapse under the Obamacare mandates and a brief, failed experiment with socialized medicine is attempted.

8.  There will be large amounts of inflation over the next few years.  The Federal Reserve is injecting huge amounts of money into the economy by keeping rates this low, but there is little reason for businesses to expand with continued weak demand.  Expect this money to cause prices for energy and food to continue to increase, eventually resulting in increases in wages and an inflationary spiral.  This is not the 1930’s, it’s the 1970’s we’re living through.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Picture Credits: Colin Brough , downloaded from stock.xchng

Paying Off Student Loan Debt


I read a blog post tonight that left me speechless.  The post, Tips to Trade Student Loan Debt and Save Money. caused my riskmeter to shoot through the roof.  The advice in the post is to get as many credit cards as possible while in college (what!?), the start transferring student loan debt to each of the cards in turn, taking advantage of zero interest rate introductory offers to pay off the loan faster.  The post shows how we often do things that make sense mathematically, but we don’t take risk into account.

First of all, most zero interest credit card offers I’ve seen start the clock immediately, so I don’t see how getting a bunch of credit cards while still in college would help.  Seems like it would just lead to a lot of “emergency” trips to the beach and the bars, leading to a non-zero balance on those cards when one left school.

Secondly, even if you were able to use the introductory periods for student loan debt, the level of risk is way, way too high.  The ideal situation would be that you transfer debt to the first card, pay on it for 6 months until the introductory offer ran out, then quickly move it to the next card, then the next, and so on.  Because you would not be paying interest, you would pay off the debt faster and end up paying less.

That is before Murphy (of Murphy’s law) enters the picture.  Here’s how it would really work out:

You just get your first job and move the student loan debt from a 5% loan to the credit cards.  You make the first couple of payments and everything is going great.  Then – bang!  There are layoffs at your job and you lose your job.  You no longer have the money to make the payments, so you miss one.  The interest rate instantly jumps to 35%, they charge you a $100 fee for missing the payment, and they add interest for the introductory period.  You now have no way to refinance the loan and your student loan now doubles in size every two years.

Instead, take out student loans only if it is absolutely the only way.  This is after:

1.  Choosing a school that is within your budget if possible.  No one will care if you got your accounting degree from State U or Harvard.  They’ll care about the skills you have and your commitment to your work.

2.  Considering if the major your choosing will allow you to pay off the loans.  If you go to a $40,000 per year seminary school, you’ll never be able to pay off the loans as a minister at a small church.  Unless you’re going to be a doctor or a lawyer, think low tuition.  Even if you are planning to be a doctor or a lawyer, what if you don’t make it through or you discover you hate those fields once you start working?  Avoiding loans will keep you from being trapped.

3.  Applying for every scholarship possible.  There are many small scholarships that get few applicants.  Get 20-40 of these and you may pay for everything.

4.  Planning to get through schools as fast as possible and minimize your lifestyle.  If you are using student loans, you don’t need to take 5 years to get your degree and spend each weekend night at the clubs.  You don’t need to have a social life.  You should be studying constantly, taking as many classes as you can, and maybe working a job while you are not studying.   You also should just rent a room at a house since all you’ll need is a place for sleeping.

5.  Accepting the fact that by getting something now (a college degree), you’ll need to put other things (like getting a house) on hold.   If you graduate owing a house in student loans, you’ll already have a house payment.  Before you’re ready to buy an actual house, you ‘ll need to concentrate your resources on getting rid of the loan.  This may mean waiting 10-20 years to get a house.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @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.

Picture Credits: Tiffany Szerpicki, Website http://www.tiffszerp.com downloaded from stock.xchng.