Don’t Fall for the Safe Position Fallacy


jehericotopfalls

People like to win and hate to lose.  Basic in the psychology of people who are investing is the idea that if you make money on a position, you have won, but if you lose money, you have lost.  You also see silly ideas like “You don’t lose money until you sell.”

“You don’t lose money until you sell.”  Bad advice.

I’ve found that I’m subject to the same impulses.  When I was younger, I used to sell a stock if I made a certain gain.  For example, I would sell if I made $1,000 so that I could “take a safe position or  “lock in the gain” and eliminate the risk of the position turning south and turning into a loss.  Because I was taking a gain, I had “won,” but if I let the money ride and the stock went back down, I would have “lost.”  Chock one up for the “w” column.  Nevermind that I had to put the money somewhere else and possibly take a loss there.  I was a winner.  This behavior meant that I sold my gainers and held onto my losers.

Because I didn’t want to take a loss, which would then mean that I would “lose,” I held onto the losers, waiting for them to at least get back to the price at which I bought them.   Sometimes I’d hold them and they’d continue on down until I finally sold them in despair or just stopped looking since they weren’t worth enough to sell and pay the commission. Sometimes they would go back up to where I bought in eventually after a year or two of waiting.  Then I would quickly sell because, according to my ludicrous logic, that way I didn’t lose any money.  I didn’t “lose” since I got out what I put into the stock.  Now, in reality, while I had the same amount of money, perhaps a year or three had passed. Those dollars didn’t buy as much as they did when I invested them, so I was still losing money. Even worse than the loss to inflation, however, was the loss of time. I lost the ability to grow my money over those two or three years in a good stock because I refused to sell a loser.  I just ended up even after that time period instead of seeing gains.

After a few years of doing this, selling winners and holding losers, I ended up with a portfolio of stocks I didn’t really want.  I’d sold the stocks that were doing well and probably continued to climb.  I held the bad ideas and the poorly run companies, selling them if they actually turned around just as they started doing well.

In investing, there is nothing as important as time.

If you’re a serious chess player, you know about something called “tempo.”  Controlling the tempo means that you get to choose your moves and your opponent needs to react to what you do.  This keeps him or her from being able to do things that you don’t like.  Someone set back on their heels all of the time can’t throw an effective punch.

Time in investing is important as well.  Investments grow with time, and you make the most during the years at the end when you have the most money.  Each year at the end can mean hundreds of thousands or even millions of dollars in additional wealth.  At the beginning, when you first start investing, it may seem like you have all of the time in the world, so waiting for a stock to turn around doesn’t matter.  Waiting to start investing is even worse.   When you’re young and have fifty years ahead of you, you’ll figure it won’t matter if you wait five years to start investing.  You’re wrong.  At the end, you’ll wish you had just five more years before retirement.

Selling your winners early costs time.  Plus, you’ll still need to put that money somewhere, so you really aren’t reducing risk

When you sell, you need somewhere to put that money.  If you leave it sitting on the sidelines, you are losing time.  You never know when the next huge run-up in stocks will come, and you don’t want to be sitting on the sidelines in cash when that happens.  Selling just because you have a gain may mean getting out of a great company just when they are starting a big climb and putting your money into a stock you don’t like as much.  You might also be buying a stock ready for a fall because it has just completed a big climb and become overbought.

Another strategy is to take a “safe position.”  Here you sell a few of your shares so that you now have gotten out all of the money you invested, leaving a little in case the stock continues to climb.  That leaves you needing to move the money you made “safe” somewhere else, putting it at risk again.  The other choice is to leave the money in cash and be losing money to inflation each year it is not invested.  Why leave a company that is doing well and perhaps you really like to buy into another one that you don’t like so much?

Holding your losers costs time.

Every year you sit holding onto losing positions for them to go back up to where you bought them is a year you could have invested in something that was growing.  There are times when a great stock will go through a sell-off, or a company will drop in price as they reorganize and wait for their industry to recover.  There are also times when the whole industry or the whole economy declines, causing some great stocks to go down in price. Oil producers are in just this position right now, the good and the bad.  These stocks should be held and perhaps your positions added to during the downturn.  This is different, however, than holding stock in a company that is performing poorly and will continue to perform badly, waiting for it to recover.

I did this with Cisco stock, holding from about the year 2000 through about 2012, waiting for it to recover and grow.  I eventually sold the stock I had bought for about $20 at $30 or so.  True, I made a 50% profit, but I should have seen my money double or even quadruple in that period of time.   I lost all of that time when I could have been invested in a growing company instead of an old, tired, bureaucratic company whose time has passed.

Churning is costly.

When you sell a winner, you need to pay brokerage commissions (both for the sale and for the purchase of something else).  You also need to pay taxes on the gain, perhaps at a rate of 25-40% when you include federal, state, and local taxes.  If you stay invested, the money rides tax deferred until you sell.  This means your money, even the money that would have been paid out in taxes, compounds.  Over a lifetime, this could be hundreds of thousands or millions of dollars.  (I use that phase a lot, don’t I.  This is a costly thing to get wrong.)

Got a question or comment about personal finance or investing?  Please leave 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.

Risks that Decay with Time. Risks that Don’t.


Clingdome2

Most of the money I have invested is in growth stocks, even though the “rule of thumb” for someone my age would be to have about 35-45% of my money in bonds.  Doing so helps smooth out the bumps in your portfolio since bonds tend to hold up in price better than stocks, except when interest rates rise.  In fact, a portfolio consisting of about 40% bonds and 60% stocks is considered the minimum risk portfolio since it will have the least amount of volatility (a measure of the rate of change in price), yet having such a portfolio will provide a long-term return of only about 1% less that one consisting of 100% stocks.

Yet I keep about 100% stocks because I don’t want to give up that 1%.  I’m perfectly happy to have 40% drops in the value of my holdings every ten to twenty years or so to get an extra percent.  It doesn’t seem like much, but over 40 years 1% can add up to a lot of money.  Why leave this money on the table ?  I know that all I need to do when the market falls is wait it out, because usually in a year or so the market will have recovered.  In really bad times, it might be five or even ten years before it gets all of the way back up.  If you were into the NASDAQ in 1999, it was ten to fifteen years before the market fully recovered and reached old highs.  I just keep waiting, and buying more all along so that I don’t just lose those years, and don’t worry about the value of my portfolio.

You can do that with stocks because stocks have a natural tendency to increase in value.  More people are born, buying more things.  Companies get better at what they do and crank out products more efficiently.  Even the value of the dollar sinks a bit, causing more dollars to be needed to buy the same shares of stock.  The stock market is like a wild river, always flowing downstream, but with a few eddies, rapids, and deep, slow sections along the way.  This means that I can pretty much guarantee a positive return in the 8-20% annualized range if I am willing to wait long enough.  You  don’t drop a boat in a river and then expect to find it upstream an hour later.

But this does not mean that all investments (a word used loosely here) are like this.  For example, you have absolutely no guarantee that you’ll make money trading options, even if you do it for a really long time.  The reason is that you have a limited amount of time before the option expire at which time you will either make money or not.  The same goes for day trading.   The same goes as well for playing roulette or the lottery.  In these cases there is no natural upward drift in value.  At best your odds are 50-50 that you’ll make money – most of the time they are less.  When they are less than 50-50, such as in roulette where there are two house numbers, putting the odds a little in the favor of the house if you’re betting red and black, if you keep playing or speculating there is a guarantee that you will lose money over time.

So don’t forget to factor time into your considerations when looking at risk and volatility, but also make sure that time is on your side when you invest.

Got a question about personal finance or investing?  Please leave 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 Much Should You Invest in Each Stock or Fund?


jehericobridgecross

Dear SmallIvy,

 Got an investing question? Please leave it 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.

Picking Stocks for Long-Term Growth


autumn river

As I’ve said before, it is very difficult to predict the near-term future.  It is much easier to predict the long-term future, at least in the investment world.  This is not to say that it is difficult to predict if a given stock will go up or down the next day when some news is heard.  If a scandal breaks out, obviously the stock will fall in price.  Likewise, if a large drug company gets a new wonder drug approved, the stock will go up.  Sometimes a stock will still trade in an unpredictable way, such as when the price of the stock has already gone up so much on the expectation that the drug would be approved that it falls a bit after the actual announcement comes.  (This behavior is the reason for the old axiom, “buy on the rumor, sell on the news”.)  But in general the reaction of a stock’s price to news is fairly predictable.

The issue is that just as you can predict the direction of the stock due to the news, so can everyone else.  You will therefore never be able to profit off of the news since you’ll be in a long line to buy or sell the shares, and the people on the other side of the trade will have heard the same news and adjusted their prices accordingly.

The long-term side, on the other hand, does not seem to suffer the same fate.  While everyone has the same information and is able to do the same analyses, there still tend to be differences in price between what a company trades at and what it should be trading at given its future earnings.  Probably the reasons for this are that 1)it is more difficult to predict with certainty future earnings, so there is a “risk premium” included in the price and 2)people tend to get bored and therefore don’t have the patience to wait long enough for the mis-pricing to be resolved.  Whatever the cause, the behaviour of the markets works in the favor of the long-term investor.  It is normally fairly easy to pick stocks that will probably be worth more in the future (due to future earnings and dividends) and yet the price of the stock will not always fully take in these future earnings into account.  Buy buying a set of good prospects, the chances are good that one will outperform the markets, which are made of both good and not-so-good prospects.

So what are the traits for which to look?  I always look for as many of the following traits as possible:

1)A steadily growing stock price (a nice, steady increase over several years),

2) Earnings that have been growing steadily (which tends to cause the steadily growing stock price),

3)A respectable Return on Equity (15% or more),

4)Room for the company to continue to grow — the market is not yet saturated,

5) Consistency in the management team (don’t buy a stock when the people who made the business successful are moving on).

6) A strong cash position (low or no debt and a low debt/equity ratio).

7) A P/E ratio that is not high compared to historic values for the company.

Basically the idea is to find stocks that have been growing, have a management team that knows what they are doing, are well-functioning businesses that invest capital well, and whose share prices have not gotten out of line with future prospects.  In future posts, I’ll go into more detail on each of these traits.

 

 Your investing questions are wanted. Please 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 is Momentum Investing?


Clingdome2

Last time we talked about value investing, which is based on the Firm Foundation Theory.  Today we’ll talk about momentum investing.    It is based upon what it known as the “Castles in the Clouds” idea.

The idea behind momentum investing is that stocks that are going up tend to keep going up, and vice-versa, just like an object that has momentum will tend to keep moving.  The reason this occurs for stocks is human nature.  If people see that a stock is going up, they start to believe that it will continue to go up, just because it has gone up.  This was seen in houses during the 2003-2007 period where individuals started paying well over offer prices for houses, taking out adjustable mortgages they could not afford to pay when the interest rates reset within a few years.  They did not worry about this because the house price had doubled in price during the last few years, so they expected someone else to come along who was willing to pay double what they paid in a few years.

The Greater Idiot Theory comes into play here….

As the name Castle in the Clouds implies, there is little if any basis for the prices being paid; the gains are being built on weak substance.  This is a game of chicken, or greater idiot theory, where you purchase a stock–not concerned about the value of the shares–because you expect to be able to find a greater idiot who will pay even more for the shares.  You just need to make sure you are not the one who ends up holding the bag because, as you can see from the housing bubble burst, things don’t end pretty when prices fall back to earth.  It’s not good to be the greatest idiot! Usually prices fall even below fair value when they do come down because, just as people buy regardless of price on the way up(attracted by the potential for a quick profit), people want to get out regardless of the price on the way down (because they’re scared they’ll lose even more).  (Note, this is where great opportunities arise for value investors.)

Because of this type of behavior, stocks tend to go up and stay up longer than a value investor would expect them to, and likewise stocks tend to stay down longer than expected.  You should keep this in mind when wondering why the great stock you picked is languishing – it may just be that people aren’t buying it because people aren’t buying it.

Fast rewards, but danger abounds….

This type of investing has the advantage over value investing that the rewards tend to come faster.  Because the stock is already on the way up, it will tend to continue up right after you’ve bought it.  The disadvantage is that you can’t stay in the position as long as you could if you bought a stock which was growing steadily because eventually the stock will run out of greater idiots and crash back down.  For examples of these types of stocks, see Krispy Kreme and Outback Steakhouse.  This will mean that you will be taking profits more often, so taxes will be higher than with the core method proposed by this blog.  There is also a greater risk of loss than with value investing since you will tend to be buying at high prices, rather than low prices.

Finding stocks for momentum buying is easy, as it was with value investing.  A good place to look is the new 52-week highs list published in most newspapers.  Also looking at what stocks analysts are touting on CNBC, finding the “Wall Street Darlings,” works.  Try to find stocks that are increasing rapidly in their long-term trends (look at a chart about 1-year long, and find stocks that have been increasing rapidly for at least a few months).  Note that we’re looking for something that is increasing rapidly over months, the long-term trend,  rather than just a few weeks or days.  Short-term moves are too difficult to time and don’t go far.

Earnings should also be growing rapidly.  Remember to get in early, however, since when it ends, it ends.  A good rule-of-thumb is if the stock fails to reach a new high after a dip, it is time to get out.  I’ll talk a bit more about technical analysis on a later post which will be helpful in assessing these types of situations.

When to maybe use momentum investing.

I might use momentum investing when I have a relatively short period of time – say a couple of years – before I’ll need the money I’m investing, and it wouldn’t be a great tragedy if things didn’t work out.  For example, if I have an amply funded vacation fund and I’m planning a trip in a year or two, I might use a portion of the money to buy a couple of stocks that are going up rapidly.  If things work out and they go up 10-20% over the next few months to a year, I’ll cash out and have some extra cash to either enhance the vacation or save for the next one.  If things don’t work out, I’ll cash out anyway and then take a smaller vacation or find funds elsewhere to use.   By choosing stocks that have momentum, I’m more likely to do well over the near future.  If I really need the money, however, I would stay in cash and not take the risk.

Got a question about personal finance or investing?  Please leave 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 is Value Investing?


jehericotopfalls

The two most popular investing strategies for picking stocks are value investing and momentum investing. You’ve probably seem mutual funds with these terms in their names, but not known what they meant and why they are important to you.  Both techniques can be profitable.  While this blog tends to lean more towards the value investing side, since the strategy tries to minimize trading, there is certainly nothing wrong with momentum investing.  In both forms of investing it is surprisingly simple to pick stocks – it is a wonder that more individuals don’t take advantage of the techniques in their stock screening.

Now before going further, if you’re a mutual fund investor and don’t plan to invest in individual stocks, all you need to know is that you want to have both value stocks and momentum (or “growth”) stocks in your account.  If you invest in a broad index fund, such as an S&P500 fund or a Small Cap index fund, you’ll have both of these types of stocks already because they just “buy everything.”  You can also find value funds and growth funds and split your money between them.  Over long periods of time, value funds have outperformed growth funds by a couple of percentage points, but there have been stretches of time, like the last 20 years or so, where growth has been king.  You want to be in both areas so that you always own shares in what is doing well.

For those interesting in owning individual stocks, let’s dive deeper….

The first technique, value investing, is based on the Firm Foundation Theory.  In this technique, popularized by Benjamin Graham (Warren Buffett’s mentor), a value is assigned to a stock based on current and expected future earnings.  Stocks are then screened where the current price of the stock is compared to this “fair value.”   If the stock is a certain percentage below the fair value, the stock is bought; if it is significantly above this value, it is sold.  One simple way to calculate fair value is to look at the Price Earnings ratio (PE), which is the ratio of total earnings to total market capitalization (price x Number of shares).  This number can be found from a variety of sources for most stocks.  For stocks that are not always profitable, Price/Sales can also be used (see an excellent discussion using this factor by the CEO of Cypress, Semiconductor in “Thinking about Cypress Stock”: http://www.cypress.com/?rID=35390 ).

If future earnings can be predicted, which is done by a number of analysts, one can also use this ratio to predict the future price of the stock.  If the PE is historically around 15, and earnings are expected to be around $4 per share next year, one could calculate the fair value of the stock as $4 x 15 = $60 per share.  If the current price is $30, one could expect a return of 100% on the stock over the year.

Now before you rush out and put all of your money into a stock because you calculate it to be cheap and sit back, waiting for your 100% returns, note that everyone else can also do the same calculation.  If earnings could be predicted reliably, and a gain of 100% can be expected over the next year while the broad market is only expected to make 15%, investors would quickly bid up the price of the shares until it falls more inline with the market.  If the gain seems extremely large compared to the broad market, it either means that earnings aren’t very predictable and investors don’t put much credence in the predictions or there is something going on with the company.  Per usual, if it seems too good to be true….

So, if it isn’t a magical path to wealth, what can you do with value investing?  

I keep a list of stocks I’m interested in, called my “watch list.”   I calculate fair values for a group of stocks, then determine the expected return of each stock based on the predicted future price (usually 3-5 years out).  I then use this to decide which of the stocks I will buy shares when I have some money to invest, choosing the one that is least expensive, relatively at the time.  Note that I do not use relative price alone in choosing stock since some stocks are cheap for a reason – I’ve already decided on the stocks I want to own, but need to select which one to buy at a given moment.  Because the market does not always correctly price stocks for future earnings, there are often times when a stock will be under priced for periods of time, even if it is a good stock to own.  So if I expect the earnings for a company to continue to grow, and the stocks drops in the near-term because the company is having some issues that should pass or the economy in general is in the doldrums, I will scoop up the shares.  If the price drops further, I’ll check the facts and reevaluate the stock, and then add to the position if everything still looks good until I’ve acquired as large a position as I wish to have in the stock.  Then I wait for things to turn.

In a future post I’ll go into momentum investing and explain how that is done.

Got a question about personal finance or investing?  Please leave 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 Choose Individual Stocks


jehericobridgecross

There is some pretty good advice that says people shouldn’t bother with individual stock picking. Instead, they should just accept the fact that they cannot outperform the markets and buy well-diversified mutual funds and try to come as close to the returns of the markets as they can by keeping fees low.  It is probably true that most people shouldn’t buy individual stocks, because most people buy (and sell) individual stocks for the wrong reason.

Some people buy stock in companies that they know (think McDonald’s).  Others buy individual stocks because they see they have record earnings.  Still, others buy into a stock because think that their business will do well (for example, everyone uses Google, so I should buy stock in Google).  Sometimes people follow the price of a stock and buy because the stock has fallen significantly in price, increased significantly in price, or follows some price pattern.  Some people buy stock in the company for which they work.  Some people even buy stocks because they like the name or the ticker symbol.

None of these are good reasons to buy stocks and you’d be much better off just putting your money away in low-cost index funds and getting another hobby if these are your reasons.  You will be buying too high, buying too late, selling too soon, and maybe putting your money into stocks that will just do nothing for the next few decades.  You might have some great stories about the stock you bought that did well, but you’ll earn 2-3% returns when the markets provide 10-15% returns over the same period.  In other words, you’ll retire with $500,000 when you would have had $50M if you’d just invested in index funds.

So why would you buy individual stocks?  Well, think about the restaurants that are in your neighborhood.  If you were to invest $10,000 and buy a 0.5% stake in all of the restaurants, over a long period of time you’d probably make a decent return on your money.  Some restaurants wouldn’t make it, but some would do spectacularly well.  Overall, because people need to eat and because inflation will cause the price of the restaurants to increase over time (the value actually stays the same), the price of your investment would increase.  In 30 or 40 years, you might be able to sell your stake for a few million dollars.  This is assuming something like a tornado doesn’t come through and destroy everything – but you could deal with that risk by buying stakes in restaurants across the whole state.  This is like buying mutual funds – you get a small stake in a lot of companies and overall you get a decent return.

But I’ll bet there are a couple of restaurants in your area that are better run than others.  When you go in the door, they’re always crowded yet people don’t mind waiting.  The food is fantastic.  The servers are consistent and generally make the experience fun and pleasurable.  You can tell that they have every aspect of the experience down to a science.  They are even located on just the right corner.

Looking at how things are run, you can expect this restaurant to earn more money than the others.  Even more important, you think they might expand the dining room to serve even more people each night or open a second restaurant across town.  While something could happen such as a divorce of the owners, a fire, or a change in management, in general, you can reasonably predict that this restaurant will do better than the others, so you would want to have a bigger stake in this restaurant than the others.

Now things do happen, even to great restaurants.  You therefore don’t want to put all of your money into one restaurant.  But maybe you find the best restaurant in your neighborhood, then find the best one in the neighboring town.  Maybe you find the best five or ten restaurants, one or two in each town or city, and buy stakes. Maybe you invest a quarter or half of your money this way, then invest the rest in a small stake in the rest of the restaurants, just in case your picks don’t work out.

This is the same way you choose and invest in individual stocks.  You find the great companies – the ones that are well run and have a consistent record of performance.  You find companies that have room to grow since the stock price increases roughly at the same rate as earnings growth.  You buy larger stakes in these companies, perhaps even just starting with one company when you only have a couple of thousand dollars to invest.  As your portfolio increases in size through regular investment, you then start to diversify out into mutual funds to protect your gains and hedge against bad stock choices.

So in looking for stocks, I try to find the best stocks in each sector and buy into those.  I look at management, through the history of earnings growth and factors like return on equity.  I look at debt and try to find companies that are able to fund growth without needing to borrow a lot of money.  I look for companies that still have a lot of room to expand and grow.  I look for the companies who are the best at what they do, both in how they treat their customers and how they treat their employees.  That is how you choose individual stocks.

 Your investing questions are wanted. Please 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 Should You Do with your Stocks Because of the Brexit?


autumn river

About a week ago, we woke up with a new word, Brexit, and everyone was all a twitter about it.  People who had never given a thought about the small island off of the coast of Europe called “Great Brittain” were suddenly selling in a panic because it — Egad! — was voting to exit the European Union.  Sure, the country had existed for more than five hundred years as an independent country and had done just fine, conquering most of the known world at one point, yet for some reason it can no longer stand up by itself.  Obviously, its economy would instantly collapse without the support of the autocrats in Brussels.  Really?

So what did I do when I heard the news of the Brexit?  Other than say it was a stupid name?  Nothing.  Absolutely nothing.

OK, not quite.  I did find that I had a couple of thousand dollars sitting there in cash in one of my accounts, so I called my broker and said I’d heard the stock market was on sale today.  I bought another hundred shares of a company that is on my watch list, LKQ Corporation, for about $32 per share.  It had fallen a couple of dollars per share that day, so I wasn’t too picky about the price I got.  Of course, it decided to fall down to about $29 per share over the next few days after I bought it at $32 as the saga of the great and powerful Brexit continued to wreak havoc on known civilization.  This is the risk when you buy a falling stock, particularly one falling for no apparent reason. 

Now, about a week later, the stock markets have all basically shaken off the effects of the Brexit.  My LKQ is back up (I’m still at a small loss because of commissions.)  Some economists will say that it is because the voters in Great Britain really didn’t mean it and will vote to nullify the Brexit vote now that they have come to their senses.  That it was just a protest vote that many didn’t really think would pass and are now eager to undo.  I hope not – I think Great Britain can stand on its own just fine and do much better without unelected eurocrats telling them what to do.

I think really that now that the event has happened, there is more certainty in the markets.  (The markets hate uncertainty because they don’t know how to value stocks when things are uncertain.  They therefore pay a much lower price than they would if they could figure out what they should be paying.)  Now that the news it out there and people have had a chance to digest, they realize that it really isn’t all that bad.

In general, once news events have happened, it is too late to do anything anyway.  You’re “locking the barn doors after the horses have been stolen.”  If events cause an unjustified sell-off, as this one appears to have done, you might be able to take advantage of the opportunity to pick up some shares.  Conversely, if you’re a couple of years away from needing the money, you should be moving to cash anyway, regardless of what the market is doing.  Your investment strategy should ignore the hysterics and remain on course regardless of the headlines of the day.  Sometimes you need to have a “stiff-upper-lip,” as the Brits like to say.

 Your investing questions are wanted. Please leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Understanding Mutual Funds and ETFs


autumn river

While mutual funds (and ETFs) can be your sole investing method, I use mutual funds primarily for diversification in my investment portfolios (and in my 401k because I have no choice). Diversification is a way to increase the chances you’ll make close to market returns and eliminates the chance of a major loss due to an event at one company. It does not eliminate the risk of losses due to declines in the market in general due to public fear or a decline in the economy. It is like the difference between buying one home without insurance and having the risk that a fire or tornado will destroy it and buying a $1000 stake in 100 homes scattered across the nation. You’ll still lose money if housing prices decline nationally, but one sink hole won’t wipe you out.

The flip side to diversification is that at best you’ll get the returns of the market. Because I believe that you can outperform the markets by selecting the shares of companies that have the best prospects for long-term growth, I reserve a portion of my investing account for single stocks. The size of that portion is based on a balance between my desire to grow the portfolio against the amount of risk I can assume. As the value of the portfolio grows, I shift a greater percentage to mutual funds to hold onto what I’ve gained.

A mutual fund is a company in which people pool their money to invest in a group of stocks. There are managed mutual funds, in which a manager selects stocks to purchase, and then there are passive funds that follow a specified strategy and pick stocks automatically to match that strategy. For example, an S&P 500 fund is a type of passive fund that buys stocks to match the returns of the S&P 500 index, a specified group of stocks. The stocks they buy are entirely determined by the make-up of the S&P 500 index. When the people who determine the index change one of the stocks, the index funds sell shares of the stock that was removed and buy shares of the one that was added.

There is nothing wrong with owning mutual funds. In fact, if you’re busy and don’t think you want to get into individual stock investing, go invest in a set of index mutual funds and ETFs. You’ll be just fine and way better off than a lot of your peers who don’t invest at all. Individual stock investing is just for those who want to try to get better than market returns, which are nothing to scoff at by themselves.

If you are investing in mutual funds, your main concern should be to minimize fees. You see, because mutual funds have so much money to invest and therefore need to buy so many different stocks, even if you have a very good fund manager, he will end up effectively “buying the market” anyway. This means that a fund that charges 2% per year will make a return 1.5% less over long periods of time than a fund that only charges 0.5%. This may not seem like much of a difference, but it will add up to millions of dollars over your working lifetime.

Because managed funds need to hire a group of fund managers, plus researchers, secretaries, accountants, and a personal pastry chef, they tend to have higher fees than passive funds. In theory having that crack group of highly trained, highly paid managers will cause you to make more money so you can afford to pay the extra expenses, but in practice your returns are the same before fees for reasons previously stated. It therefore makes sense to place your money primarily in passive mutual funds, meaning index funds and ETFs, unless there is a sector of the market in which you wish to invest and there is no passive fund available. You might also only have the choice of managed funds in your 401k plan, so you just need to accept the higher fees and move the money into an IRA when you can because you change jobs.

While it is not always possible to hold unmanaged funds for the reasons stated above, in general index funds and ETFs would be recommended for those following the serious investing strategy championed in this blog. There is no reason to give up the additional gains that can be had by reducing fees. History and logic both shown that managed funds will not be able to provide a return sufficient to offset the higher fees over long periods of time.

 Your investing questions are wanted. Please 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.

How to Reduce your Capital Gains Taxes when Selling a Stock


jehericoplungeRight now, given the sell off in the stock market last week, you may have a stock that you still really like but that has declined in price, creating a loss.  You may also have a stock that you have held for a long time while the company has grown, and therefore have a big gain.  Maybe you want to trim back your winning position in this second company a bit because it is getting to become to large a portion of your portfolio, but doing so would cause a big gain and capital gain taxes.  Luckily, there is a way that you can take advantage of the market downturn to trim the position but cut or eliminate capital gains taxes.

For example, I have shares of Home Depot (HD) that I have held for quite a while, having bought in when the stock was in the mid $30’s.  The stock is currently trading at $119, so I would be realizing a gain of about $85 per share if I sold today.  Because the position has done so well, however, the value has grown considerably.  I also have concerns that Home Depot is becoming a very large company and may have trouble growing at the rate it has in the past in the years to come.

I also bought shares of railcar maker, Greenbrier (GBX),  when they were in the $40s.  They are now trading at about $22 since the decline in the price of oil may cause less demand for the oil-carrying railcars they produce.  I believe in the company long-term, however, both because they make a lot of other types of train cars and rail transportation will grow as the economy picks up speed due to lower energy prices and there is more shipping and because eventually oil prices should recover somewhat since there are always boom and bust cycles in commodities.  I therefore don’t want to sell my position in the company.

One strategy I could take is to sell some of my Home Depot shares and use the money to buy more shares of Greenbrier.  For example, if I sold 100 shares of Home Depot, I could buy about 550 shares of Greenbrier at the current prices.  I could then hold the extra shares in Greenbrier for a couple of months, hoping for something of a recovery during the time, then sell off 550 of the original shares I held, taking a loss.  Note that it is important that I wait a period of time after buying the new shares before I sell the old ones or the IRS will consider it a wash sale and I won’t be able to deduct the loss.  (It has been a 30 day wait in the past, but check this out carefully as the rules may have change and it could cost you thousands of dollars if you are wrong.)  The sale of 100 shares of Home Depot would generate about a $8500 gain.  The sale of the 550 shares of Greenbrier would create about a $12,000 loss, so I could deduct the gain from the sale of Home Depot and still have a deduction that I could use to offset regular income from work and/or carry forward into future years.

The danger here, besides doing it wrong and losing the ability to use the loss, is that I’ll be taking up a bigger position in Greenbrier for the months in which I hold the extra shares.  Because the shares have already declined so far the risk of a big decline in that period is somewhat reduced (shares are certainly cheap compared to where they have been, and surely someone will step in soon and start buying again), but things could decline further.  Also, there could be something that happens at the company like a scandal or a big lawsuit that could cause the shares to drop dramatically.  While this is rare, it happens from time to time with individual stocks. Sometimes the price will never recover after such an event occurs, so you need to be sure to put more money into a company than you can afford to lose.

If done correctly, you can use losses to reduce the gains you have while still maintaining positions in companies that you think will recover and grow.  You need to be careful to avoid wash sales, and you need to be careful not to hold too big a position due to the risk that creates, but done right is can save you a lot of money on taxes.

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Got and 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.