Archive for 2005
Clements
I usually agree with Jonathan Clements. (He writes the “Getting Going” article for the WSJ.) I also usually agree when someone has a disagreement with conventional wisdom. But parts of the article he wrote entitled “Five Bits of Conventional Wisdom to Ignore” were flawed to the point of being misleading. (See article, subscription required.)
First, he writes that homes are not the greatest investment of all time. While I agree with that statement, I disagree with much of the rest of his argument. He argues that there is no real cash flow from a home (and gives short shrift to implied rent). Also, he argues that you need to trade down to a cheaper home to realize your gains. These are both incorrect — he ignores the opportunity cost. If you did not own your home, you would have to pay rent. Rent that would theoretically have to compensate the owner for his investment and compensate for the agency costs incurred in a non-owner occupied property. By owing, you are forgoing rental payments for mortgage payments (and taxes, etc.) Also, you do not have to scale down your investment to realize your gains. The opportunity cost of owning is renting. To find your gains, compare the outcome of owning versus renting. It makes no difference how you invest the proceeds.
Second, he criticizes people for thinking they can make money in stock market. While I agree that most people end up trading too much by chasing trends and usually pay too much for “professional” advice, his math is seriously flawed. He argues that you should expect a 6% gross return from a portfolio of bonds and stocks; of this 2% goes to fees; then 25% goes to taxes, netting a 3% annual return. My experience is much different than this. The stock market has returned an average of 11% in the past — even if we assume a lesser return we should still see 8-9% long-term. Then you would have to choose the most expensive funds on the market (the average expense ratio is 1.25%). Then you would have to have either all short-term gains or a mix of short- and long-term gains and be in the highest tax bracket to hit 25%. The real expected return should be at least 5-6% for most of us, not 3%.
He next argues that you should invest in sectors you believe to be overvalued. The reason for this is that we are overconfident in our ability to predict which sectors will perform well. For most people –people who don’t spend time in finance — this is good advice. However, for those of us who put in the effort, we can easily see that we should not invest in expensive markets. For example, I stayed out of tech during the late 90s. There were a few years I lagged the market, but in the end, I had the last laugh. Today, I am out of REIT and even though I missed some recent gains, I am optimistic I made the right choice. It’s not about hitting every market rise but being right in the long-run.
He next says that is doesn’t matter if you invest internationally or domestically, or in bonds or stocks. What matters is you don’t chase trends. For the most part, he is right. Sticking to your guns and not chasing fads is most important. However, it is important to have the right allocation for your risk needs.
Last, he makes the point that you should invest according to your risk tolerance and not your risk needs. This is wrong! A retiree should not invest in stocks if he can not afford the risk. If his portfolio decreases by 10-20% in one year, how will that affect his tolerance? The most risk tolerant person can become extremely risk averse if he is on the brink of disaster. Of course, if the retiree has the capital to afford to lose a large part of your portfolio, then it’s not an issue. But the portfolio should be structured to the risk needs of the retiree first and to the risk tolerance second.
First, he writes that homes are not the greatest investment of all time. While I agree with that statement, I disagree with much of the rest of his argument. He argues that there is no real cash flow from a home (and gives short shrift to implied rent). Also, he argues that you need to trade down to a cheaper home to realize your gains. These are both incorrect — he ignores the opportunity cost. If you did not own your home, you would have to pay rent. Rent that would theoretically have to compensate the owner for his investment and compensate for the agency costs incurred in a non-owner occupied property. By owing, you are forgoing rental payments for mortgage payments (and taxes, etc.) Also, you do not have to scale down your investment to realize your gains. The opportunity cost of owning is renting. To find your gains, compare the outcome of owning versus renting. It makes no difference how you invest the proceeds.
Second, he criticizes people for thinking they can make money in stock market. While I agree that most people end up trading too much by chasing trends and usually pay too much for “professional” advice, his math is seriously flawed. He argues that you should expect a 6% gross return from a portfolio of bonds and stocks; of this 2% goes to fees; then 25% goes to taxes, netting a 3% annual return. My experience is much different than this. The stock market has returned an average of 11% in the past — even if we assume a lesser return we should still see 8-9% long-term. Then you would have to choose the most expensive funds on the market (the average expense ratio is 1.25%). Then you would have to have either all short-term gains or a mix of short- and long-term gains and be in the highest tax bracket to hit 25%. The real expected return should be at least 5-6% for most of us, not 3%.
He next argues that you should invest in sectors you believe to be overvalued. The reason for this is that we are overconfident in our ability to predict which sectors will perform well. For most people –people who don’t spend time in finance — this is good advice. However, for those of us who put in the effort, we can easily see that we should not invest in expensive markets. For example, I stayed out of tech during the late 90s. There were a few years I lagged the market, but in the end, I had the last laugh. Today, I am out of REIT and even though I missed some recent gains, I am optimistic I made the right choice. It’s not about hitting every market rise but being right in the long-run.
He next says that is doesn’t matter if you invest internationally or domestically, or in bonds or stocks. What matters is you don’t chase trends. For the most part, he is right. Sticking to your guns and not chasing fads is most important. However, it is important to have the right allocation for your risk needs.
Last, he makes the point that you should invest according to your risk tolerance and not your risk needs. This is wrong! A retiree should not invest in stocks if he can not afford the risk. If his portfolio decreases by 10-20% in one year, how will that affect his tolerance? The most risk tolerant person can become extremely risk averse if he is on the brink of disaster. Of course, if the retiree has the capital to afford to lose a large part of your portfolio, then it’s not an issue. But the portfolio should be structured to the risk needs of the retiree first and to the risk tolerance second.
New Job
Brian is working on another project today, so I’ll be writing in his place. I’m been his wife for six months, but his financial partner for almost two years.
Brian has recently accepted a job teaching high school math at a public school. Though he has no formal training in education, he can take this position since he has enrolled in an accreditation program.
Needless to say, I had some strong feelings about him taking this position. And it wasn’t all about the money.
The pay, when we add up all the changes, is actually not that much different that what he was making part time. We’ll be saving $1800 year in health insurance premiums, he’ll have the summers off, which cuts out $3000 in daycare expenses and he’ll have time to start his own business, which, hopefully, we’ll lead to a lot more income in the future.
It’s going to give him a lot more time. He’ll have the summers to spend with our son; he’ll have a shorter workday so he’ll have more time in the mornings and afternoon. He has a shorter commute.
All in all, he’s going to come out way ahead in the deal.
It’s taken me a lot longer to accept that as a family, we should come out ahead too.
I was hung up, not on the paycut, but on the lack of potential future earning. Teachers in the public school system are paid based on a grid – there’s no additional raises or bonuses available. He also is giving bonus that would have come in March, some ESPP options that would have come at the end of the year, and a raise that would have taken affect in January.
It’s not an insignificant amount when you add it all up.
But it’s that age old question, “what is time worth?” How much is happiness worth? If this is the right fit for him, how much money should it take to keep him from it? Should any amount of money keep him from it? How much should my opinion and money issues be taken into account?
In the end, he promises me that we wouldn’t have to worry about money, that I would still have the flexibility to keep my job options open and that this is truly what he wants to do with his life.
Maybe I am jealous that he’s escaping the cubical culture. Maybe I want to have summers and spring break. Maybe I want the larger paychecks and bonus potential.
But I’m willing to give up some of my financial insecurities and love of a large balance in our checking account, happiness is worth a lot.
Brian has recently accepted a job teaching high school math at a public school. Though he has no formal training in education, he can take this position since he has enrolled in an accreditation program.
Needless to say, I had some strong feelings about him taking this position. And it wasn’t all about the money.
The pay, when we add up all the changes, is actually not that much different that what he was making part time. We’ll be saving $1800 year in health insurance premiums, he’ll have the summers off, which cuts out $3000 in daycare expenses and he’ll have time to start his own business, which, hopefully, we’ll lead to a lot more income in the future.
It’s going to give him a lot more time. He’ll have the summers to spend with our son; he’ll have a shorter workday so he’ll have more time in the mornings and afternoon. He has a shorter commute.
All in all, he’s going to come out way ahead in the deal.
It’s taken me a lot longer to accept that as a family, we should come out ahead too.
I was hung up, not on the paycut, but on the lack of potential future earning. Teachers in the public school system are paid based on a grid – there’s no additional raises or bonuses available. He also is giving bonus that would have come in March, some ESPP options that would have come at the end of the year, and a raise that would have taken affect in January.
It’s not an insignificant amount when you add it all up.
But it’s that age old question, “what is time worth?” How much is happiness worth? If this is the right fit for him, how much money should it take to keep him from it? Should any amount of money keep him from it? How much should my opinion and money issues be taken into account?
In the end, he promises me that we wouldn’t have to worry about money, that I would still have the flexibility to keep my job options open and that this is truly what he wants to do with his life.
Maybe I am jealous that he’s escaping the cubical culture. Maybe I want to have summers and spring break. Maybe I want the larger paychecks and bonus potential.
But I’m willing to give up some of my financial insecurities and love of a large balance in our checking account, happiness is worth a lot.
A Couple Stories
Sorry for the very long delay in posting. Life got the better of me. Nothing serious, just busy.
During my “sabbatical,” I found some funny examples of personal finance gone bad.
The first example is from a show on HGTV called Dream House. (Here’s a link to the official site and a link to the more informative Rocky Mountain News coverage of the show.) The idea of the show is to show a couple’s adventure toward building their “dream house.” It’s a very simple concept but as you may imagine, the execution rarely goes as smoothly as the couple’s original plans. This season is no exception.
The couple inherited a nice plot of heavily-sloped land in Colorado. They started building before knowing how deep the bedrock was, naively assumed that everything would go as planned, and assumed they would only have a $300-350K mortgage. As happens all too often today, they stretched their budget to afford such a large mortgage.
Then the inevitable happened: the cost projections were flawed, the bedrock was too deep (so it would be more costly to build the foundation), and they got pregnant. They were faced with a house they couldn’t afford, temporarily reduced income (as she was the primary breadwinner), and a large increase in expenses.
What to do when faced with a project you can’t afford? Of course, take on more debt. They mortgaged the land and took out a $500K construction loan! By their own admission, they need his start-up (oh yeah, I forgot to mention, his income comes from a start-up) to take off to afford the new payments.
Good luck! I hope all the stress is worth it.
And the other story: a 39-yr old man bought a virtual space station for $100K. He financed it by taking out a second mortgage on his house. Wow! (On the positive side, a 30-something buying a virtual property is not living in his parent’s basement.)
During my “sabbatical,” I found some funny examples of personal finance gone bad.
The first example is from a show on HGTV called Dream House. (Here’s a link to the official site and a link to the more informative Rocky Mountain News coverage of the show.) The idea of the show is to show a couple’s adventure toward building their “dream house.” It’s a very simple concept but as you may imagine, the execution rarely goes as smoothly as the couple’s original plans. This season is no exception.
The couple inherited a nice plot of heavily-sloped land in Colorado. They started building before knowing how deep the bedrock was, naively assumed that everything would go as planned, and assumed they would only have a $300-350K mortgage. As happens all too often today, they stretched their budget to afford such a large mortgage.
Then the inevitable happened: the cost projections were flawed, the bedrock was too deep (so it would be more costly to build the foundation), and they got pregnant. They were faced with a house they couldn’t afford, temporarily reduced income (as she was the primary breadwinner), and a large increase in expenses.
What to do when faced with a project you can’t afford? Of course, take on more debt. They mortgaged the land and took out a $500K construction loan! By their own admission, they need his start-up (oh yeah, I forgot to mention, his income comes from a start-up) to take off to afford the new payments.
Good luck! I hope all the stress is worth it.
And the other story: a 39-yr old man bought a virtual space station for $100K. He financed it by taking out a second mortgage on his house. Wow! (On the positive side, a 30-something buying a virtual property is not living in his parent’s basement.)
Basic Investment Ideas
I find it hard to continue to post new investment ideas every day. It’s difficult to even post two times a week with new ideas. It’s difficult because it isn’t very hard to be a reasonably good investor. Of course, you can put a lot of time and effort into investing to try to be better than average. But for most people, it is a much better idea to follow a few simple tenants.
The first five ideas come from WSJ columnist Jonathan Clements in today’s Getting Going column.
1) Saving is the most important factor in accumulating wealth. Despite the fact that we have a young son and are jealous of people with bigger homes, we still manage to save about 30% of our income so that we will have that bigger home some day. It’s not necessary to save 30% but making efforts to save as much as you can, as early as you can, will give you more safety and options later in life.
2) Time. The earlier you save, the more compounding and the less you will have to save later.
3) Diversification. Although many value investors — including myself — have derisively used the term “di-worse-ification,” the average investor would be much better off making less concentrated investments. For example, in this month’s Money magazine, a couple was profiled who had significant stakes in both of their employers and in Amazon.com. If either of their employers had a significant setback, they could be in big trouble.
4) Rebalancing. The most important part of an investment plan (i.e. a plan that defines how you are going to allocate your assets) is to make sure you follow through. If you follow the plan, emotion will play as little a role as possible and you will not get caught chasing hot sectors.
5) Indexing. In order to outperform the market you need some advantage. If you are not willing or able to do hours of research looking through annual reports (and looking at pictures and charts doesn’t count), there is no reason to believe you will have an advantage. As Warren Buffett said, if you “bring nothing to the party, [] why should [you] expect to take anything home.” For most investors, it is better to invest in index funds instead of trying to outperform the markets.
To this list I would like to add:
6) Use tax-deferred and tax-free accounts as much as possible.
7) Take free money whenever you can — maximize contributions to ESPPs and matched 401(k) contributions (if you have the option).
8) Maximize your exposure to stocks in your retirement accounts — especially if you have a long time to retirement. Over long periods of time the real return of stocks has been higher with less risk.
9) Minimize expenses. The biggest difference in long-run equity mutual fund performance is not the manager but expenses. Keep this in mind when looking at investments.
If you follow these simple rules, you can accumulate a large nest egg over your lifetime with little risk.
The first five ideas come from WSJ columnist Jonathan Clements in today’s Getting Going column.
1) Saving is the most important factor in accumulating wealth. Despite the fact that we have a young son and are jealous of people with bigger homes, we still manage to save about 30% of our income so that we will have that bigger home some day. It’s not necessary to save 30% but making efforts to save as much as you can, as early as you can, will give you more safety and options later in life.
2) Time. The earlier you save, the more compounding and the less you will have to save later.
3) Diversification. Although many value investors — including myself — have derisively used the term “di-worse-ification,” the average investor would be much better off making less concentrated investments. For example, in this month’s Money magazine, a couple was profiled who had significant stakes in both of their employers and in Amazon.com. If either of their employers had a significant setback, they could be in big trouble.
4) Rebalancing. The most important part of an investment plan (i.e. a plan that defines how you are going to allocate your assets) is to make sure you follow through. If you follow the plan, emotion will play as little a role as possible and you will not get caught chasing hot sectors.
5) Indexing. In order to outperform the market you need some advantage. If you are not willing or able to do hours of research looking through annual reports (and looking at pictures and charts doesn’t count), there is no reason to believe you will have an advantage. As Warren Buffett said, if you “bring nothing to the party, [] why should [you] expect to take anything home.” For most investors, it is better to invest in index funds instead of trying to outperform the markets.
To this list I would like to add:
6) Use tax-deferred and tax-free accounts as much as possible.
7) Take free money whenever you can — maximize contributions to ESPPs and matched 401(k) contributions (if you have the option).
8) Maximize your exposure to stocks in your retirement accounts — especially if you have a long time to retirement. Over long periods of time the real return of stocks has been higher with less risk.
9) Minimize expenses. The biggest difference in long-run equity mutual fund performance is not the manager but expenses. Keep this in mind when looking at investments.
If you follow these simple rules, you can accumulate a large nest egg over your lifetime with little risk.
Another Judge
When President Bush nominated now Chief Justice Roberts, I supported his decision. Not for the normal reason given in the media or by politicians — i.e. that they agree with the nominee’s politics — but because he has a lot of experience. For more see this blog.
The new nominee, Harriet Miers, does not have the experience necessary for such a position. Although she is described as a work-a-holic and is undoubtedly smart, she has never sat on another bench before. Her biggest claim to fame is that she is White House counsel under President Bush. Before that she held W’s hand in Texas.
Can we honestly say that she is the most qualified person for the job? To me, it doesn’t even pass the laugh test. This is obviously someone who has been very faithful to W and is being rewarded for her loyalty. In addition, she has not played a visible role and so there is little opportunity to critique her personal beliefs.
But this is exactly the problem — if judicial nominations are critiqued based on their political beliefs, we will be stuck with inexperienced, untested candidates. I have no doubt that she is intelligent and capable, but there are candidates who have proved they are great judges. Why not nominate a proven candidate?
The new nominee, Harriet Miers, does not have the experience necessary for such a position. Although she is described as a work-a-holic and is undoubtedly smart, she has never sat on another bench before. Her biggest claim to fame is that she is White House counsel under President Bush. Before that she held W’s hand in Texas.
Can we honestly say that she is the most qualified person for the job? To me, it doesn’t even pass the laugh test. This is obviously someone who has been very faithful to W and is being rewarded for her loyalty. In addition, she has not played a visible role and so there is little opportunity to critique her personal beliefs.
But this is exactly the problem — if judicial nominations are critiqued based on their political beliefs, we will be stuck with inexperienced, untested candidates. I have no doubt that she is intelligent and capable, but there are candidates who have proved they are great judges. Why not nominate a proven candidate?
Superfund
In an era of low returns, alternative assets start to look better and better to the average investor as they get frustrated with low returns. This is why a lot of hedge funds are seeing huge inflows of cash. But at least hedge funds are only marketed to rich, wealthy investors. Right?
While technically true, there is a new breed of “fund” being agressively marketed to middle-class individual investors. A recent New York Times article entitled “Have I Got a Fund for You,” describes one such fund, Superfund. They are currently trying to air a commericial advertising their “fund”.
Hedge funds, by their very nature, can not advertise; they can not have more than a small number of non-qualified investors. The Superfund is not organized as a hedge fund but as a “managed futures funds that are publicly registered partnerships.” This way they can bypass the regulations that protect small investors.
I might think that they are just trying to provide a service to a previously unserviced population. But once I saw their fee structure, I realized that it was much closer to to a fleecing than a service. According to the NY Times: “Superfund is guaranteed at least 8.75 percent in brokerage and management fees, and can take up to a 25 percent cut of any profits after expenses in any month when a fund reaches a new high.” The horror! The horror! (sp?)
While technically true, there is a new breed of “fund” being agressively marketed to middle-class individual investors. A recent New York Times article entitled “Have I Got a Fund for You,” describes one such fund, Superfund. They are currently trying to air a commericial advertising their “fund”.
Hedge funds, by their very nature, can not advertise; they can not have more than a small number of non-qualified investors. The Superfund is not organized as a hedge fund but as a “managed futures funds that are publicly registered partnerships.” This way they can bypass the regulations that protect small investors.
I might think that they are just trying to provide a service to a previously unserviced population. But once I saw their fee structure, I realized that it was much closer to to a fleecing than a service. According to the NY Times: “Superfund is guaranteed at least 8.75 percent in brokerage and management fees, and can take up to a 25 percent cut of any profits after expenses in any month when a fund reaches a new high.” The horror! The horror! (sp?)
2 and 20
Hedge funds have a problem. It’s a problem I would love to have — to much money and not enough good investment ideas. We’ll at least I’ld love to have the first problem. The problem is that too many people are looking for yield in a low yield environment. To find yield, people are taking on too much risk — both interest rate risk and default risk. (I.e. people are not getting paid enough to lengthen the duration of their portfolio or to invest in the bonds of riskier companies.) Even Greenspan has commented on this problem.
In the search of higher cash returns, more people have entrusted their savings to hedge funds. Hedge funds, generally speaking, try to produce alpha or excess return. They employ a variety of strategies to reach this goal. Many of them trade often, use leverage, and try to create yield for their investors.
But the biggest mark of a hedge fund is the compensation structure. Hedge funds charge 2% of assets and 20% of profits. Of course, they don’t pay 20% of losses. (They will generously stop charging 20% of profits until they recoup previous losses.) The idea is to give the managers a large incentive to perform. The effect is often much different.
If a manager of a regular corporation had the option of betting $1mm on a fair flip of a coin, there is no way he would take the gamble. But, if a hedge fund came across the same gamble, he would be incented to take it. If he was successful, he would have an extra $200K in comp. If not, he would still get 2% of assets.
If you think this scenario is too academic, check this Reuters article out. Hedge funds have been investing in “cat” bonds for while. Cat bonds are bonds whose payments are correlated with catastrophe losses. They allow reinsures to spread the risks of their losses and give a higher yield to investors willing to accept more risk. After Katrina, I thought some of these hedge funds would realize that they didn’t appreciate the risks.
But the opposite has occurred. Hedge funds are now setting up captive reinsurance companies and trying to compete with established reinsurance companies. Good luck. They don’t have the expertise or relationships to compete. They will drive prices down, will make our insurance more affordable (thank you), and hopefully hurt their investors. Reinsurance is based upon long-term contracts and relationships; insurance companies (especially well-financed ones) do not want to change their reinsurer often. The hedge funds will have to compete on price (and probably charge significantly less) to get customers.
This begs the question: why don’t the hedge funds just invest in established reinsurance companies? The answer is 2 and 20. There is a small probability of a major event. If it occurs, they don’t have to pay — and may even liquidate and restart so they don’t have to make up their losses. If it doesn’t occur, they get 20% of a much larger gain. If they, instead, invested in reinsurance companies they would be at the mercy of the market to value their investments. It’s easy money for the managers even though there is a much better alternative for investors.
The better question is: why would investors in hedge funds pay 2 and 20 for reinsurance exposure?
In the search of higher cash returns, more people have entrusted their savings to hedge funds. Hedge funds, generally speaking, try to produce alpha or excess return. They employ a variety of strategies to reach this goal. Many of them trade often, use leverage, and try to create yield for their investors.
But the biggest mark of a hedge fund is the compensation structure. Hedge funds charge 2% of assets and 20% of profits. Of course, they don’t pay 20% of losses. (They will generously stop charging 20% of profits until they recoup previous losses.) The idea is to give the managers a large incentive to perform. The effect is often much different.
If a manager of a regular corporation had the option of betting $1mm on a fair flip of a coin, there is no way he would take the gamble. But, if a hedge fund came across the same gamble, he would be incented to take it. If he was successful, he would have an extra $200K in comp. If not, he would still get 2% of assets.
If you think this scenario is too academic, check this Reuters article out. Hedge funds have been investing in “cat” bonds for while. Cat bonds are bonds whose payments are correlated with catastrophe losses. They allow reinsures to spread the risks of their losses and give a higher yield to investors willing to accept more risk. After Katrina, I thought some of these hedge funds would realize that they didn’t appreciate the risks.
But the opposite has occurred. Hedge funds are now setting up captive reinsurance companies and trying to compete with established reinsurance companies. Good luck. They don’t have the expertise or relationships to compete. They will drive prices down, will make our insurance more affordable (thank you), and hopefully hurt their investors. Reinsurance is based upon long-term contracts and relationships; insurance companies (especially well-financed ones) do not want to change their reinsurer often. The hedge funds will have to compete on price (and probably charge significantly less) to get customers.
This begs the question: why don’t the hedge funds just invest in established reinsurance companies? The answer is 2 and 20. There is a small probability of a major event. If it occurs, they don’t have to pay — and may even liquidate and restart so they don’t have to make up their losses. If it doesn’t occur, they get 20% of a much larger gain. If they, instead, invested in reinsurance companies they would be at the mercy of the market to value their investments. It’s easy money for the managers even though there is a much better alternative for investors.
The better question is: why would investors in hedge funds pay 2 and 20 for reinsurance exposure?
Greenspan - another warning
The last two days I have opened the Wall Street Journal (my main source of news, besides the Daily Show…) Greenspan has been in the first section. He was on the front page yesterday warning of consumer’s reliance on housing loans to support their spending habits. Today he was on the second page warning that investors are not appreciating risks to the economy.
I know that when Greenspan speaks, the press and investors listen. But the warnings he provided over the last few days are not new. We all know that people have been taking money out of their homes — just listen to the radio ads or look at new mortgage businesses being formed. And, when people have money, they usually find a way to consume more, rather than save. We also know that there is “froth” (to say the least) in the housing market so consumers will not be able to tap increases in home equity in the future.
Also, we know that investors are doing anything to look for more yield. The risk spread between junk and treasuries is absurdly low. The yield spread between short and long-term bonds is also extremely low — i.e. the yield curve is flat. The flat yield curve has previously been referred to by Greenspan as a “conundrum.” And we can all see the low price being paid for taking on extra risk by looking at bond mutual fund yields.
There is no new information in these articles. Well, maybe a little — the risks be more obvious than we previously thought. But, if they are so obvious, when will the market take notice? Do we remember how the “irratonal exuberance” warning ended?
I know that when Greenspan speaks, the press and investors listen. But the warnings he provided over the last few days are not new. We all know that people have been taking money out of their homes — just listen to the radio ads or look at new mortgage businesses being formed. And, when people have money, they usually find a way to consume more, rather than save. We also know that there is “froth” (to say the least) in the housing market so consumers will not be able to tap increases in home equity in the future.
Also, we know that investors are doing anything to look for more yield. The risk spread between junk and treasuries is absurdly low. The yield spread between short and long-term bonds is also extremely low — i.e. the yield curve is flat. The flat yield curve has previously been referred to by Greenspan as a “conundrum.” And we can all see the low price being paid for taking on extra risk by looking at bond mutual fund yields.
There is no new information in these articles. Well, maybe a little — the risks be more obvious than we previously thought. But, if they are so obvious, when will the market take notice? Do we remember how the “irratonal exuberance” warning ended?
Yahoo Columnists
I’m having flashbacks to 2000 today. Back in 2000, Time Warner merged with AOL to create a media behemoth. The goal was to unlock synergies between delivery and content. Obviously, that didn’t turn out as management had hoped. (On a side note, the new Time Warner re-believes that AOL is the key to their future.)
Today, Yahoo announced a plan to enter the content world by hiring eight new financial columnists. With, I’m sure, more to come. I hope, for their sake, they are only trying to differentiate themselves by providing a little exclusive content, rather than trying to revamp their business model. We shall see.
On the positive side, I’ll take any free financial content I can get.
Today, Yahoo announced a plan to enter the content world by hiring eight new financial columnists. With, I’m sure, more to come. I hope, for their sake, they are only trying to differentiate themselves by providing a little exclusive content, rather than trying to revamp their business model. We shall see.
On the positive side, I’ll take any free financial content I can get.
This Week
I’m sorry I haven’t posted lately. It was a rough week for me all around — I was sick, worked too much, and the market wasn’t too kind. It is the first time our portfolio had a very rough week. In the past, my portfolio has taken beatings, but this was completely different.
From past experiences, I know that these things happen from time to time. Net worth does not increase linearly (assuming you take some risk). And, since I take a lot of risk, our net worth jumps around quite a bit.
But I need to make some changes now that I’m married with child because my wife does not react to volitility in the same way, I have more responsibilities because of my son, and we do not have as much free cash flow to protect our portfolio.
I realize now that I can’t continue taking the risks I have taken in the past. It hurts, but I can’t continue to manage to my own risk tolerance and not take into account my new circumstances. After a conversation with my wife, we decided on a new investment plan involving lower leverage and more diversification.
From past experiences, I know that these things happen from time to time. Net worth does not increase linearly (assuming you take some risk). And, since I take a lot of risk, our net worth jumps around quite a bit.
But I need to make some changes now that I’m married with child because my wife does not react to volitility in the same way, I have more responsibilities because of my son, and we do not have as much free cash flow to protect our portfolio.
I realize now that I can’t continue taking the risks I have taken in the past. It hurts, but I can’t continue to manage to my own risk tolerance and not take into account my new circumstances. After a conversation with my wife, we decided on a new investment plan involving lower leverage and more diversification.
Dealing With Losses
We have a very large exposure in Property & Causualty insurance and reinsurance stocks. Needless to say, the last few days have not been kind.
In times like these, when your portfolio begins free-fall, I always remember a quote from one of the best investors of all time, Peter Lynch, “I’ve always said, the key organ here isn’t the brain, it’s the stomach. When things start to decline - there are bad headlines in the papers and on television - will you have the stomach for the market volatility and the broad-based pessimism that tends to come with it?”
I’m not going to pretend that losses don’t affect me, but I’ve learned to keep my finger off the trigger. The worst thing to do is to take risk but then sell as soon as the market turns against you. I’m still optimistic about the long-term prospects of the companies we own but days like today, test my confidence to the fullest.
In times like these, when your portfolio begins free-fall, I always remember a quote from one of the best investors of all time, Peter Lynch, “I’ve always said, the key organ here isn’t the brain, it’s the stomach. When things start to decline - there are bad headlines in the papers and on television - will you have the stomach for the market volatility and the broad-based pessimism that tends to come with it?”
I’m not going to pretend that losses don’t affect me, but I’ve learned to keep my finger off the trigger. The worst thing to do is to take risk but then sell as soon as the market turns against you. I’m still optimistic about the long-term prospects of the companies we own but days like today, test my confidence to the fullest.
The Bull Case for Stocks
The Fed increased the target for the federal funds rate to 3.75% today. The Fed’s statement included: “Higher energy and other costs have the potential to add to inflation pressures.”
The market tanked. Everything on my “My Yahoo” page went from green to red in a moment.
High energy costs and increases in materials costs (most likely due to high energy prices) are causing the Fed to raise their target rate. And all of these factors are weighing on the market. But, I would argue, the risks are overblown.
The story goes: high energy prices slow down the economy but high energy prices also increase the price of goods and inflationary pressures. Soon, people start having nightmares of 1970s stagflation.
The Fed, by raising its target rate, said that the risks of inflation outweigh the risks of stagnation; or, alternatively, that it’s going to keep the same playbook despite the risks of stagnation due to the Hurricane. (I wonder: would we be concerned about stagnation instead of inflation if the Fed had not raised rates?)
High energy prices are being double-counted. They are leading to lower growth assumptions and higher discount rates (through a higher inflation assumption). So, if we buy stocks now we have a large upside if energy prices decline. Not a bad position given that energy prices should come down.
Based on recent articles I’ve read, the cost of producing a barrel of oil is somewhere between $25-35. From Econ 101, if the cost of production is less than the price, there should be more entrants, forcing the price down.
I have no clue how long it is going to take to be back in equilibrium — where the cost of production is equal to the price — but when it does, I bet the price will be lower than the $66 it’s trading at right now. And when oil prices go down, growth should increase, inflationary pressures should ease, and stocks should do well.
Of course, the worst could happen — our oil wells could run dry, new technology could not be developed to tap new fields, and new technology could not be developed to reduce our dependence on oil. But I wouldn’t bet on it.
An aside: I’m not good at economic forecasts and my timing is usually horrible, but I have done well over the long-run. Also, I don’t recommend trying to predict the direction of commodity prices but rules are made to be broken…
The market tanked. Everything on my “My Yahoo” page went from green to red in a moment.
High energy costs and increases in materials costs (most likely due to high energy prices) are causing the Fed to raise their target rate. And all of these factors are weighing on the market. But, I would argue, the risks are overblown.
The story goes: high energy prices slow down the economy but high energy prices also increase the price of goods and inflationary pressures. Soon, people start having nightmares of 1970s stagflation.
The Fed, by raising its target rate, said that the risks of inflation outweigh the risks of stagnation; or, alternatively, that it’s going to keep the same playbook despite the risks of stagnation due to the Hurricane. (I wonder: would we be concerned about stagnation instead of inflation if the Fed had not raised rates?)
High energy prices are being double-counted. They are leading to lower growth assumptions and higher discount rates (through a higher inflation assumption). So, if we buy stocks now we have a large upside if energy prices decline. Not a bad position given that energy prices should come down.
Based on recent articles I’ve read, the cost of producing a barrel of oil is somewhere between $25-35. From Econ 101, if the cost of production is less than the price, there should be more entrants, forcing the price down.
I have no clue how long it is going to take to be back in equilibrium — where the cost of production is equal to the price — but when it does, I bet the price will be lower than the $66 it’s trading at right now. And when oil prices go down, growth should increase, inflationary pressures should ease, and stocks should do well.
Of course, the worst could happen — our oil wells could run dry, new technology could not be developed to tap new fields, and new technology could not be developed to reduce our dependence on oil. But I wouldn’t bet on it.
An aside: I’m not good at economic forecasts and my timing is usually horrible, but I have done well over the long-run. Also, I don’t recommend trying to predict the direction of commodity prices but rules are made to be broken…
About Me
I just realized that I have been posting for a while and have never introduced myself. Even though I am only 26, I have been investing for about 10 years. I started by using my parent’s financial planner to help me pick two active mutual funds.. She recommended I pick funds with high Morningstar ratings. It was more than I knew at the time so I followed her advice.
Later, I found out she had a cushy relationship with the fund family she pushed the hardest. I doubt there was anything illegal going on and the fund family has a decent lineup of funds but she did have a conflict she did not disclose to me. Ever since then I have been a skeptic about investment advice and have been learning how to manage money on my own.
Since that time I have spent way too much time talking to other investors, reading books, 10Ks, and 10Qs — doing anything I can to gain an advantage — and more importantly, doing anything I can to make sure I don’t screw up. Despite all of my efforts to the contrary, I have done a lot of dumb things.
The two biggest mistakes I’ve made are that I have been overconfident and overly aggressive. During college and especially during law school, I played a high stakes financial game and didn’t appreciate the risks I was taking. I took out as much student, credit card, and margin debt as I reasonably could (I never paid more than 10% on the debt) and invested the proceeds in undervalued stocks. Even though I was eventually proved correct in my valuations, for a while my positions went the wrong way. I didn’t have any extra capital to support my positions in the short-run and was forced to periodically liquidate part of my portfolio.
Eventually I was proved to be very correct in my analysis and was rewarded for taking the risk. But it was still a mistake to lever myself to the point at which I could not support my portfolio. Had I had extra cash flow from a job, more lines of credit, or less leverage I could have survived any liquidation and not had to sell any of the undervalued shares on the open market.
Since then I have always left extra margin in my investment account and had lines of credit available for emergency. Over time, I will scale back my leverage to decrease my risk and increase my cash flow. It will allow me to have more flexibility and more toys as I grow older.
Unlike a lot of blogs, I don’t reveal my personal balance sheet or income statement. All I can say is that my wife and I are well-off and should have the freedom to retire early even after paying for our child’s education.
The Important (Non-Financial) Part of My Life
I got married in June and have a 10-month old boy. (I know, the math doesn’t work…) My wife and I both work in the actuarial field — so I usually avoid talking about insurance in my blog even though it is a very important part of the financial picture.
My background is as varied as my interests — I have degrees in math, economics, and psychology; and I have an unused law degree. I also manage accounts for a couple of friends and have had very good results managing their accounts and my own.
Later, I found out she had a cushy relationship with the fund family she pushed the hardest. I doubt there was anything illegal going on and the fund family has a decent lineup of funds but she did have a conflict she did not disclose to me. Ever since then I have been a skeptic about investment advice and have been learning how to manage money on my own.
Since that time I have spent way too much time talking to other investors, reading books, 10Ks, and 10Qs — doing anything I can to gain an advantage — and more importantly, doing anything I can to make sure I don’t screw up. Despite all of my efforts to the contrary, I have done a lot of dumb things.
The two biggest mistakes I’ve made are that I have been overconfident and overly aggressive. During college and especially during law school, I played a high stakes financial game and didn’t appreciate the risks I was taking. I took out as much student, credit card, and margin debt as I reasonably could (I never paid more than 10% on the debt) and invested the proceeds in undervalued stocks. Even though I was eventually proved correct in my valuations, for a while my positions went the wrong way. I didn’t have any extra capital to support my positions in the short-run and was forced to periodically liquidate part of my portfolio.
Eventually I was proved to be very correct in my analysis and was rewarded for taking the risk. But it was still a mistake to lever myself to the point at which I could not support my portfolio. Had I had extra cash flow from a job, more lines of credit, or less leverage I could have survived any liquidation and not had to sell any of the undervalued shares on the open market.
Since then I have always left extra margin in my investment account and had lines of credit available for emergency. Over time, I will scale back my leverage to decrease my risk and increase my cash flow. It will allow me to have more flexibility and more toys as I grow older.
Unlike a lot of blogs, I don’t reveal my personal balance sheet or income statement. All I can say is that my wife and I are well-off and should have the freedom to retire early even after paying for our child’s education.
The Important (Non-Financial) Part of My Life
I got married in June and have a 10-month old boy. (I know, the math doesn’t work…) My wife and I both work in the actuarial field — so I usually avoid talking about insurance in my blog even though it is a very important part of the financial picture.
My background is as varied as my interests — I have degrees in math, economics, and psychology; and I have an unused law degree. I also manage accounts for a couple of friends and have had very good results managing their accounts and my own.
Trading Houses (cont.)
The WSJ just came out with a Saturday edition that emphasizes personal finance. Their lead article made me want to revisit a blog I posted a few days ago.
The WSJ article (subscription req’d) “New Tools to Hedge Your Home” discusses a new and old way to hedge your home.
A problem with the old way, selling short an index of homebuilders, is that this is an imperfect hedge. In addition, the index of homebuilders has performed extremely well historically — often much better than the increase in home prices. It’s not a good long-term strategy to be short something that historically has performed extremely well.
There is a new way to hedge the value of your home through the use of derivatives. The first to market is HedgeStreet. Through their website you can speculate on the short-term direction of real estate prices in six markets. If the value of your home is correlated with the value of the real estate index in any of the six markets listed, you can hedge the short-term value of your home.
But I would advise against using derivatives to hedge the short-term value of your home. First, if you do not plan on selling your home soon, a lower price only means that your property taxes might go down. (The site currently does not allow for long-term hedging — the longest contract is for three months.)
Second, the markets are currently very illiquid and so hedging can be very difficult and expensive. As more contracts and market-makers enter the market, hopefully these problems will be fixed.
Third, derivatives are complicated instruments that can easily be misused.
Fourth, the hedges will probably be far from perfect for your circumstances.
The biggest problem I have with the products is that it reflects our current preoccupation with short-term changes in real estate values. Currently, real estate values are generally overvalued, but over the long-run values should increase from their current prices. I would not recommend investing more in real estate at this point, but there is no need to speculate in a negative NPV transaction that isn’t really hedging your real risk.
The WSJ article (subscription req’d) “New Tools to Hedge Your Home” discusses a new and old way to hedge your home.
A problem with the old way, selling short an index of homebuilders, is that this is an imperfect hedge. In addition, the index of homebuilders has performed extremely well historically — often much better than the increase in home prices. It’s not a good long-term strategy to be short something that historically has performed extremely well.
There is a new way to hedge the value of your home through the use of derivatives. The first to market is HedgeStreet. Through their website you can speculate on the short-term direction of real estate prices in six markets. If the value of your home is correlated with the value of the real estate index in any of the six markets listed, you can hedge the short-term value of your home.
But I would advise against using derivatives to hedge the short-term value of your home. First, if you do not plan on selling your home soon, a lower price only means that your property taxes might go down. (The site currently does not allow for long-term hedging — the longest contract is for three months.)
Second, the markets are currently very illiquid and so hedging can be very difficult and expensive. As more contracts and market-makers enter the market, hopefully these problems will be fixed.
Third, derivatives are complicated instruments that can easily be misused.
Fourth, the hedges will probably be far from perfect for your circumstances.
The biggest problem I have with the products is that it reflects our current preoccupation with short-term changes in real estate values. Currently, real estate values are generally overvalued, but over the long-run values should increase from their current prices. I would not recommend investing more in real estate at this point, but there is no need to speculate in a negative NPV transaction that isn’t really hedging your real risk.
Sell-Side Analysts
A sell-side analyst “works for a brokerage or firm that manages individual accounts and makes recommendations to the clients of the firm.” Investopedia. Every time a stock is upgraded or downgraded, one of these analysts are at work.
Their obligation is to the firm they work for, not to individual investors. Depending on the firm they work for, their objective could be to: increase trading, please a company by issuing a favorable recommendation, increase client satisfaction, or to avoid any number of other normal pressures a person faces at work.
During the internet bubble, some sell-side analysts developed quite a following. So much so that we still remember their names to this very day: Meeker, Blodget, Grubman to name a few.
After the internet bubble popped, these idolized analysts’ names were dragged through the mud. I’m not saying they didn’t do anything wrong, but a lot of them did what their job required of them. If they could explain away the irrational exuberance during the time, if they could convince themselves and the world that they knew the secret to the new economy, they could make a killing. And they did.
They made their clients happy by producing eye-popping returns (at least until the bubble popped); they made their companies happy by bringing in more assets and investment banking business; and they made themselves very wealthy. The good analysts knew the bubble couldn’t last but it was fun while it lasted.
At least in today’s more rational market, these abuses don’t happen. Analysts are there to tell you how they really feel about an investment. They are not there to make money for themselves or their firm. They have an undying to devotion to the well-being of the individual investor. Or so I thought…(Okay, I never really did.)
Sell-side analysts are, after all, trying to sell you something. In that spirit, most of the stocks a company covers are ranked as a “buy”. After all, who wants to buy a “hold” or a “sell?” In fact, Jefferies & Co. has 10 buys for every one sell; A.G. Edwards has 15 buys for every sell. (WSJ Online; Subscription Req’d.) It’s so bad that most investors recognize a “hold” for what it is — a “sell” with connections.
If you thought the game has changed, it hasn’t. Just the timing has — there is no crash so the losses aren’t as visible. If you decide to use the “expertise” of a broker’s firm, make sure you know what percent of the firm’s recommendations are “sells” and how their recommendations have performed over time compared to an index. Assuming that they aren’t playing games with the numbers, chances are that after fees their recommendations will have underperformed and you would be much better served in a boring, yet lucrative, index fund.
Their obligation is to the firm they work for, not to individual investors. Depending on the firm they work for, their objective could be to: increase trading, please a company by issuing a favorable recommendation, increase client satisfaction, or to avoid any number of other normal pressures a person faces at work.
During the internet bubble, some sell-side analysts developed quite a following. So much so that we still remember their names to this very day: Meeker, Blodget, Grubman to name a few.
After the internet bubble popped, these idolized analysts’ names were dragged through the mud. I’m not saying they didn’t do anything wrong, but a lot of them did what their job required of them. If they could explain away the irrational exuberance during the time, if they could convince themselves and the world that they knew the secret to the new economy, they could make a killing. And they did.
They made their clients happy by producing eye-popping returns (at least until the bubble popped); they made their companies happy by bringing in more assets and investment banking business; and they made themselves very wealthy. The good analysts knew the bubble couldn’t last but it was fun while it lasted.
At least in today’s more rational market, these abuses don’t happen. Analysts are there to tell you how they really feel about an investment. They are not there to make money for themselves or their firm. They have an undying to devotion to the well-being of the individual investor. Or so I thought…(Okay, I never really did.)
Sell-side analysts are, after all, trying to sell you something. In that spirit, most of the stocks a company covers are ranked as a “buy”. After all, who wants to buy a “hold” or a “sell?” In fact, Jefferies & Co. has 10 buys for every one sell; A.G. Edwards has 15 buys for every sell. (WSJ Online; Subscription Req’d.) It’s so bad that most investors recognize a “hold” for what it is — a “sell” with connections.
If you thought the game has changed, it hasn’t. Just the timing has — there is no crash so the losses aren’t as visible. If you decide to use the “expertise” of a broker’s firm, make sure you know what percent of the firm’s recommendations are “sells” and how their recommendations have performed over time compared to an index. Assuming that they aren’t playing games with the numbers, chances are that after fees their recommendations will have underperformed and you would be much better served in a boring, yet lucrative, index fund.
Dividends
Back in 1938, John Burr Williams codified the fundamental principle of value investing: the value of a stock is the present value of its future dividends. It seems obvious, but underlying this statement is some very powerful, yet often forgotten, advice.
We forget at our our own peril. “From 1871 to 2003, 97 percent of the total after-inflation accumulation from stock comes from reinvesting dividends. Only 3 percent comes from capital gains.” (The Future For Investors
) (By the way, if you are looking for a great introduction to investing, read this book!)
Not only have dividends been the driving force behind the real returns of the market as a whole, but the returns of individual stocks are driven by their yield. Jeremy Siegel sorted the stocks comprising the S&P 500 every year by dividend yield. He found, “in strictly increasing order, the portfolios with higher dividend yields offered investors higher returns.” (Ibid.)
David Dremen found similar results looking at the 1500 largest companies from 1970-1996. (Contrarian Investment Strategies: The Next Generation) He found that higher yielding stocks produced higher returns.
In addition, both authors found that “high yielding stocks also provide you with the best protection in a bear market.” (Ibid.) So, stocks with high dividends return more and offer better downside-protection. (So much for “tinstaafl”.)
There is one small difference between the findings of the two studies, however. The Siegel study found that the highest yielding quintile produced the highest return while the Dremen study found the highest yielding quintile produced the second highest return (to the second highest yielding quintile). I’m guessing it’s just because there is still enough variance left in the data to get different results with slightly different methodologies and data sets.
Either way, I am going to continue buying stocks with large dividends. And I am not going to worry whether a dividend is too high — just whether the company can support it in the future. For a reasonable dividend strategy — I agree with most of what he has to say except that I don’t worry as much about a high payout ratio (dividends/earnings) — see this blog).
But there is one big question left unanswered: why do dividends predict higher returns? From a strictly mathematical viewpoint, they should reduce the value of the company because they increase the tax burden.
I can think of three reasons why dividends increase value: (1) Dividends encourage managers to make better investments with the cash they have — i.e. they don’t have cash to burn on bad investments; (2) management will only give out large dividend payments if they are very confident about the future; and (3) a company can not pay dividends if it does not have cash earnings (without diluting shareholders).
Interestingly enough, there are people who argue that an increased payout ratio (dividends/earnings) is an indicator of higher future growth. (See, e.g., this month’s SmartMoney, p. 56.) I’m not yet convinced this is true because there is a very strong mathematical reason for the opposite to occur: the growth rate is = (1-Payout Ratio)*ROE. The mathematical relationship between the payout ratio is the exact opposite as what they are claiming!
In any case, there is very little doubt that buying high dividend paying stocks is good for your financial health. And I personally invest in high dividend paying stocks — I own no REITs, trusts, or bonds but have a yield of nearly 4%. (Of course, I think the companies I own have other good attributes as well. I don’t invest solely based on one factor.) Even if the market goes sidewise for some time, I will still get close to a t-bond return. And, if history is any guide, I should outperform the market over the long-run.
We forget at our our own peril. “From 1871 to 2003, 97 percent of the total after-inflation accumulation from stock comes from reinvesting dividends. Only 3 percent comes from capital gains.” (The Future For Investors
) (By the way, if you are looking for a great introduction to investing, read this book!) Not only have dividends been the driving force behind the real returns of the market as a whole, but the returns of individual stocks are driven by their yield. Jeremy Siegel sorted the stocks comprising the S&P 500 every year by dividend yield. He found, “in strictly increasing order, the portfolios with higher dividend yields offered investors higher returns.” (Ibid.)
David Dremen found similar results looking at the 1500 largest companies from 1970-1996. (Contrarian Investment Strategies: The Next Generation
) He found that higher yielding stocks produced higher returns.In addition, both authors found that “high yielding stocks also provide you with the best protection in a bear market.” (Ibid.) So, stocks with high dividends return more and offer better downside-protection. (So much for “tinstaafl”.)
There is one small difference between the findings of the two studies, however. The Siegel study found that the highest yielding quintile produced the highest return while the Dremen study found the highest yielding quintile produced the second highest return (to the second highest yielding quintile). I’m guessing it’s just because there is still enough variance left in the data to get different results with slightly different methodologies and data sets.
Either way, I am going to continue buying stocks with large dividends. And I am not going to worry whether a dividend is too high — just whether the company can support it in the future. For a reasonable dividend strategy — I agree with most of what he has to say except that I don’t worry as much about a high payout ratio (dividends/earnings) — see this blog).
But there is one big question left unanswered: why do dividends predict higher returns? From a strictly mathematical viewpoint, they should reduce the value of the company because they increase the tax burden.
I can think of three reasons why dividends increase value: (1) Dividends encourage managers to make better investments with the cash they have — i.e. they don’t have cash to burn on bad investments; (2) management will only give out large dividend payments if they are very confident about the future; and (3) a company can not pay dividends if it does not have cash earnings (without diluting shareholders).
Interestingly enough, there are people who argue that an increased payout ratio (dividends/earnings) is an indicator of higher future growth. (See, e.g., this month’s SmartMoney, p. 56.) I’m not yet convinced this is true because there is a very strong mathematical reason for the opposite to occur: the growth rate is = (1-Payout Ratio)*ROE. The mathematical relationship between the payout ratio is the exact opposite as what they are claiming!
In any case, there is very little doubt that buying high dividend paying stocks is good for your financial health. And I personally invest in high dividend paying stocks — I own no REITs, trusts, or bonds but have a yield of nearly 4%. (Of course, I think the companies I own have other good attributes as well. I don’t invest solely based on one factor.) Even if the market goes sidewise for some time, I will still get close to a t-bond return. And, if history is any guide, I should outperform the market over the long-run.
Trading Houses
I don’t know if you’ve seen the new show on TLC called “Flip This House.” I haven’t, but I think I can figure out the premise: someone purchases a house, puts some elbow-grease into it, and tries to sell it for a profit — an amazingly common theme in this crazy time.
Every time I open a newspaper or magazine (or watch TV) I hear about how much people have made in real estate or how dumb they are for investing in real estate right now. For example, last month’s Money magazine featured condo flippers. Some people are buying condos that won’t be built for years with extreme leverage. This is crazier than being a tech speculator in the late 90s. At least the techies were not as leveraged, had a market to sell into when the crash came, and didn’t have to pay huge transaction fees.
But the really strange real estate conversation is: should you sell your home and rent? It belies the real change in philosophy towards housing: people are looking at their homes as an investment rather than a place to live. Yes, housing is overpriced, but people should not be selling their houses because they think they are overpriced because:
(1) The transaction costs can eat away at any difference between the price and true value of the home.
(2) Even if the housing market is overvalued, that does not mean that after you sell, the value of your house will decrease. Trying to time a market — even if it’s overvalued — is hard.
(3) There are other reasons to own a home rather than rent — like freedom, attachment, and pride of ownership.
Even though real estate is probably overpriced, you shouldn’t sell your house to rent. Instead of looking at a house as a sure road to riches, if you see it as a place to live, you’ll be much happier with your return.
Every time I open a newspaper or magazine (or watch TV) I hear about how much people have made in real estate or how dumb they are for investing in real estate right now. For example, last month’s Money magazine featured condo flippers. Some people are buying condos that won’t be built for years with extreme leverage. This is crazier than being a tech speculator in the late 90s. At least the techies were not as leveraged, had a market to sell into when the crash came, and didn’t have to pay huge transaction fees.
But the really strange real estate conversation is: should you sell your home and rent? It belies the real change in philosophy towards housing: people are looking at their homes as an investment rather than a place to live. Yes, housing is overpriced, but people should not be selling their houses because they think they are overpriced because:
(1) The transaction costs can eat away at any difference between the price and true value of the home.
(2) Even if the housing market is overvalued, that does not mean that after you sell, the value of your house will decrease. Trying to time a market — even if it’s overvalued — is hard.
(3) There are other reasons to own a home rather than rent — like freedom, attachment, and pride of ownership.
Even though real estate is probably overpriced, you shouldn’t sell your house to rent. Instead of looking at a house as a sure road to riches, if you see it as a place to live, you’ll be much happier with your return.
IPO Fund
The reason a fund complex launches a new fund is to try to attract more assets. I’m okay with that. But sometimes a fund complex takes it too far. Take, for example, the new Van Kampen IPOX 30 Index Portfolio.
IPOX allows the investor access to recent large IPOs. But there are significant problems with the fund — drawbacks that make the fund uninvestible. The fund charges up to a 4.95% sales load!
There is no secondary market for the shares. The company states that they are creating one and that you can deal the shares back to the company.
In addition, despite their claims that their strategy will produce market beating returns, I have significant doubts because (1) IPOs have traditionally underperformed (see Buying IPOs Is a Loser’s Game) and (2) according to a recent Morningstar study, high expenses mean low returns.
If you want the excitement of IPOs feel free to play around with this fund but if instead, you would like to increase your net worth, I would stay away.
IPOX allows the investor access to recent large IPOs. But there are significant problems with the fund — drawbacks that make the fund uninvestible. The fund charges up to a 4.95% sales load!
There is no secondary market for the shares. The company states that they are creating one and that you can deal the shares back to the company.
In addition, despite their claims that their strategy will produce market beating returns, I have significant doubts because (1) IPOs have traditionally underperformed (see Buying IPOs Is a Loser’s Game) and (2) according to a recent Morningstar study, high expenses mean low returns.
If you want the excitement of IPOs feel free to play around with this fund but if instead, you would like to increase your net worth, I would stay away.
Fooled by Randomness
I found a letter in this month’s SmartMoney that is a great example of how not to invest:
1) Relying on someone else’s analysis (especially a magazine!) and not even making an attempt to value the security.
2) OK, he made a really bad attempt — apparently the true value can be derived from trading ranges.
3) Again, relying on a magazine for a valuation.
4) Attributing skill to a very random outcome.
5) Believing in a strategy because it worked for a very small sample. (I didn’t read — or more likely, did read but don’t remember — Sturm’s article. He may be right, but a sample size of one is completely not credible.)
The frustration I get from reading claims like these are a big reason I started this blog. (That and my wife thought I needed another outlet for my financial opinions.) Although there is little to no connection between his actions and the results, he attributes his results to his actions. Going forward, he probably won’t be so lucky — as the saying goes, a fool and his money are soon parted.
By the way, there is a very good book on this subject, Fooled by Randomness, a book that will help anyone be a better and more humble investor.
I bought 1,000 shares of Getty Images at $68.70 after reading “99Pound Gorillas” in your January issue. During the course of the next five to six months, the stock bounced around between $72 and $77. I began to view this as a trading range.Let’s count the mistakes:
Well, in August’s “No Monkey Business Here,” you recommended taking some gains since the stock has treached $73. I was somewhat in agreement. But the following day I read, in the same issue, Paul Sturm’s “Cut Your Losses; Ride Your Winners.” The research about how people sell winning stocks too early made a lot of sense. Later that day, Getty came out with good earnings. Near the end of the week, the stock was over $82. All of this is evidence that the study discussed in Sturm’s article is 100 percent right on, for this situation.
1) Relying on someone else’s analysis (especially a magazine!) and not even making an attempt to value the security.
2) OK, he made a really bad attempt — apparently the true value can be derived from trading ranges.
3) Again, relying on a magazine for a valuation.
4) Attributing skill to a very random outcome.
5) Believing in a strategy because it worked for a very small sample. (I didn’t read — or more likely, did read but don’t remember — Sturm’s article. He may be right, but a sample size of one is completely not credible.)
The frustration I get from reading claims like these are a big reason I started this blog. (That and my wife thought I needed another outlet for my financial opinions.) Although there is little to no connection between his actions and the results, he attributes his results to his actions. Going forward, he probably won’t be so lucky — as the saying goes, a fool and his money are soon parted.
By the way, there is a very good book on this subject, Fooled by Randomness
, a book that will help anyone be a better and more humble investor. Buyers/Sellers Remorse
I know long-term interest rates are going to increase. Heck, I knew this six months ago. It was going to happen — and happen soon. I would have put money on it (but luckily I didn’t).
I’m continually amazed by pundits and my ability to see the future so clearly, only to forget our predictions so easily. And those of us that do remember have ready excuses due to “unforeseen events.”
Each time I find a sure thing, I give myself a few days to think it over. Usually, I start finding problems with my idea. Most of us would be better off if we did this more often — much like shop-a-holics should put something on hold instead of making an immediate purchase. Buyers and sellers remorse is a big part of investing — and can cost you much more than a trip to the mall.
However, many people still try to time the market — moving money in and out of the market to try to get better returns. Of course, these timers inevitably end up hurting themselves in the end.
Money calculated the return investors actually earned investing in 700 mutual funds from 1998-2001 and compared that value to the returns of the funds over the same time period. The shareholders annual return was 1%, compared to 6% for the funds.
The difference is that shareholders were buying and selling at exactly the wrong moments. When the fund performed well, the investors gained confidence, and cash flowed in to the fund. When the fund performed poorly, the investors lost confidence, and cash flowed out. The investors were buying at the top and selling at the bottom.
The investors would have been much better off to buy and hold rather than to let their emotions control their investment strategy.
Before you decide to buy or sell, make sure you have good reasons and that your emotions aren’t guiding your decision. Don’t think that you can predict the future or get upset with yourself for your lack of foresight. (For example, it was obvious to me that the market was overvalued in the late 90s, and I should have cashed in, but if I would have given myself the leeway to bet against the NASDAQ, I would have been broke way before the bubble eventually popped.)
Maybe interest rates will stay flat for a while, maybe they won’t. But I’m smart enough to know that I don’t know what will happen; and smart enough that my investment strategy doesn’t totally depend on my forecast of the future.
I’m continually amazed by pundits and my ability to see the future so clearly, only to forget our predictions so easily. And those of us that do remember have ready excuses due to “unforeseen events.”
Each time I find a sure thing, I give myself a few days to think it over. Usually, I start finding problems with my idea. Most of us would be better off if we did this more often — much like shop-a-holics should put something on hold instead of making an immediate purchase. Buyers and sellers remorse is a big part of investing — and can cost you much more than a trip to the mall.
However, many people still try to time the market — moving money in and out of the market to try to get better returns. Of course, these timers inevitably end up hurting themselves in the end.
Money calculated the return investors actually earned investing in 700 mutual funds from 1998-2001 and compared that value to the returns of the funds over the same time period. The shareholders annual return was 1%, compared to 6% for the funds.
The difference is that shareholders were buying and selling at exactly the wrong moments. When the fund performed well, the investors gained confidence, and cash flowed in to the fund. When the fund performed poorly, the investors lost confidence, and cash flowed out. The investors were buying at the top and selling at the bottom.
The investors would have been much better off to buy and hold rather than to let their emotions control their investment strategy.
Before you decide to buy or sell, make sure you have good reasons and that your emotions aren’t guiding your decision. Don’t think that you can predict the future or get upset with yourself for your lack of foresight. (For example, it was obvious to me that the market was overvalued in the late 90s, and I should have cashed in, but if I would have given myself the leeway to bet against the NASDAQ, I would have been broke way before the bubble eventually popped.)
Maybe interest rates will stay flat for a while, maybe they won’t. But I’m smart enough to know that I don’t know what will happen; and smart enough that my investment strategy doesn’t totally depend on my forecast of the future.
A Break From Finance
Every once in a while, I think about something other than finance — this is one of those moments. Even less often, I think about politics. But the recent news surrounding the coming John Roberts confirmation hearings is aggravating.
First, let me start with a little background about me: I have never voted for a Republican Presidential candidate — but most of that is because of W. (I am only 26 and so two of my votes would be better described as settling for the person I disliked the least.) But I can’t believe the politics being played right now by the Democrats before the confirmation hearings of Roberts.
Despite disagreeing with almost everything Roberts believes in, he is a good candidate. A person is not unfit for the judiciary because we disagree with him. Yet, politicians and the media have been attacking Roberts because he argued the “wrong” side of cases.
He argued for overturning Roe v. Wade when it was his job to do so. By the way, it is a lawyer’s job to argue for his client to the best of his ability. (I still remember a little about law from my days in law school — I have a law degree but am not a practicing lawyer.)
Democrats: let’s face the facts. Roberts has beliefs that are the exact opposite of ours. Roe v. Wade may be overturned, states may get more rights, religion may become a part of our government — and I hate to think about these things happening (at least 2 of the 3) — but Roberts is a good candidate. He has the intelligence, experience, and morality necessary to perform the duties of the Chief Justice of the Supreme Court. Although I fear the ramifications of a Chief Justice Roberts, there is no good reason to stop his confirmation.
First, let me start with a little background about me: I have never voted for a Republican Presidential candidate — but most of that is because of W. (I am only 26 and so two of my votes would be better described as settling for the person I disliked the least.) But I can’t believe the politics being played right now by the Democrats before the confirmation hearings of Roberts.
Despite disagreeing with almost everything Roberts believes in, he is a good candidate. A person is not unfit for the judiciary because we disagree with him. Yet, politicians and the media have been attacking Roberts because he argued the “wrong” side of cases.
He argued for overturning Roe v. Wade when it was his job to do so. By the way, it is a lawyer’s job to argue for his client to the best of his ability. (I still remember a little about law from my days in law school — I have a law degree but am not a practicing lawyer.)
Democrats: let’s face the facts. Roberts has beliefs that are the exact opposite of ours. Roe v. Wade may be overturned, states may get more rights, religion may become a part of our government — and I hate to think about these things happening (at least 2 of the 3) — but Roberts is a good candidate. He has the intelligence, experience, and morality necessary to perform the duties of the Chief Justice of the Supreme Court. Although I fear the ramifications of a Chief Justice Roberts, there is no good reason to stop his confirmation.
Actively Managed Mutual Funds
Actively managed mutual funds are one of the most popular investments for individual investors. They give individual investors access to diversification and professional management. So they should be a good investment for most people, right? Actually, it’s quite the opposite.
Actively managed mutual funds are not as good as other investments (including, most notably, index funds and ETFs) because there are many unchecked conflicts of interest between the manager and the shareholders of the funds. This can be seen in the performance of active mutual funds — which consistently underperform index funds (up to 4.5% after tax according to one study cited in the article cited below).
The objective of a mutual fund manager is to maximize the value of their management contract — i.e. increase the assets under management and increase expenses. These are the exact opposite of what the shareholders want.
The bigger the fund, the lower the probability that the manager will be able to outperform the market. There are only so many good investment ideas a manager can have, and the more assets, the more the manager’s mediocre ideas are going to creep into the portfolio. Warren Buffet once opined that since people only have a few good ideas, investors should invest like they can only invest in 20 companies over their entire lifetime. The more diversified, the more the portfolio will start to perform like an index — but don’t worry, you’ll still be paying the fees like it’s actively managed.
In addition to the hefty expense ratio you’ll be paying, some managements have the gall to charge you for selling more of their product, by charging 12b-1 fees. They claim it’s for your benefit since the more assets, the lower they can make the expense ratio. However, most funds have not reduced expenses when they get more assets. So they charge you extra to make the fund more like an index but don’t pass on the benefit of lower expenses.
Another source of conflict people often overlook is that managers try to maximize before tax return and so turn over their portfolios more than shareholders would like. If you are holding the fund in a tax-free account, this wouldn’t matter, but for the rest of us, this is another reason to favor index funds and ETFs.
It just doesn’t make sense to expect superior performance from an actively managed mutual fund. It’s hard to outperform (especially on an after-tax basis) when you have a diversified portfolio with high fees and high turnover. So, if you do choose to go with an actively managed mutual fund, prefer funds with low turnover, low fees, and a concentrated portfolio. If you favor these funds, you will have a better chance of beating the market. Of course, you would probably be much better off buying an index fund or ETF.
(For a great interview on this issue — and for the source of much of this blog — check out WSJ.com “Yale Manager Blasts Industry” (Sept. 6, 2005) — sorry, I don’t have a link.)
Actively managed mutual funds are not as good as other investments (including, most notably, index funds and ETFs) because there are many unchecked conflicts of interest between the manager and the shareholders of the funds. This can be seen in the performance of active mutual funds — which consistently underperform index funds (up to 4.5% after tax according to one study cited in the article cited below).
The objective of a mutual fund manager is to maximize the value of their management contract — i.e. increase the assets under management and increase expenses. These are the exact opposite of what the shareholders want.
The bigger the fund, the lower the probability that the manager will be able to outperform the market. There are only so many good investment ideas a manager can have, and the more assets, the more the manager’s mediocre ideas are going to creep into the portfolio. Warren Buffet once opined that since people only have a few good ideas, investors should invest like they can only invest in 20 companies over their entire lifetime. The more diversified, the more the portfolio will start to perform like an index — but don’t worry, you’ll still be paying the fees like it’s actively managed.
In addition to the hefty expense ratio you’ll be paying, some managements have the gall to charge you for selling more of their product, by charging 12b-1 fees. They claim it’s for your benefit since the more assets, the lower they can make the expense ratio. However, most funds have not reduced expenses when they get more assets. So they charge you extra to make the fund more like an index but don’t pass on the benefit of lower expenses.
Another source of conflict people often overlook is that managers try to maximize before tax return and so turn over their portfolios more than shareholders would like. If you are holding the fund in a tax-free account, this wouldn’t matter, but for the rest of us, this is another reason to favor index funds and ETFs.
It just doesn’t make sense to expect superior performance from an actively managed mutual fund. It’s hard to outperform (especially on an after-tax basis) when you have a diversified portfolio with high fees and high turnover. So, if you do choose to go with an actively managed mutual fund, prefer funds with low turnover, low fees, and a concentrated portfolio. If you favor these funds, you will have a better chance of beating the market. Of course, you would probably be much better off buying an index fund or ETF.
(For a great interview on this issue — and for the source of much of this blog — check out WSJ.com “Yale Manager Blasts Industry” (Sept. 6, 2005) — sorry, I don’t have a link.)
Human Nature
A recent comment said that I don’t account for human nature in my strategies. I agree, I don’t. But I think there are good reasons for this. In investing and planning for our future, we have to try to beat the humanity right out of ourselves. Some examples of bad behaviors:
People have a tendency to spend, rather than save.
People have a tendency to buy into growth stories rather than boring, profitable companies.
People have a tendency to chase trends.
People have a tendency to buy after a run-up and not buy after a sell-off.
People have a tendency to put significance on insignificant events (e.g. recent stock performance).
The list could go on but my point is that we have to fight against our natural tendencies to the extent possible. Although the short-run is exciting (it’s fun to see our net worth go up and sad to see it go down), we should try to not react to short-term events and put more emphasis on the long-run. Easier said than done. I struggle with it every day.
The best thing you can do for yourself is to know what your weaknesses are: do you like to trade? Do you get caught up in manias? Do have trouble saving? Are you over/under-aggressive?
And create a plan — you can follow — to address these issues. Before you decide on an investment/savings plan, ask yourself whether you will be able to follow it.
The investment ideas I discuss are not for everyone — they have worked for me and may work for you — but that is up to you to decide.
People have a tendency to spend, rather than save.
People have a tendency to buy into growth stories rather than boring, profitable companies.
People have a tendency to chase trends.
People have a tendency to buy after a run-up and not buy after a sell-off.
People have a tendency to put significance on insignificant events (e.g. recent stock performance).
The list could go on but my point is that we have to fight against our natural tendencies to the extent possible. Although the short-run is exciting (it’s fun to see our net worth go up and sad to see it go down), we should try to not react to short-term events and put more emphasis on the long-run. Easier said than done. I struggle with it every day.
The best thing you can do for yourself is to know what your weaknesses are: do you like to trade? Do you get caught up in manias? Do have trouble saving? Are you over/under-aggressive?
And create a plan — you can follow — to address these issues. Before you decide on an investment/savings plan, ask yourself whether you will be able to follow it.
The investment ideas I discuss are not for everyone — they have worked for me and may work for you — but that is up to you to decide.
Options Are Expenses
I should be able to stop with the title, because it seems obvious that options are expenses. As Warren Buffet said, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
It’s hard to argue with that logic, but special interests don’t heed to logic. (If I had millions on the line, maybe I could convince myself that options shouldn’t be expenses, too.) The arguments against options are:
(1) They are hard to value;
(2) Expensing options will overburden the technology industry and the US economy;
(3) If companies buy the stock on the open market to replace the shares they give, shareholders are not worse off.
There are probably other, equally ridiculous, reasons but I’ll limit myself to this list.
(1) It is true that stock options are hard to value — they are even harder to value than exchange-traded options because options given to employees have a longer term-to-maturity — but they are far from impossible to value. There are standard option-pricing formulas that will give good approximations of the value of the option.
Also, there are other items that effect the P&L that can be even harder to value — pension liabilities and assets; reserves for returns, asset impairment, insurance losses; and depreciation schedules, just to name a few. The difficulty of valuation does not mean that we should not value at all — it is much better to be approximately right than precisely wrong.
(2) Nothing like a statement: “we can’t make a profit if you make us keep ALL of our expenses on our books.” If that’s true, then maybe you shouldn’t exist.
Of course, the logic goes the other way as well — maybe because these companies have been inflating profits there is has been overinvestment (and the subsequent crash) in the technology sector.
(3) I can’t believe this argument even exists. It’s true that if you purchase shares on the open market with shareholder cash that the number of shares does not increase. But where is the shareholder’s cash?
The real reason for the battle is that executives want to take money from our pocket, put it in theirs and not tell us. And if they have to tell us, we might tell them to stop.
It’s sad that there is any debate about expensing options. It’s distracting from the real issue: how should companies value and expense options? Of course, if I was one of those executives, I wouldn’t want to tell my shareholders how much they’ve been paying me either.
It’s hard to argue with that logic, but special interests don’t heed to logic. (If I had millions on the line, maybe I could convince myself that options shouldn’t be expenses, too.) The arguments against options are:
(1) They are hard to value;
(2) Expensing options will overburden the technology industry and the US economy;
(3) If companies buy the stock on the open market to replace the shares they give, shareholders are not worse off.
There are probably other, equally ridiculous, reasons but I’ll limit myself to this list.
(1) It is true that stock options are hard to value — they are even harder to value than exchange-traded options because options given to employees have a longer term-to-maturity — but they are far from impossible to value. There are standard option-pricing formulas that will give good approximations of the value of the option.
Also, there are other items that effect the P&L that can be even harder to value — pension liabilities and assets; reserves for returns, asset impairment, insurance losses; and depreciation schedules, just to name a few. The difficulty of valuation does not mean that we should not value at all — it is much better to be approximately right than precisely wrong.
(2) Nothing like a statement: “we can’t make a profit if you make us keep ALL of our expenses on our books.” If that’s true, then maybe you shouldn’t exist.
Of course, the logic goes the other way as well — maybe because these companies have been inflating profits there is has been overinvestment (and the subsequent crash) in the technology sector.
(3) I can’t believe this argument even exists. It’s true that if you purchase shares on the open market with shareholder cash that the number of shares does not increase. But where is the shareholder’s cash?
The real reason for the battle is that executives want to take money from our pocket, put it in theirs and not tell us. And if they have to tell us, we might tell them to stop.
It’s sad that there is any debate about expensing options. It’s distracting from the real issue: how should companies value and expense options? Of course, if I was one of those executives, I wouldn’t want to tell my shareholders how much they’ve been paying me either.
Finding Undervalued Companies
One of the hardest things to do as an individual investor is to locate undervalued companies. There just isn’t enough time in the day for one person to scour the annual reports of many different companies — especially if you have a day job or family commitments. The time constraint is the biggest disadvantage facing an individual investor. Below is a summary of sources I have used and their advantages/disadvantages:
1) Lists of companies trading at their 52-week lows. Companies listed here are often cheap but can have serious operating issues and so you must be very confident that the problems are only short-term or that, even with the problems, the company is still undervalued.
2) Screens. Screens are an easy way to compare basic statistics about companies — and look for companies with high dividends, low P/E, etc. but often the companies that have great statistics sometimes have them because of one time positive events in the previous year or their future looks pitiful. For a good screener, try MSN’s deluxe screener.
3) News. I look for companies with current operating or financial issues, but good long-term prospects. This is a good source for finding companies with problems (e.g. Merck and Citigroup) but will bias your portfolio toward large cap stocks — as smaller companies get less coverage.
4) Industry Rankings. On finance.yahoo.com, you can look at competitors of any companies and get basic statistics as to how the company compares to others in its industry. Even though the industries listed, the categorization of companies are somewhat arbitrary and the statistics listed are not enough to value the company, they can give you a good starting point.
Hopefully, these sources will help you start on your road to selecting winning investments.
(I don’t currently have any interest in the companies listed.)
1) Lists of companies trading at their 52-week lows. Companies listed here are often cheap but can have serious operating issues and so you must be very confident that the problems are only short-term or that, even with the problems, the company is still undervalued.
2) Screens. Screens are an easy way to compare basic statistics about companies — and look for companies with high dividends, low P/E, etc. but often the companies that have great statistics sometimes have them because of one time positive events in the previous year or their future looks pitiful. For a good screener, try MSN’s deluxe screener.
3) News. I look for companies with current operating or financial issues, but good long-term prospects. This is a good source for finding companies with problems (e.g. Merck and Citigroup) but will bias your portfolio toward large cap stocks — as smaller companies get less coverage.
4) Industry Rankings. On finance.yahoo.com, you can look at competitors of any companies and get basic statistics as to how the company compares to others in its industry. Even though the industries listed, the categorization of companies are somewhat arbitrary and the statistics listed are not enough to value the company, they can give you a good starting point.
Hopefully, these sources will help you start on your road to selecting winning investments.
(I don’t currently have any interest in the companies listed.)
Forecasts
Yogi Berra once said, “It’s tough to make predictions, especially about the future.” (The quote is also attributed to Sam Goldwyn)
I hesitate to tell people to follow Yogi Berra’s advice — in any contect — but investors would be wise to heed Berra’s warning: the future is impossble to predict. We have a rough idea of what may happen but no idea what course the future will take.
I have been “certain” that long-term interest rates are going to increase. And I haven’t been the only one — Greenspan refers to flattening yield curve (i.e. short-term rates increasing and long-term rates decreasing to the point that you can earn as much investing in short-term securities as you can investing in long-term securities) as a “conundrum.”
At some point the yeild curve will become normal — where long-term rates are higher than short-term rates, but I have no idea when this will occur. Pundits (and I include economists in this category) have have come up with ex-post rationalizations of the flat yield curve. Some attribute the phenomenon to Asian countries having excess dollars to invest and others say it’s because our economy is heading into recession.
However, the first explanation doesn’t address the fact that other countries can easily shorten the maturity of their investments. The second doesn’t jive with current economic data, including recent reports of a better job market.
Despite the fact that forecasts are notoriously wrong, the financial news is littered with columns predicting the future. For example, the most recent cover story of Barron’s (subscription required) surveys sell-side analysts to come up with a predicted increase in the S&P 500 of 6.5% for the rest of the year. Even if we ignore the fact that sell-side analysts are notoriously optimistic because their job is to increase brokerage commissions, the predictions are usually wrong.
When investing, it is best to not try to time the markets — there is no way to know what is going to happen in the short-run. All we can do is to try to win in the long-run. Do not invest because people say the market is going to go up over the next few months; do not keep cash because people say the market is going to go down. No one knows what is going to happen and — if they did — they wouldn’t tell you!
Even the best investor of all time, Warren Buffet, ignores forecasts of future growth. He often purchases companies that are projected to have rough times ahead. For example, Berkshire Hathaway, GEICO, and Wells Fargo were headed toward trouble (according to economists) when Buffett made his initial purchases.
Instead of listening to pundits, it is much more lucrative to use the past results of a company to predict the future for that company. You should look at the previous five years ROE (return on equity) and ROIC (return on invested capital) to predict the future profitablity of the company. Minor adjustments can be made to reflect very good or bad recent operating conditions to approximate returns in a normalized operating environment.
Given the difficult task of forecasting the future, it is better to do analyses of individual companies, rather than chase popular sectors. In addition, you will have the benefit of increasing returns when the tide turns and your out of favor industry comes back into favor. Currently, I am very heavily weighted in large financial companies because many of the companies in this industry have high returns on capital and low valuations. Over time, as the industry regains favor I hope to cash in on rising values — and, in the meantime, I’ll happily collect the dividends.
I hesitate to tell people to follow Yogi Berra’s advice — in any contect — but investors would be wise to heed Berra’s warning: the future is impossble to predict. We have a rough idea of what may happen but no idea what course the future will take.
I have been “certain” that long-term interest rates are going to increase. And I haven’t been the only one — Greenspan refers to flattening yield curve (i.e. short-term rates increasing and long-term rates decreasing to the point that you can earn as much investing in short-term securities as you can investing in long-term securities) as a “conundrum.”
At some point the yeild curve will become normal — where long-term rates are higher than short-term rates, but I have no idea when this will occur. Pundits (and I include economists in this category) have have come up with ex-post rationalizations of the flat yield curve. Some attribute the phenomenon to Asian countries having excess dollars to invest and others say it’s because our economy is heading into recession.
However, the first explanation doesn’t address the fact that other countries can easily shorten the maturity of their investments. The second doesn’t jive with current economic data, including recent reports of a better job market.
Despite the fact that forecasts are notoriously wrong, the financial news is littered with columns predicting the future. For example, the most recent cover story of Barron’s (subscription required) surveys sell-side analysts to come up with a predicted increase in the S&P 500 of 6.5% for the rest of the year. Even if we ignore the fact that sell-side analysts are notoriously optimistic because their job is to increase brokerage commissions, the predictions are usually wrong.
When investing, it is best to not try to time the markets — there is no way to know what is going to happen in the short-run. All we can do is to try to win in the long-run. Do not invest because people say the market is going to go up over the next few months; do not keep cash because people say the market is going to go down. No one knows what is going to happen and — if they did — they wouldn’t tell you!
Even the best investor of all time, Warren Buffet, ignores forecasts of future growth. He often purchases companies that are projected to have rough times ahead. For example, Berkshire Hathaway, GEICO, and Wells Fargo were headed toward trouble (according to economists) when Buffett made his initial purchases.
Instead of listening to pundits, it is much more lucrative to use the past results of a company to predict the future for that company. You should look at the previous five years ROE (return on equity) and ROIC (return on invested capital) to predict the future profitablity of the company. Minor adjustments can be made to reflect very good or bad recent operating conditions to approximate returns in a normalized operating environment.
Given the difficult task of forecasting the future, it is better to do analyses of individual companies, rather than chase popular sectors. In addition, you will have the benefit of increasing returns when the tide turns and your out of favor industry comes back into favor. Currently, I am very heavily weighted in large financial companies because many of the companies in this industry have high returns on capital and low valuations. Over time, as the industry regains favor I hope to cash in on rising values — and, in the meantime, I’ll happily collect the dividends.
Winning Investments
“The reason I love investing is that there is a clear-cut definition of success. If it goes up, you win. If not, you lose.”
The comments above are a very common sentiment among investors and traders. Even though I know better, when I purchase a stock and it immediately goes up, I swell with pride. If it immediately goes down, I get frustrated that I was “wrong.”
But the true test is not what happens immediately after purchase — the test is whether you were correct in your purchase of the company. Did you purchase the company for below its intrinsic value? If so, it’s a good purchase.
You can not predict the short-run price of a stock, but over the long-run — by buying companies below their intrinsic value — you can increase your chances of winning.
For example, I have purchased a lot of shares in a reinsurer over the last year. Due to recent tragic events, the shares of the reinsurer have not performed well. According to my analysis, the shares became even more undervalued and so I purchased more yesterday. Today, the stock price increased substantially (though it’s still below my initial purchase price).
But that does not mean that my initial purchases were wrong or my last purchase was right. I still believe that all the purchases were right — but it is too early to know if my analysis will be redeemed in the end.
To make matters more complicated, the actually ending is only one possible outcome out of many. Countless events occur subsequent to purchase that change the value of the company. Needless to say, there is no way of predicting what will actually happen. All we can do is make our best guess.
For example, when I purchased shares in the reinsurance company, there was no way of knowing that there would be an extremely costly event. All I could know is that the probability existed.
So how do you know when you win? Although, it’s not as exciting or instantly gratifying as looking at immediate returns, looking at long-term returns of a portfolio to a comparable benchmark is the right way to measure success. So the next time you get upset over a “bad” purchase, look into whether you should buy more and increase your chances of winning over the long-run.
The comments above are a very common sentiment among investors and traders. Even though I know better, when I purchase a stock and it immediately goes up, I swell with pride. If it immediately goes down, I get frustrated that I was “wrong.”
But the true test is not what happens immediately after purchase — the test is whether you were correct in your purchase of the company. Did you purchase the company for below its intrinsic value? If so, it’s a good purchase.
You can not predict the short-run price of a stock, but over the long-run — by buying companies below their intrinsic value — you can increase your chances of winning.
For example, I have purchased a lot of shares in a reinsurer over the last year. Due to recent tragic events, the shares of the reinsurer have not performed well. According to my analysis, the shares became even more undervalued and so I purchased more yesterday. Today, the stock price increased substantially (though it’s still below my initial purchase price).
But that does not mean that my initial purchases were wrong or my last purchase was right. I still believe that all the purchases were right — but it is too early to know if my analysis will be redeemed in the end.
To make matters more complicated, the actually ending is only one possible outcome out of many. Countless events occur subsequent to purchase that change the value of the company. Needless to say, there is no way of predicting what will actually happen. All we can do is make our best guess.
For example, when I purchased shares in the reinsurance company, there was no way of knowing that there would be an extremely costly event. All I could know is that the probability existed.
So how do you know when you win? Although, it’s not as exciting or instantly gratifying as looking at immediate returns, looking at long-term returns of a portfolio to a comparable benchmark is the right way to measure success. So the next time you get upset over a “bad” purchase, look into whether you should buy more and increase your chances of winning over the long-run.
Good Return with No Effort
Most people don’t want to put any effort into finances, but they want to see results. The bad news is: if you don’t apply yourself and you want to beat the market, you are probably going to lose. The good news is that with no effort, you can get very close to market returns using index funds and exchange traded funds (ETF).
It surprises how ordinary people think they can beat the market by following hot stocks, industries, or managers. But, the truth is, you have to put in a minimum of research to get market-beating returns (see High Returns With Little Effort).
For most people, this effort is just too boring. So, for all of you that don’t want to read annual reports and don’t want to learn the basics of valuation, do yourself a favor and don’t try to beat the market. If you bought tech stocks in the 90s and are currently buying real estate and energy stocks, if you have many different sector mutual funds, or if you have no idea what you are currently invested in, you have a problem.
The easiest way to solve this problem is to put your investments on autopilot. Using a simple strategy of buying and holding an index mutual fund or — even better — an ETF can give you close to market matching returns. They offer a market return less fund expenses — and the lower the expenses, the higher the return.
In fact, according to a recent Morningstar study, the fund expense ratio is the one piece of information that is predictive of future returns. Index funds and ETFs have lower fees than actively managed funds and so should have higher returns in the future.
If you do not want to do your own basic research, you should not take hot stock tips or speculate on hot managers or sectors; you should find a boring index EFT or mutual fund.
P.S. If you need help finding an ETF or mutual fund, you can start by checking out these ETFs: vti, ivv, spy; or these mutual funds: vfinx, fsmkx, fsemx, fsiix, fstmx, or fusex.
It surprises how ordinary people think they can beat the market by following hot stocks, industries, or managers. But, the truth is, you have to put in a minimum of research to get market-beating returns (see High Returns With Little Effort).
For most people, this effort is just too boring. So, for all of you that don’t want to read annual reports and don’t want to learn the basics of valuation, do yourself a favor and don’t try to beat the market. If you bought tech stocks in the 90s and are currently buying real estate and energy stocks, if you have many different sector mutual funds, or if you have no idea what you are currently invested in, you have a problem.
The easiest way to solve this problem is to put your investments on autopilot. Using a simple strategy of buying and holding an index mutual fund or — even better — an ETF can give you close to market matching returns. They offer a market return less fund expenses — and the lower the expenses, the higher the return.
In fact, according to a recent Morningstar study, the fund expense ratio is the one piece of information that is predictive of future returns. Index funds and ETFs have lower fees than actively managed funds and so should have higher returns in the future.
If you do not want to do your own basic research, you should not take hot stock tips or speculate on hot managers or sectors; you should find a boring index EFT or mutual fund.
P.S. If you need help finding an ETF or mutual fund, you can start by checking out these ETFs: vti, ivv, spy; or these mutual funds: vfinx, fsmkx, fsemx, fsiix, fstmx, or fusex.
High Returns with Little Effort
Don’t get me wrong — indexing is a great strategy. Indexing will beat active mutual funds any day of the week. But there are basic strategies to beat an index over the long-run — ways to enhance the return of a basic index by overweighting certain stocks.
In Contrarian Investment Strategies: The Next Generation, David Dremen shows that buying low P/E, low P/CF, low P/B, and low P/Div stocks outperforms the market index substantially.
The outperformance of the strategies over a market index vary, but any one of these strategies has outperformed the market over the long-run and there is no reason to believe that these strategies will not work in the future. The best strategy — the low P/E ratio strategy — has outperformed the market by an average of almost 4% over the study period. The worst strategy — a low P/Div ratio (or high yield) — still outperformed the market by almost 1% per year.
So, whether you are a mutual fund investor or select individual stocks, you should put a higher weighting in stocks that have a low P/E, low P/CF, low P/B, and low P/Div. Doing this will increase your odds of outperforming over the long-run. So forget all of the amazing growth stories and invest in a cheap, boring stock and laugh all the way to the bank.
With only a little more effort, you can increase your odds of beating your neighbors index fund. And, of course, trounce his actively managed fund as well.
In Contrarian Investment Strategies: The Next Generation, David Dremen shows that buying low P/E, low P/CF, low P/B, and low P/Div stocks outperforms the market index substantially.
The outperformance of the strategies over a market index vary, but any one of these strategies has outperformed the market over the long-run and there is no reason to believe that these strategies will not work in the future. The best strategy — the low P/E ratio strategy — has outperformed the market by an average of almost 4% over the study period. The worst strategy — a low P/Div ratio (or high yield) — still outperformed the market by almost 1% per year.
So, whether you are a mutual fund investor or select individual stocks, you should put a higher weighting in stocks that have a low P/E, low P/CF, low P/B, and low P/Div. Doing this will increase your odds of outperforming over the long-run. So forget all of the amazing growth stories and invest in a cheap, boring stock and laugh all the way to the bank.
With only a little more effort, you can increase your odds of beating your neighbors index fund. And, of course, trounce his actively managed fund as well.
Stocks Can Be Less Risky Than Bonds
It’s hard to escape the undeniable truth of often repeated truisms, such as you need to balance your portfolio between stocks and bonds. Even for very young long-term investors, financial advisors often recommend allocated some of your portfolio to bonds. Some, like this writer, even recommend owning commodoties to balance your portfolio.
However, this advice doesn’t make sense in the long-run. It’s true that year-to-year different asset classes will outperform, but over the long-run stocks have always outperformed. So, if you want to have more in your basket at the end of the day — and don’t care about short-term fluctuations — there is one asset class you should overweight: stocks. (An aside: commodities have been a horrible long-term investment and should be avoided — especially in times like today, when there is a speculative ferver surrounding them.)
We all know that over the long-run stocks return more than bonds. But few know that stocks are also less risky over the long-run.
The confusion stems from the fact that the risk of stocks varies widely depending on the holding period. While most measures of risk use standard of deviation of return over a one year period, the holding period for long-term investors is often much longer. Even if you are not Warren Buffett — who jests that his favorite holding period is forever — you probably hold you investments for much longer than one year.
In fact, if you are like me and plan to hold your investments at least 15 years, the risk of stocks is similar to slightly below the risk of fixed income investments. See The Future For Investors. In the land of no free lunches, this is a big free lunch for long-term investors.
The true risk (if you believe in CAPM), is the total risk of your portfolio over your holding period. However, the fact that the return is higher and the risk is lower for an asset class means more people should be allocating more of their portfolios to equities. Additionally, the models your financial advisors are using are probably wrong since they use a one-year standard deviation to measure risk and, therefore, overestimate the risk of stocks.
So, if you are a long-term investor, do yourself a favor and allocate more of your portfolio to stocks and less to bonds and commodities.
However, this advice doesn’t make sense in the long-run. It’s true that year-to-year different asset classes will outperform, but over the long-run stocks have always outperformed. So, if you want to have more in your basket at the end of the day — and don’t care about short-term fluctuations — there is one asset class you should overweight: stocks. (An aside: commodities have been a horrible long-term investment and should be avoided — especially in times like today, when there is a speculative ferver surrounding them.)
We all know that over the long-run stocks return more than bonds. But few know that stocks are also less risky over the long-run.
The confusion stems from the fact that the risk of stocks varies widely depending on the holding period. While most measures of risk use standard of deviation of return over a one year period, the holding period for long-term investors is often much longer. Even if you are not Warren Buffett — who jests that his favorite holding period is forever — you probably hold you investments for much longer than one year.
In fact, if you are like me and plan to hold your investments at least 15 years, the risk of stocks is similar to slightly below the risk of fixed income investments. See The Future For Investors. In the land of no free lunches, this is a big free lunch for long-term investors.
The true risk (if you believe in CAPM), is the total risk of your portfolio over your holding period. However, the fact that the return is higher and the risk is lower for an asset class means more people should be allocating more of their portfolios to equities. Additionally, the models your financial advisors are using are probably wrong since they use a one-year standard deviation to measure risk and, therefore, overestimate the risk of stocks.
So, if you are a long-term investor, do yourself a favor and allocate more of your portfolio to stocks and less to bonds and commodities.
Good and Bad Debt & Margin Debt
Good and Bad Debt & Margin Debt
There is good debt and bad debt. Even the IRS agrees: mortgage, business, and student debt are deductible, while credit card, personal lines of credit, and margin debt are not. (An aside: there is an option to offset investment income against margin interest, but then the character of all your investment gains changes to income — i.e. long-term capital gains and dividends will lose their special tax status and be taxed at your marginal rate.) I suppose there are reasonable reasons to favor one type of debt over another — the government wants to encourage home ownership, entrepreneurship, and education but not speculation or excessive spending.
There are good and bad debt — but the analysis is not as easy as saying one type of debt is “bad” and another is “good”. Mortgage debt is in not necessarily a good type of debt — many people take on too much debt and do not appreciate the risk of newer mortgage products. For example, Option ARMs — a mortgage with a teaser rate that allows people to buy more than they can afford — have a lot of built-in interest rate risk.
On the opposite end of the spectrum, credit card or margin debt is not necessarily bad debt. You can use either to leverage your investments. For example, some fixed rate credit cards are offered way below my current estimated cost of capital of roughly 6-8%. If I can borrow at a fixed rate below my cost of capital, I am adding long-term value.
With margin borrowing (or variable rate credit cards) you are also taking on interest rate risk and if interest rates increase, the value of your investment can decrease at the same time your borrowing costs increase. Still, especially with margin borrowing, you can significantly leverage your investments and increase value to your portfolio.
The most important problems people encounter when they use margin are: they over-leverage, they leverage the wrong investments, and they don’t manage their cash flows. The first, and most common, problem is that people leverage their portfolio to the hilt so that even a small an adverse price movement can mean liquidating part of your portfolio.
The normal person who uses margin is a risk-taker, the same sort of person who wants to invest in the next big thing. But, if you invest in more conservative run companies, with large dividend payments and low P/E ratios, you should not have as much price risk in your portfolio and will reduce your chance of a margin call.
It also helps your chances if you have positive cash flow to devote to your portfolio when the inevitable price declines come. If you are adding cash to your portfolio, there will have to be a much bigger decline in value before you need to liquidate.
I have learned most of these lessons the hard way. Now, I currently use a reasonable level of margin on more conservative investments and make sure that I have positive cash flow to devote to my portfolio when the value of my portfolio decreases. This does not guarantee that I will not have a margin call down the road, but it definitely decreases my chances while still increasing my returns.
Although most people’s goal is to become debt-free, debt can be a powerful way to increase your returns. As long as you are responsible in managing your risk, margin debt and other “bad” debt can be a good way to leverage yourself and create long-term value. However, if you are not responsible managing your risk, taking out any debt — even to purchase a home — can be disastrous.
(Disclaimer: I am not a tax advisor, so do not rely on statements contained herein — consult a tax advisor before filing. I try to be as accurate as possible but there are no guarantees.)
There is good debt and bad debt. Even the IRS agrees: mortgage, business, and student debt are deductible, while credit card, personal lines of credit, and margin debt are not. (An aside: there is an option to offset investment income against margin interest, but then the character of all your investment gains changes to income — i.e. long-term capital gains and dividends will lose their special tax status and be taxed at your marginal rate.) I suppose there are reasonable reasons to favor one type of debt over another — the government wants to encourage home ownership, entrepreneurship, and education but not speculation or excessive spending.
There are good and bad debt — but the analysis is not as easy as saying one type of debt is “bad” and another is “good”. Mortgage debt is in not necessarily a good type of debt — many people take on too much debt and do not appreciate the risk of newer mortgage products. For example, Option ARMs — a mortgage with a teaser rate that allows people to buy more than they can afford — have a lot of built-in interest rate risk.
On the opposite end of the spectrum, credit card or margin debt is not necessarily bad debt. You can use either to leverage your investments. For example, some fixed rate credit cards are offered way below my current estimated cost of capital of roughly 6-8%. If I can borrow at a fixed rate below my cost of capital, I am adding long-term value.
With margin borrowing (or variable rate credit cards) you are also taking on interest rate risk and if interest rates increase, the value of your investment can decrease at the same time your borrowing costs increase. Still, especially with margin borrowing, you can significantly leverage your investments and increase value to your portfolio.
The most important problems people encounter when they use margin are: they over-leverage, they leverage the wrong investments, and they don’t manage their cash flows. The first, and most common, problem is that people leverage their portfolio to the hilt so that even a small an adverse price movement can mean liquidating part of your portfolio.
The normal person who uses margin is a risk-taker, the same sort of person who wants to invest in the next big thing. But, if you invest in more conservative run companies, with large dividend payments and low P/E ratios, you should not have as much price risk in your portfolio and will reduce your chance of a margin call.
It also helps your chances if you have positive cash flow to devote to your portfolio when the inevitable price declines come. If you are adding cash to your portfolio, there will have to be a much bigger decline in value before you need to liquidate.
I have learned most of these lessons the hard way. Now, I currently use a reasonable level of margin on more conservative investments and make sure that I have positive cash flow to devote to my portfolio when the value of my portfolio decreases. This does not guarantee that I will not have a margin call down the road, but it definitely decreases my chances while still increasing my returns.
Although most people’s goal is to become debt-free, debt can be a powerful way to increase your returns. As long as you are responsible in managing your risk, margin debt and other “bad” debt can be a good way to leverage yourself and create long-term value. However, if you are not responsible managing your risk, taking out any debt — even to purchase a home — can be disastrous.
(Disclaimer: I am not a tax advisor, so do not rely on statements contained herein — consult a tax advisor before filing. I try to be as accurate as possible but there are no guarantees.)
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