The Sacrifices and Rewards of Gaining Financial Independence


Maybe financial independence isn’t for you.  If you aren’t willing to limit your home purchase price to what you can afford with a 15-year fixed rate loan, you aren’t ready.  If you need to have a new car every few years because you like the prestige and new car smell, it’s not for you.  If you want to go to resorts all over the Caribbean while you’re in your twenties and look good in a bathing suit, it’s not for you.  If you absolutely need to have every cable and movie channel there is while you’re in college, it’s not for you.

Well, that’s not quite true.

Actually, getting to financial independence doesn’t require you be perfect; it just requires you be better than average and take advantage of the tool you have – your income – to reach the goal of financial independence.  You might be able to have some of the things listed above, but only if you make enough money to take care of the important things first and still afford them.  You can’t be buying new cars without first putting away 10-15% of your pay for retirement.  You can’t have the expensive phone plan without saving regularly for your children’s college.  You can’t be eating out every day for lunch without putting a few hundred dollars away each month for investing.  These are the things you need to be doing to become financially independent.

I’ll periodically get a comment that the strategies I outline are not realistic.  People can’t get a reasonable home for that price.  They need a new car for work because they drive clients around.  They really enjoy travel and want to get out while they’re young.  Understand that many of the tactics I put forth are things you could do to get you towards financial independence faster.  Some suit your life, others do not.

The trick is to be doing enough and making the sacrifices you need to make to get to your goal.  How fast you get to that goal and how the status you’ll have depend on what you are willing to do to get there.  Personally I would not give up eating dinner with my family and being at the kid’s activities to work a second job, but doing so would certainly build my portfolio faster.  Some people may think it is worth the sacrifice, or perhaps it is the only way they can get to financial independence with the income choices they have.  Some people take jobs for a period of time in their lives where they work 80-100 hours a week to build up some cash, and then quit those jobs and take a more reasonable schedule once they’ve gotten over a financial hurdle.

There are also emotional reasons that go beyond money.  Maybe you want to drive an expensive sports car when you are 22 and the ability to do so is worth making all kinds of payments.  Maybe you want to travel the world while you are young and able to do things you can’t when you’re older.  Maybe you want to go to an expensive private college just so you can have the experience of doing so.  Just realize that doing so comes with a cost, so don’t be surprised when you are 45, the car is long gone, the trips are but a memory, you are still paying off the student loans and you have no money in the bank.

There are huge advantages to financial independence.  You don’t need to worry about your job because you can pay for everything even if your job vanishes, allowing you the time to find the right next job instead of needing to take whatever comes along.  You don’t need to worry about when bills are paid because you have plenty of extra cash to cover the float until the next paycheck or dividend check.  You can take more vacations, buy more cars, and send your children to expensive private colleges and have these things only be a small fraction of your income because you have so many assets adding to your income.  You’ll also pay a lot less since you won’t be paying interest on them and you might even be able to get a cash discount, so you’ll get to use your whole paycheck.

So how do you know if you are doing enough to get to financial independence?  Well, the growth of money is really quite predictable, especially with the number of online calculators now available:

1) See how much you are putting away in your 401k and plug it into a calculator to see what you’ll have if you retire at 60, 65, and 70.  Assume a return of about 12% if you are investing mainly in equities (stocks).  If you aren’t happy with the results, see where you can contribute more.

2) See how much you will have in your personal, taxable investment account.  Once again, plug the amount you are investing each month into an online calculator and see where you will be at 40, 50, and 60.  Maybe see when you will make your first million, or when you have enough to stop working if you wanted to.

3) Look at your children’s college costs and see how they compare to what you are putting away.  If the two won’t meet up, see what you can do to put more money away.  Once again, see if there are things you can cut to free up more cash to save and invest, or see if there are ways you could raise your income, at least for a period of time.  Maybe see if you can pay down some debt with a temporary second job and free up cash that way.

Some people may still say that they are not willing to give up the things needed to get to financial independence.  That’s a choice that is made.  Just realize that you have the choice and look at the longterm impacts of your choices instead of the short-term sacrifices.  You won’t get to financial inpendence through hoping.

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

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

BJ’s Restaurants (BJRI) Takes a Jump


BJ’s Restaurants, Inc. (BJRI) took a jump Friday as earnings came in better than expected.  The shares were up more than $4 per share, to almost $35 per share.  This is nice to see because I have quite a few shares of BJ’s scattered between my regular and retirement accounts.  I have also been planning to write covered calls on some of the shares, but the price has been too low.  I may take advantage fo this jump to write some calls on Monday.  I could probably sell the August $35s for $0.80 per option, or $800 for 1000 shares.  That would be a return of $800/$35,000 = 2.3% for the month, or about a 27% annualized return.  Then again, I may just sit pat since I usually find I do better if I stay long than if I write covered calls.

BJ’s is one of my longterm, core holdings, despite it not getting very much love until Friday.  Even after the jump, one columnist on Motley Fool didn’t think much of the move.  The reason that I like BJ’s is that they have a great business that has been successful at increasing earnings, plus they have room to expand.  I therefore plan to hold it both in good times when all of the newspapers and investing sites are recommending it and during the down times when everyone is panning it.  I don’t know when it may make a big jump like it did Friday, so trying to jump in and out of the stock would be very risky.

During down times I accumulate more shares.  I have faith in the business, so when the shares drop and become inexpensive, I buy more.  I may sell a few shares, or write covered calls on some of the shares I hold, if the price shoots up to the point where it is expensive relative to expected earnings.  I still keep a core position, however.

So would I ever sell?  I follow the annual reports and watch the commentaries in Value Line Investment Survey, which come out about every three months for BJ’s.  I don’t worry about short-term impacts like dips in the economy or small missteps.  I see what management and Value Line thinks of the longterm prospects.  As long as it looks like the company will continue to grow, I’ll hold on.  If it looks like they have grown about as much as they will, or if it looks like a new management team is changing the fundamentals of how the company is run, I’ll probably sell out.  Otherwise, I’ll stay in, taking out money here and there.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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

Sometimes A Lagging Investment Return is Good Enough


I always hate it when I look at the returns in my 401K because, while they may be really good some periods, they aren’t as good as they could have been.  I have my 401k funds invested about as follows:

15% Large Cap Index Fund

20% International Index Fund

15% Large Cap Value Fund

15% Mid Cap Index Fund

10% Small Cap Index Fund

10% REIT Fund

7% Developing Markets Fund

8% Convertibles Fund

Note that I currently don’t hold any bonds, since I think interest rates have nowhere to go but up, making bonds risky.  Instead I have the REIT fund and the convertibles fund that provide investments somewhat uncorrelated to the equity investments and which also provide some income to soften the blow during down markets and provide return when the markets are stagnant.

Lately the small caps and mid caps have trouncing the large caps.  I therefore have 25% of my portfolio going up 35-45% per year, while the rest is only going up by 15-25% per year.  Looking at this, I can’t help but wish the large caps were doing as well as the small caps, or that I had a lot more in small caps.  International also did badly earlier in the year, although it has recovered somewhat lately.

These feeling of wanting to chase returns are natural, but miss the whole point of diversification.  It is true that I am not doing as well as I would have been if I had put 100% into the small caps fund.  Still, I am doing better than I would have been if I had invested it all into large caps, a bond fund, or the international fund.  Because I have some money in small caps, I do better than I would have if I didn’t hold any small caps.  Likewise, if large caps do well over the next year as analysts expect them to do, this becoming an old bull market where large caps tend to outperform small caps, I’ll do better than I would if I were entirely in small caps.

In fact, small caps have done so well that many analysts think they may be due for a correction or at least a breather while they wait for earnings to catch up to their lofty prices.  It that is the case, I’ll be happy to be partially in large caps instead of being fully in small caps, thinking that the rally will continue for another year.

Because I don’t know which segment of the market will do better this next year, I want to have some money everywhere.  That way no matter which segment is having a good year, I’ll be making money.  If I have two investments, one that makes 12% and the other that makes 20%, if I hold equal amounts of each I’ll make 16%.  This isn’t as good as I could have done if I had invested it all in the second investment, but still  it is a lot better than I would have done if I had been wrong and invested it all in the first investment.

So when investing in a 401K account, or investing a large amount of money in general, sometimes you need to settle for good enough.  The truth is the analysts don’t know what will do the best during any period of time and neither do you.  You always want to have some money in the winning area, even if it means you don’t have all of your money there.

Does this mean you should always have bonds and fixed income investments as well?  No.  While bonds may be the big winners over stocks in some years, over long periods of time bonds don’t perform as well as stocks, and therefore you’ll be giving up a significant amount of income if you are 50% in bonds, say, from the time you are 20 until the time you are ready to retire.  Bonds are for the time when you are nearing retirement and need to worry about wealth preservation more than growth.  Before that, most of your money should be in stocks.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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

What is a Buy-Write Fund? Can a Buy-Write Fund Provide Income?


Today I was looking at the prospectus for the PowerShares S&P 500 Buy-Write Portfolio (symbol PBP).  This is a buy-write fund that buys shares in the companies in the S&P500 index and then writes covered calls on those shares for the next month at the next highest strike price.  They attempt to match the performance of an index created by the Chicago Board Options Exchange (CBOE) called the “CBOE S&P500 BuyWrite Index.”  Of course, the index has no fees or trading costs, while the index fund does, so the buy-write portfolio will never quite match the performance of the index.  Still, the fees aren’t that outrageous, coming in at about 0.70%.  The trading costs are necessarily high since they must write options each month.

(For those unfamiliar with options, a call is a contract in which you agree to sell your shares for a specified price, called the strike price on or before a certain date, called the expiration date.  In return, you receive some cash called a premium.  If the shares are at or above the strike price when the expiration date comes, they will normally be bought buy the person who bought the contract from you.  If not, the contract will normally expire worthless and you get to keep the premium.)

PBP has done poorly relative to the S&P500 Index.  This is because the index has been on a tear lately, shooting up in price and making new highs.  When this happens, the index fund managers need to buy back the calls at a loss each month, so while they make some money on the increase in the value of the shares, they don’t make as much as they would have if they had just held the shares.  Therefore the fund has a positive return but they don’t do as well as the underlying index.

The performance, however, from 2007 until 2012 was right in line with that of the S&P500 index or even a bit better at times.  For example, during the 2008-2009 period the S&P500 index fell by about 50% while PBP only fell by about 30%.  This is because the premiums they were collecting from the options were offsetting the decline in the value of the shares.  They would also do a lot better than the index in periods where the stock market was essentially flat or trading within a range since they would be collecting option premium payments all of the time that the index was going nowhere.   Also, the greater the volatility, the greater the price of the options that would be sold.

One question is whether such a fund would be a good replacement for something like a bond fund for steady interest since there is cash generated by the options being sold.  It does not look like a good time to buy bonds with interest rates ready to increase if the economy ever starts to improve and the Federal Reserve ever takes their boot off of the neck of short-term rates.  In addition, bond rates are barely worth the money since they are so low.

PBP returned about 9% over the last year and 7%+ annualized over the last three years.  Looking back further, the performance is even better, with an annualized return of over 10% during the last five years.  The S&P500 index did much better over the period, providing an annualized rate of return of over 19% for the period, but the Vanguard Total Bond Market ETF only returned 4.7% annualized over the last five years.

Obviously when you are getting a better return, you are taking more risk.  While a buy-write portfolio is safer than buying stocks outright, they have risks that bonds don’t have.  With a bond, assuming the company issuing the bond is able to repay their loan to you at the maturation date of the bond, you will get the par value no matter what the price of the bond does in the mean time.  With a buy-write portfolio, there is nothing to say that the stocks on which the calls are written won’t fall through the floor and stay down for a period of time.  Stocks like those in the S&P500 aren’t likely to go down forever (and if they do, you’ll have a lot of other things to worry about because the US economy will basically be gone), but they could take a nasty spill just when you need the money if you have too much invested right before retirement or another life event.

Still, with bonds looking so pricey and so risky, a buy-write portfolio might be a good place to look.  There will be some protection from inflation since the fund will hold equities, although not as good a protection as holding equities only would have.  It also can provide an income, and you will be making money even when the stock market is stagnant.  It will also decline less than the stock market during downturns as we saw back in 2008.  PBP, or perhaps another buy-write fund may deserve a place in your portfolio.

I will consider buying in with my IRA this year.   Note that an IRA is the place to have interest and dividend generating stocks since the income produced will be taxed each year in a standard account even if you reinvest the dividends.  This type of fund will go nicely with my other income generating assets like my REIT funds.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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

Understanding the Risk and Return of Individual Assets


There is a difference between the return of individual assets and that of a group of those assets.  There is also additional risks involved.  Having a clear understanding of the difference  in the behavior and return of individual assets and the whole market is critical when making financial decisions.  Unfortunately, many people make decisions with individual assets based on the behavior of a group of assets or an entire market.

One prime example is the reverse mortgage.  In a reverse mortgage, one borrows against the equity in their home.  One popular way of doing this is to take payments from the mortgage company for a period of time, the time period of which is based on the age of the homeowners, the size of the payments, and the value of the home.  During the period during which you are receiving payments, this is like a traditional mortgage, but in reverse.  At first the loan value will grow almost entirely due to the equity you are removing.  As you get closer to the end of the payment cycle, however, the amount of interest added to the loan value increases drastically, making most of the increase in loan value due to interest.  This is similar to the start of a traditional mortgage where the first payment of $1000 may be $50 in principle and $950 in interest, while the last payment may be $950 in principle and $50 in interest.  The bigger the balance of the loan, the more interest is paid each month.

There is a big difference between the average rate of appreciation for the entire housing market and the rate of appreciation for an individual home, or even an entire community.  It is true that the average home will appreciate at a rate somewhere near the rate of inflation, plus a little bit more because the number of people in the world is growing and the number of people buying homes is increasing.  If you factor some average rate of appreciation into the calculations when projecting the amount of equity that will remain after a certain period with a reverse mortgage, this can lead to misleading results.  It can make it lo0k like taking out a reverse mortgage isn’t much worse than selling the home and buying a smaller home, but there is a huge amount of uncertainty in the assumptions made, which in turn greatly increases the risk of the transaction.

As an example of this mistake, see the comment stream in Reverse Mortgages — Run Away, Don’t Walk.  Newechm, who claims she sells reverse mortgages, states:

“So if the [$450,000] home sells and you buy a $250,000 condo, you can offer the seniors $8000/year given $200K invested. If there is no market correction or LTC need you will have a total of $200K plus $80,000 plus new home value $370K = 650,000

With the reverse you will have the same annual draw $8000 and the home value will be $666,100 after ten years. There will also be a line of credit available of $208,000 to handle any LTC needs if they arise and the funds are protected and guaranteed, no matter what the market does they are there. The total remaining equity available will be $535,680. So the total is $615,680 it is only $35,000 difference in ten years, not $203,000. “

The home that was worth $450,000 at the start of the reverse mortgage is assumed to be worth $666,100 now after ten years.  How did that happen?  She is assuming that the value of the home increases by something like 5% each year as if it were money deposited in a bank account in the 1970s where you could be sure of earning 5% every month like clockwork.  The housing market in general doesn’t work like that, however.  If you look at the price of homes over a long period of time, like 50 years, you may find that you’ve made the equivalent of earning 5% per year (a 5% annualized rate, as the accountants would say).  In actuality, however, you had some years where home prices increased 20%, and others where they lost 15%.   You could have a period during those 10 years where you have the reverse mortgage where home prices only rise by 1-2% total, or even have a year like 2009 where prices drop significantly.

Individual cities and neighborhoods are even worse.  As any realtor will tell you, all real estate is local.  There are areas where the value doesn’t increase at all for ten or twenty years and then there are areas that prices double in a few years.  There are areas where home prices get really expensive and then fall back down to reasonable levels (see Phoenix or Las Vegas).  There are even places where home prices implode and may not recover for twenty to fifty years (see Detroit).

Within a neighborhood, not all homes increase the same way.  You may have a pool when no one wants to own a pool, so no one wants to buy your house even though others without pools are selling.  Your home may be too small or two big, or your appliances may be too dated.  You might need to put $100,000 into your home to sell it, and where are you going to get the money to do that when you’ve tapped out a reverse mortgage because you didn’t have any other money to use for food and medicine?

What happens in the example above if the home stays at $450,000 during the life of the reverse mortgage, which is entirely possible for a single home over 10 years?  Well, you owe $130,000 to the mortgage lender (home value, $666,000, minus equity, $536,000 ) and you have gotten only $80,000 from the lender ($8000 per year times 10 years), so you therefore have paid $50,000 and change to the mortgage lender.  Note that number is certain.  You’ll owe it no matter what that home price did.  After the ten years, you’ll continue to see equity sucked out of your home and you’ll be paying the interest rate on the entire loan balance, which will only compound since you are not making payments.

If you had sold the home and bought a smaller one, you would have that money minus realtor and moving expenses, or maybe $50,000 – $30,000 = $20,000 more.  You would also have invested the proceeds in a diversified group of assets, many of which are fixed income, and you therefore would have gained additional income there instead of paying out interest.  Because you are diversified and because many of the assets are fixed income your chances of making a good positive return there is much higher.

If your goal is to stay in you existing home because it has high sentimental value but you have no other money to live on, a reverse mortgage is a way to do that.  But you pay a high price and would be much better off moving down in home.  One option I’ve seen is to sell the home to your children and then subdivide the land and build a smaller home next door.  If you have enough land, this might be an option to explore.

In any case, don’t make the mistake of assuming an individual asset will provide the return of the whole market, and don’t let anyone convince you to make a purchase or sign a contract with calculations that do so.  This goes for individual homes, individual stocks, or individual businesses.  Unless it is a bank account or a CD, expect returns to be unpredictable without a lot of time and a lot of diversification.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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

Are You Winning with Money?


Recently I’ve been engaged in a debate with a reverse mortgage advocate on whether reverse mortgages are a great way to provide money for retirement or an expensive loan that takes hard-earned equity from old people.  You can see the comments here, in Reverse-Mortgages:  Run Away Dont Walk.  I doubt we’ll ever get agreement on the best approach, but the best result from a purely mathematical basis comes from when you downsize your home and then use the equity you free up to create a retirement portfolio.  In that case you are receiving interest.  In the case of the reverse mortgage you are paying interest, and a lot more interest than you would pay to purchase the home with a conventional mortgage for reasons I go into in the comments. You might want to do the reverse mortgage if it is your only choice and you absolutely cannot downsize to another home, but the higher price you pay is the cost of the choice you make.

But the real sad thing is the scenario presented where you have a couple that has to tap the equity in their home to pay for expenses.  People shouldn’t be in the position in their retirement years where they need to start using the equity in the home they’ve worked so hard to pay off to cover retirement expenses.  I see nothing wrong with selling a big home and freeing up the equity because you want to use the money for other things, but it is different when that and Social Security is all you have (and don’t count on Social Security – it’s not a good plan with the country looking at $20T in debt in the next couple of years).

I’d like to see my readers being smart with money starting from a young age, such that you are a decamillionaire or even a centamillionaire by the time you retire so that you have plenty of money to live on.  Not only would that provide a lot more security and ensure no worries about running out of money, but it would allow you to take more risks and increase your retirement income.  So the question arises, where should you be to get there?  Here are some ways to tell where you are financially, going from the bottom to the top.

In deep trouble, in risk of bankruptcy:  Obviously if you have a huge amount of debt you are near bankruptcy, but what are the early signs?  If you have credit card debt and find that the balances are growing each year, you are slipping into serious financial trouble.  Even if you are finding that you need to use the cards to float bills for a few weeks each month, you are just one emergency away from getting into a hole from which you’ll find it hard to get out.  If you are in this situation, the first step is to gain some extra income from an extra job so you can pay down some debt and create a positive cashflow where your income exceeds your expenses each month.  Then, budget and work to keep paying down your debt until you become debt free.  The bigger the hole the slower will be the start, but keep working and eventually you’ll get onto firm ground.

Debt free, no credit cards, but no savings:  This is a better place to be than to be using credit cards, payday loans, and the like, but if all of your money is going out the door each month and you don’t have any money set aside for emergencies, you could easily see yourself in a situation like a car accident or even a car repair where you could take on some debt that will push you over the edge.  Here you need to gain some income or cut some lifestyle for a period to build up an emergency fund of about $10,000-$15,000.  This is cash that will be there to pay for any curve balls that come your way and keep you out of debt.

Some cash in the bank, but no investments.  You are better off than probably 75% of Americans, but you will have trouble in retirement and have trouble paying for your kid’s college.  Try to cut back lifestyle enough to put 10-15% into retirement like a 401k or an IRA and start an educational IRA or 529 plan for your children’s college costs.  You’ll need the money sooner than you think.  One plan is to direct more to retirement with each bonus or raise so that you won’t miss the money.  Also see if you are paying too much for your home – payments of no more than 25% of your take-home pay is an amount that will allow most people some freedom to invest.

You have an emergency fund and fully funded retirement and college accounts, but no other investments.  This is fantastic.  You’re doing better than a large majority of Americans, but you’ll not be financially independent until retirement.  For that to happen, you’ll need to invest in a taxable account you can access for expenses before retirement age.  See if you can free up some money each month for investing, even if it is only a few hundred dollars.  It may start small, but you’ll be surprised at how far you go in 10 or 20 years.

You have a net worth of your age x your salary/10 or more:  This is the definition from The Millionaire Next Door for individuals who are likely to become wealthy in their lifetimes.  This puts you in a very select group of individuals.  Keep it up from the time you are in your mid twenties and you’ll not need to worry about money by the time you reach your mid-forties.

How are you doing with money?  Are you winning?  Can you do better?  I’d love to hear your story.

Follow on Twitter to get news about new articles. @SmallIvy_SI

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

What is Value Investing?


There are two main investing styles – momentum investing and value investing.  Momentum investing is investing in growth.  Finding stocks that are growing fast, therefore increasing in price rapidly, and buying them regardless of the cost.  People who are buying things like Google and Facebook are momentum investors.  They are buying what is hot, expecting it to stay hot, at least for a while.

Value investing is just the opposite.  Value investors are like the guys who listen to alternative rock and hate it when one of their favorite bands makes it to the radio.  They try to find the stocks that no one would touch with a 20-foot pole and buy them.  They are trying to find stocks that are so beat up that they can scoop them up on the cheap.   They then hold and sell then when the stock turns around and becomes in vogue again.

For the last several years, value investors have been losing out to momentum investors.  Growth funds have been on a tear, shooting up like 4th of July fireworks while value stocks have done well but lagged behind.  This is common in a bull market, however.  As people get used to getting richer, they start to chase the hot stocks since they think the big returns will repeat again and again.  They don’t want to miss the next big thing.  The trouble with momentum investing, however, is that it relies on the bigger idiot theory – that just because you overpay for a stock doesn’t mean there won’t be a bigger idiot right behind you willing to overpay even more.  The trouble is, however, that eventually you run out of idiots and you can be left holding the bag.

John Buckingham wrote a good column on value investing in the June 16th, 2014 issue of Forbes.  There he points out that while value has lagged growth lately, history has shown that value investing is the better approach.  Since 1978, the Russell 3000 Growth Index has lagged the Russell 3000 Value Index by a 10.7% to 12.4% annualized rate of return.  Looking even longer term, value stocks beat growth stocks 13.7% to 9.4% since 1926.

Don’t think that value investing is safer than growth investing, however.  When you are value investing, you’re buying stocks that have declined in price, sometimes dramatically.  You might be betting on turnarounds, but turnarounds don’t always come rapidly, if at all.  Sometimes a stock falls through the floor and stays there for years.  I was a big fan of Pacific Sunwear for years.  The teen retailer seemed impervious to downturns in the economy even when adult retailers were seeing their customers stay home.  The company misstepped, however, branching out into everything from shoes to girls wear, and suddenly they were no longer cool.  The stock fell from the mid-twenties to the $2-$4 range and stayed there ever since.

One of the stock mentioned in John Buckman’s article is one I have been holding for a little over six months, Ensco (ESV).  The company makes offshore drilling rigs, which I saw as a good way to invest in the energy market.  They have seen some cuts in the rates they can charge for their rigs,  and my position is down about 6% right now.  Still, as Mr. Buckingham points out, the stock is paying about a 6% dividend, which gives a bit of comfort while waiting for the stock to do something.  I will probably reevaluate after about a year, and either buy a few more shares or cash out.

In general I don’t go into turn-arounds.  I’ve seen to many languish for years, waiting for the changes the company is making to produce results.  I normally instead find stocks that are good values but which have shown consistent growth.  I find these are a lot more predictable.  Still, there are times when a stock gets really cheap compared to earnings and even dividend that you can’t help but bite.

What about in a 401K plan or an IRA where you are investing in funds?  Should you buy a value fund since they outperform growth historically?  Should you stick to growth since it has beat value for the last several years?  Probably the best answer is to buy both.  You will never have all of your money in the style that performs the best at any given time, but you will always have money in the winning style.  That is often good enough.

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