Against the Standard Advice

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

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

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

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

4)  Find stocks with good dividends to supplement growth.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Picture Credits: Jorge Vicente, downloaded from stock.xchng

Investing Your Child’s Money For His Or Her Future

Today the news is full of stories of children returning home to stay after college.  The recession has certainly made it difficult for some to find jobs.  In some cases parents may also be making their homes a little too comfortable. With few rules, no expenses and no responsibility, who wouldn’t want to stay?

By starting children out early learning about saving and investing, and by giving them a little nest egg with which to start, you can dramatically reduce the chances that they will be knocking on your door, duffel bag in hand after college.

Starting an investment fund can be very quick and easy.  It simply takes a couple thousand dollars and some mutual funds.  If you start a fund about the time they are born, and add to it as they get those checks from relatives early on, and then match their contributions once they start to earn their own money, you can build up a substantial fund by the time they leave the house.  This is money they can then use when they have the unexpected expenses that always occur instead of running up credit card debt.

The first step is to find a fund family with a low enough minimum.  I personally like Vanguard because their funds have very low expenses and the minimums for many of them are only a couple of thousand dollars.

You are looking for a fund that invests in a large number of stocks over a broad range of the market.  Good choices would be a largecap fund such as an S&P500 fund or a midcap or smallcap fund.  Selecting specific sector funds or ETFs is probably not a good idea since you want something you can hold for years rather than needing to move in and out of it, incurring capital gains taxes.

Once you have selected a fund, simply create a custodial account in the child’s name and send in a check.  As time passes, add extra money to the fund.  You should avoid the temptation to make many if any changes – you want to minimize expenses and taxes.  Just let it grow with the economy.  If you need to do something, wait for dips and buy more shares.

Once the fund has grown large enough, you should consider selling part and using the proceeds to buy another fund in a different sector of the market.  For example, if you’ve amassed $15,000 in a largecap fund, you may want to sell half and buy a smallcap fund.  This diversification will reduce the risk of losses and smooth out the fluctuations that occur.  In general, different sectors of the market do well at different times.

Note that capital gains and dividends will be tax-free below a threshold amount, but be sure to check with your accountant on what those minimums are in any given year.  They are generally less for investment income than earned income.  You may also need to file tax returns in some years if the income is large enough even when they haven’t made enough to pay taxes.  Payment of quarterly estimates may also be required.  Minimization of trading, and thereby the realization of gains, will delay the time at which you will need to start preparing tax returns for their accounts.

Once the child reaches 18, the money will be theirs (you have no say over this).  You therefore should have been teaching them all along that the money is there to help them in emergencies, such as when the car breaks down, and not just for day-to-day expenses.  You should also be teaching them to leave the principle alone and just spend the interest/dividends.  In that way, even though they may waste some, hopefully there will be enough remaining when they are older and wiser to help secure their financial security.

By giving your children a nest egg with which to start their lives, you can help keep them out of debt, help them have a down payment for a house when they are ready, and be able to stay out on their own between jobs and other issues. You will also give them an extra source of income that they can use throughout their lives.

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

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

Investing within a Health Savings Account

I’m excited that my company is finally offering a Health Savings Account, or HSA.  This is what the Medical Savings Account and Flexible Savings Account should have been, and what all health plans will probably become in the future after companies discover that other methods cost too much and enough employees start to wonder where all of that money they are putting into health insurance goes.  Here’s how an HSA works:1.  An employee opens up an HSA account.  This is his or her account, meaning it is not connected with the employer and is not lost if the employee leaves or the company goes bankrupt.

2.  The employer can choose to put money into the HSA.  The employee can also put money into the account, like an IRA.

3.  The employee can withdraw money from the account as needed for medical expenses.  Because the company is not involved in deciding what is or is not a medical expense, they no longer need to have your health information.

4.  Large expenses (long hospital stays, organ transplants, etc…) are covered by a major medical insurance plan either the employer offers or the employee buys.  These types of plans cover expenses after a large deductible – say $5000 or $10,000.  Because this is true insurance – most people won’t use it during any given time - instead of prepayment of medical services as is a PPO plan – this will cost a lot less.  Think of how reasonable car insurance is compared to health insurance.  The reason is that most people plan to make use of their health insurance each year and don’t care about the cost of the services provided, but only use their car insurance if there is a serious accident.

The reason I believe that HSA will work a lot better is that people will be saving up their own money for their own medical bills.  Unlike existing PPO plans, there is no “use-it-or-lose-it” feeling.  The money stays with you and builds up over time.  You can even invest it in mutual funds. 

This means that you are building up money while you are young that you can use when you are older and have more medical expenses.  Because it is your money, you should also have more choice on how you receive care.  For example, hiring a home nursing aid rather than going to a nursing home when you need a bit of help around the house.

As said, you can also invest inside the HSA once the balance builds up large enough (over $1000 in my case).  The question then arise, how to invest in such a case.

In an HSA, a good portion of the money must be available to pay for medical expenses during the year.  I therefore will allow funds to build up until I have about a typical 1-year’s worth of medical expenses in a money market before I start to invest at all.

There may also be some years that are worse than others and we’ll need to draw more.  For example, if someone breaks a leg or there is an appendicitis or something.  I therefore want to reduce the risk that the account will drop in value a lot right when I need the money.  Once I get to the point of investing,  will therefore buy a mix of bonds and other fixed income securities that will provide a steady stream of income and reduce volatility.  I will also buy some larger, well established companies that pay dividends (for example, an S&P500 fund).

Hopefully my family will remain fairly healthy and therefore the balance will continue to build up.  This means that eventually there will be so much money in the HSA that I can start to buy some stocks that provide more appreciation to make the balance grow faster while still having enough funds to take care of any expenses that come up.  For example, if I have $30,000 in the account, I will be able to take care of a couple of major medical occurrences (remember that the major medical insurance will cover the majority of these bills).  I therefore might spread some of the funds into a small cap fund or an international fund.

As always with mutual funds, expenses are the key.  I therefore will try to find funds in each category with a low turnover rate and low expenses.

Please send investment questions to vtsioriginal@yahoo.com or leave them in a comment.

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

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

Buy and Hold No Longer Works

In their annual Investing Guide, Forbes Magazine’s first “new rule of money management” is that buy and hold will not work anymore.  They say that you must pay a lot more attention to your accounts, being ready to “sell losers and buy into trends.”

There are several investing rules that have been learned over a long period of time.  I’ve found that whenever people start saying that the old rules don’t work anymore, those people are about to be proven wrong.  For example, back in 1999 everyone was saying that it was no longer important for a company to have earnings.  You just needed to become big faster than anyone else and worry about earnings later.  We saw start-up companies with offices in multiple cities right after the IPO, buying ads on the Superbowl despite losing thousands of dollars peach day.   Anyone see the Pets.com sock puppet lately?

It is true that buy and hold has not worked well over the last ten years when one looks at the entire market.  The S&P has barely moved at all during that time and one would have been better off with money in a bank CD than in an S&P500 mutual fund.  Then again, we’ve had two big bubbles burst during those years, so it is not a normal stretch of time historically.

Even still, if you had been dollar cost averaging – buying shares at regular intervals – or buying on the dips, you would be well ahead now even though the market was flat.  Shares of an S&P 500 fund bought after the 2008 in early 2009 crash would have returned over 100% over the next two years!

There have certainly been some individual stocks that have done very well during 2000-2012 as well.  Examples are Apple Computer, AFLAC, and Rollins (who owns Orkin Pest Control).  If one had bought and held those stocks you would have doubled your money a couple of times during that period.  Just because the market it flat does not mean that there are no good investments.  Even in bad economic times, people still need food and coffins.

The thing about the market is that is tends to have a lot of years of going nowhere and a few periods of huge gains.  While it is wise to do as the article suggests and sell out of stocks that are not doing well (and here we mean that the company is not doing well, not the stock price), trying to jump in and out of the market will just result in missing the big upswings and missing out on a lot of the possible return.

Finding great companies and using buy and hold is the only way to beat the returns of the market.  Trying to time the markets is a sucker’s game.  Don’t be ready to throw out the rules that have been developed through observations of markets for over a hundred years just because we’ve hit a rough patch.

To contact me, please email vtsioriginal@yahoo.com or leave a comment.

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

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

Writing Covered Calls – An Example

A while back I spoke of covered call writing, which is one of the only ways anyone should use options.  (The other way is to protect a position from a loss by buying a put against an open position – essentially buying insurance on a stock.)  When one writes a covered call, you write a legal contract that will allow someone else to buy the shares from you at a specified price (the strike price) before a specified date (the expiration date).  In exchange, they buyer of the calls gives you money (called a premium).

I typically don’t write covered calls because I find I almost always can do better just holding the stock.  About a week ago, because the return was just too great, I went ahead and wrote a call on some Aflac stock I own.  The stock was trading at about $44.5 and the January calls, expiring on January 21st – about three weeks away – were selling for a premium of $1.10 per share.  This means I would receive $110 for each call I wrote (a call option comes in 100 share increments).

If the stock does not close above $44 per share by the 21st, it is likely that the call buyer will let the call expire worthless, meaning I’ll get to keep the premium.  If I could do this every month for the next year, I would earn about $110*12 = $1320 for the year – about a 30% return.  Considering I was only writing a call for 3 weeks, the return was actually closer to 40%.  Not many stocks go up 40% in a year, so it was a really good return.

If the stock goes up, once it moves above $44 per share I will no longer be making any more gain on the appreciation since the call buyer will be likely to exercise the calls and buy the shares at $44 per share.  Today the stock is at about $44.30, so I will likely lose the shares if the price stays high.  I will still make a profit since I’ll get to keep the premium and receive more for the shares than I paid for them if the calls do get exercised and I lose the shares.  If the stock goes to $50 a share, however, I’ll be kicking myself since I’ll only receive $4400 + $110 – $4510 per hundred shares and I could have sold them for $5000 if I had not written the calls.

The bigger danger, however, is that the stock may drop in price.  If it drops below $42.90 per share, I would have been better off to simply sell the shares at $44 per share.  The good news though is that I will have lost less than if I had just held the shares outright since I will have received the money from the premiums.  The bad news it that I’ll then need to decide if I want to write additional calls at a lower price – $42 per share say - and possibly lock in the loss, or wait until the price recovers a bit before writing calls.

Keep following and I’ll update my progress on the position as we get closer to next Friday when these calls expire.

Please send investment questions to vtsioriginal@yahoo.com or leave them in a comment.

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

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