Will the Mortgage Settlement Affect your 401K Investments

I received an interesting letter from my Senator, Bob Corker.  As many of you will recall, there was a settlement recently from the large banks who are doing foreclosures and the states.  In the lawsuit, the banks were accused of not correctly filing paperwork for the foreclosures they were doing.  This was the “robosigning scam” where there was so many foreclosures going on that officials were (allegedly) signing some of the documents using machines, possibly without reviewing them.  As a result of the lawsuit, the banks agreed collectively to pay $26 billion, including $6 billion to the states as a fine.

I’m hopeful that no one was wrongly foreclosed upon as a result of this scandal.  I’m also hoping, however, that no one who did owe the money and who just decided not to pay did not recieve money from this settlement.  I’ve heard of too many people who find little loopholes in the laws (like saying that the type on their documents was too small) to get out of paying money they legitimately owe.  Playing that game hurts everyone, from shareholders in the banks to the next people who get mortgages (since their rates may be higher).

As is usually the case in these types of lawsuits, the people who end up paying aren’t the ones responsible for the wrongdoing (if there really is any in this case), but investors who come later.  Often when there are shareholder lawsuits for some type of wrongdoing by the executives, it is the same shareholders who saw their investments crash who end up paying out the settlement money (since the company, of which the shareholders are owners, ends up paying the money).  A lot of this money then tends to go to the lawyers who brought the suit.

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.

 

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.

Dividend Reinvestment Plans

One way for those who are starting out with a relatively small amount of money to buy shares cheaply is through dividend reinvestment plans (or DRIPs).  DRIPs are offered by dividend paying companies as a way for existing investors to buy more shares of the company.

In a dividend reinvestment plan, the company will issue additional shares of stock to the investor instead of a dividend.  In this way, your money gets reinvested in the company rather than building up in your bank account.  If you do not have a need for the cash right now, or you have so few shares that the dividend is only $10 anyway, this can make a lot of sense.

Another advantage of using DRIPs is that many companies allow you to also send in additional cash to buy shares directly from the company.  This is usually far cheaper than buying shares through a broker since you will not need to pay commissions.  This will not make much of a difference if you are buying 500 shares at a time, but if you’re sending in $50 a month, buying shares through a broker would not be practical since the commissions would eat you alive.

While the amounts may seem small, the effect of dividend reinvesting can be huge over time.  As an example, I bought 90 shares of Duff and Phelps Utility Fund (DNP) in 1996 in an IRA.  The fund pays about an 8% dividend, with distributions sent monthly.

I placed the company on dividend reinvestment.  Initially I was buying less than one share per month (actually, I think I was getting as full share about every two months, or six shares per year).  While this was nothing at first, eventually I had enough shares that I was receiving a full share and then some each month.  At this point (16 years later) I have more than 250 shares of the fund.  Despite the fact that the fund rarely rises above $12 per share and I bought in at about $8 per share, I have more than tripled my money because I have been reinvesting dividends.  Compounding is amazing, given time.

There are some drawbacks to dividend reinvestment plans, however.  The first is that most stocks that pay large dividends and have DRIPs are late in their lives.  You therefore will not get the price appreciation (typically) that you would from a smaller, newer growth stock.  For young investors who are growing assets over a long time horizon, growth is the main goal.

It is not a bad idea to have a few of these stocks in your portfolio, however, as they lend stability.  You can also use a stock with a DRIP as a way to build up cash through regular small investments, then sell the shares and buy a growth stock when the amount of capital grows to a few thousand dollars and you can buy 100 shares or more.

The second drawback is that you must keep track of your cost basis as you buy the additional shares for tax purposes.  The solution here is to use DRIPs in a tax deferred or tax-free account (e.g., an IRA or a Roth IRA).  Otherwise, keep track of when you bought shares and what price was paid (don’t trust your broker – they will lose your cost basis periodically).  This can be done in a spreadsheet or ledger.  If you don’t like this, write to Congress and tell them you want the Fair Tax.

Happy DRIPping!

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.

What PE Ratio Range Should be Used When Buying Stocks?

(Reader’s note – the PE, or Price Earnings ratio, is the price of a stock divided by its earnings per share.  It is a widely used measure to determine how expensive a stock is when compared to its peers or the market.)

There are two camps of investors – Value Investors and Momentum Investors.  Value investors look for stocks that are underpriced, buy them until they are overpriced, and then sell.  Momentum investors find stocks that are going up, buy them, and then sell them when they start to slow their ascent.  Value Investors buy low and sell high.  Momentum investors buy high and sell higher.

With a PE of 90, that stock would certainly not be of interest to Value investors.  It is really high in price.  The average PE for US stocks is typically around 15, although it varies by industry.  Value investors would be looking for PEs of around 10 or less.

It might be of interest to momentum investors, but even for them, a PE of 90 is pretty rich.  If you are buying based on the greater idiot theory (figuring you paid too much but you can sell it to someone for more), obviously when the price gets to a certain point you start to wonder if you’ll end up being the greatest idiot.

Unless the earnings are expected to jump way up and justify the price (like earnings are expected to double or triple), I wouldn’t touch the stock.  You are likely to see a decline, or at least see it sit in the same price range for years while earnings try to catch up to the lofty price.  Some of the great growth stocks do have PE’s in the 30′s of even 40′s, however.  For example, Home Depot regularly had a PE in the 30s while it was still a hot growth stock.  It’s rate of earnings growth justified a high PE.  It was an industry leader.

I can see few stocks justifying a PE of 90, however.  I would put my money somewhere else for now and watch your stock to see if it becomes more reasonably priced.

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.

What You May Not Know About the Payroll Tax Cut (Social Security Funding Decrease)

If you were following the news at all before Christmas you probably know that the Republicans once again put politics before their principles and agreed to a two-month extension of the payroll tax holiday.  As is a Republican tradition, they of course did this only after doing as much damage as possible by saying they would not extend the tax holiday.  They thereby managed to irritate both their base who was calling for an end to the holiday and the general public who wanted the holiday extended.

Here are somethings that were not widely reported about the deal, however:

1.  The “Payroll Tax” is the funding paid by workers and businesses to fund Social Security.  Up until about a year ago, workers and their employers each paid 6.2% of the worker’s salary into the system.  Since the holiday, the worker is paying only 4.2%.  This means that the funding for Social Security has been reduced, increasing the rate of demise of the system.  To protect yourself, all SmallIvy readers should put the $1000 not paid into Social Security this year into an IRA.  You have until April 15th.

2.  The bill also included an extension of unemployment benefits and the “Doc Fix.”  The Doc Fix is a provision that keeps the payment rates from Medicare to doctors from being lowered as is written in the law.  The lower payment rates are often cited as a cost reduction (as they were in the scoring of the Obama Health Care Law, allowing it to appear to reduce costs), but it is widely known that they will never take effect since doing so would cause a lot of doctors to stop seeing Medicare patients.  Each time the lower rates are about to go into effect, a temporary stop is passed.

3.  The bill from the Democratic-controlled Senate to the Republican-controlled House included income level phase-outs.  This meant that those at the higher end of the middle class income spectrum would see some of their income being taxed at the higher 6.2% rate, while those at the lower end would be paying 4.2%.  This would make Social Security more of a welfare program than it currently is since individuals at the lower-end of the income spectrum would be paying less for benefits than those in the upper-middle class.  Note that most wealthy individuals have little payroll income (or realized income at all) compared to their wealth and therefore would be unaffected.  This is a good reason to save and invest to become wealthy rather than working for all of your income.

4.  To pay for the 2% payroll tax extension, an additional charge would be created in the fees charged by Fannie Mae and Freddie Mac to loan originators.  These fees would be passed along to the home buyer, resulting in an increase of about $15 per month in the mortgage payment.  Note that this would be about $180 per year or $5400 over the life of a 30-year loan.  Including interest, a home buyer would pay somewhere north of $10,000 over the life of the loan.

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.