Use Time to Reduce Your Risk


 

 

jerichopoolIn Risk Allows You to Make Money in the Stock Market, I talked about how taking risks is what allows you to make more money investing in stocks than you could earn from a bank account.  Because you are putting your money at risk, the price you pay for shares of a stock are reduced (or discounted in accountant speak) from the price they would be at if you were assured that the company would make the earnings expected and pay those earnings out in a dividend.  You might get a check for $100 per year for your $1000 investment, or a 10% return, but you might not.  You would therefore invest only $500 and still expect a $100 per year payment if the business does well and things work out.  You get a higher return (20% instead of 10%) to make it worth taking the risk.

Luckily, with the market-based system you don’t need to figure out the right price to pay to get an appropriate risk premium.  Smart people with sophisticated computer programs do that for you by buying shares if they are cheap and selling shares if they are expensive.  As a result, the price of a stock will generally, but not always, already contain an appropriate discount for the amount of risk you are taking.  To improve your chances of getting a good price, you can also follow the share prices for a few weeks before you make a purchase and try to buy when the stock is it the low end of the range.  This can be done easily by placing a limit order, where you set the maximum price you are willing to pay for a stock.  You can also look at the price-earnings ratio, or PE, or the price to sales ratio, or PS, and only buy stocks that are at or below their average PE or PS level, averaged over the last several years.  In general, because I am buying for the long-term, I don’t worry too much about getting an extra ten cents or quarter per share since it won’t really matter in the long run and I may miss out on a big move up if I’m too picky.  Instead I tend to pick stocks from my watch list that have declined in price recently by at least a few dollars when I have money to invest and am ready to buy more shares.

 In Risk Allows You to Make Money the Stock Market I gave three ways to help manage risk and put the odds on your side.  These were:

1.  You invest appropriately for the time frame you have.

2.  You diversify your investments to reduce single-investment risk.

3.  You choose your investments appropriately based on your time frame and objectives.

Today I’ll cover the first item, investing based on your time frame.

The more volatile the investment you’re making is, the less able you are able to predict future values.  If I put $1000 in the bank in a CD paying 5% per year, I can predict with almost certainty that I will have $1050 in a year.  If I put $1000 in a stock that I think has the potential to grow earnings by about 15% per year, I have no clue what the price of the stock will be in a year.  I might have $2000.  I might have $500.  All that I know for sure is that I’ll lose $50 or so immediately due to transaction costs and brokerage fees.

The company I invest in may have a bad quarter, miss earnings estimates, and fall 20%.  The economy in general may run in troubles and the stock price may fall.  A competitor in the same industry as the stock you purchased may run into trouble and people may sell stocks in the whole industry.    The company may even post record earnings, but those earnings may be less than the “whisper numbers” some people may be expecting, and the price of the stock may fall.

While it is hard to time when the price of a company may go up, it is reasonable to expect that the stock of companies that are run well and are growing will increase in price at a rate about equal to the growth rate of their earnings.  This will be in fits and starts, with some declines or even crashes along the way, but over long periods of time you should be able to get a fairly predictable rate of return.  It might be that the stock doubles the first year and then trades within a range over the next few years, it might be that the stock price increases steadily each year, or it might be that it goes nowhere for several years and then doubles in price.

The way to manage the risk that the stock price may not increase over short periods of time is to simply only buy stocks if you are planning to invest for a long period of time.  For mutual funds I’d be reluctant to invest unless I was planning to invest for at least five years and maybe ten years or longer.  For individual stocks I’d probably be looking at ten years or more.  This gives time for the company to grow and people to realize that it is a great company and bid up their stock price.  I don’t have to guess what will happen with the economy, people’s emotions, or understand what trading strategies people are employing will do to the price over any given period.  I just know that if I wait long enough, things should work out and I should get the return needed to justify the risk I am taking.

I therefore would use the following guidelines:

1.  For cash needed within six months, use a bank account.

2.  For cash needed in one to three years, invest in bank CDs or perhaps high quality bonds set to be redeemed within the period.

3.  For cash not needed for five to ten years, split the money between stocks, bonds, and cash, and use mutual funds to diversify.

4.  For cash not needed for a decade or more, invest in stocks through mutual funds and select individual stocks.

By using time to put the odds in your favor, you can get greater returns by collecting the risk premium.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

Looking at Retail Stocks


 

 

farmhouseMy wife is looking to invest some money in her account, so I pulled out my watch list of stocks.  I normally keep a list of stocks that meet my criteria as good, long-term investments handy for just such a time as this.  I then down-select from that list based on 1)the relative price of the stock versus what I consider to be “fair value” based on future earnings potential and 2)how big a position I have in the stock already.

In looking through the list this time,  two retailers looked like good options.  These were Pier One, the ubiquitous chain of home decor items, and The Container Store, a relatively new chain of stores that sell containers to hold the knickknacks you pick up at Pier one but no longer want to have out taking up space on your end table.

I only had a few shares of Pier One in my son’s educational IRA account, so there was room for plenty more.  It had fallen from about $20 where we had bought in to the low teens.  This made an attractive entry point, although it makes you wonder if the chain has lost its luster and is no longer fashionable.  (Note that I consider all of our accounts when deciding whether we are too heavily invested in any one position.  There is no mine and yours when you become married.)

I had bought a fairly sizable position in The Container Store, but I was still building the position during pullbacks in price and it could stand to get a bit larger.  It had also fallen back a bit since I had bought in, although not as badly as Pier One.  The Container Store appears to have a lot of room for growth, but really doesn’t have quite enough history to know if they are going to grow into a retail behemoth or fail as a concept.  There is something attractive about getting in early, however.  Wouldn’t it have been great to get into Home Depot near the beginning when they only had stores on one or two states.

So what are the things about these two businesses that make them SmallIvy stocks?  Well, they have shown a good, consistent earnings growth rate.  I like stocks that are able to grow their earnings year after year.  I find that I tend to buy into retail and restaurants quite a bit because they are really designed for growth.  All they need to do for a period of time is open another store.

The second thing I like about them is they have a relatively high 3-5 year appreciation potential, as listed by the Value Line Investment Survey, the stock rating and screening publication I use.  I look for stocks that are have the potential to grow a large amount over the next several years.  If I can find stocks that have potential returns between 15 and 20% per year for the next several years,  I tend to examine them more closely.

The third thing that I like to see is a steady increase in price.  If I can find a stock that you could lay a ruler over and find an ever-increasing price curve, I’ll definitely take a second look.  That means that they have been able to deliver consistently good results over a long period of time.  A few stocks do that for decades, and those are the truly great ones.  In this case The Container Store doesn’t have a long enough history to say yet, and Pier One has seen a few ups and downs.  Of course, most stocks saw downs during 2008-2009 since people stopped spending since they could no longer use their homes as a piggy bank.

In the end I did what any smart investor would do – I left it up to my wife to decide.  She decided to go with Pier One.  We’ll also put some of the money in an ETF – probably the Vanguard Growth Fund ETF VUG.  No reason to put all of our eggs in one basket, particularly when it’s my wife’s money.  Luckily I’ve done fairly well in the past with her accounts with picks like Sealed Air (bubble wrap) and Equifax (bank transaction services).  Hopefully this pick will work out as well.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

What’s 1%? The Effect of Fees on Your Investment Returns


 

One-percent is such small number.  Many people (but sadly not most people) could afford to put 1% down on a home.  Differences of 1% are normally rounded off and seen as insignificant in most engineering analyses.  So why would it matter if your mutual funds were charging you 1.5% fees versus 0.5% fees each year?  After all, it’s just a 1% difference, right?

Over long periods of time, a 1% lower return each year will make a huge difference.  If you invest $200 per month in bonds, assuming a 7.5% average return over a career, you’ll end up with $200,000 more if you pay 0.5% versus paying 1.5%.  Stocks are far worse.  Over a career, investing the same $200 and assuming a 12.5% average return, you’ll miss out on $1.3 million if you pay an extra 1%!  One point three million dollars just due to a 1% higher fee.

The table below gives the value of both a bond and stock account that is charged a 0.5% and 1.5% fee after 20, 30, 40, and 45 years.  Note that managed funds will typically charge fees in the 1-1.5% range, while unmanaged index fund and ETF fees will be in the 0.5% range or less (I think the Vanguard S&P500 fund charges something like 0.15%!).  All analyses are assuming a $200 monthly contribution and a 7.5% return for bonds and 12.5% return for stocks before fees.

  Bonds Stocks
Years 0.5% fees 1.5% fees 0.5% fees 1.5% fees
20 $92,400 $104,000 $173,000 $198,000
30 $201,000 $244,000 $561,000 $699,000
40 $398,000 $525,000 $1,720,000 $2,350,000
45 $551,000 $759,000 $2,990,000 $4,290,000

Note a couple of things.  First notice that after about 20 years, you’ll have twice as much investing in bonds than you’ll have investing in stocks.  In thirty years that ratio will grow to almost three times.  In 45 years, you’ll have six times as much by investing in stocks.  The stock portfolio will provide a comfortable retirement, while the bond portfolio will not be quite enough to feel truly secure.  This is why you want to invest in stocks when you are investing for a long period of time because the long-term returns are so much better.

The second thing to notice is the huge amount that you’ll give up due to the higher fees in both the stock and bond portfolios.  Over a working lifetime, you’ll have about a quarter of a million dollars less in your bond portfolio with a 1.5% fee as you’ll have with a 0.5% fee.   In the stock portfolio, you’re giving up more than a million dollars.  Perhaps the worst part about paying higher fees is that you lose the ability for a portion of your portfolio to compound because you’re paying it out in fees.  Not only do you pay the fees – you lose the interest on the fees, and the interest on the interest.

Of course, the main reason people invest in managed funds and pay the higher fees needed for research, trading, and the fancy offices in which the mutual fund managers reside is that, theoretically, they make a higher return due to their adept trading than that which would be produced in an unmanaged index fund.  The trouble is, however, because they have to buy so many different stocks, because they have so much money to invest, they basically just end up “buying the market” anyway.  As a result, managed funds typically do worse than unmanaged funds over long periods of time because they get the same returns as the unmanaged funds, yet their fees are higher.

So, if you’re looking for investments in your 401k, it would be wise to choose unmanaged index funds and buy the funds with the lowest fees.  If you have the choice between a large cap stock fund with a 1% fee and an S&P500 index fund with a 0.25% fee, go for the index fund.  When adding mutual funds to your taxable portfolio or your IRA, consider index funds through a provider like Vanguard or ETFs on those index funds.  If you think that a particular manager will be able to outperform the markets over the long-term, maybe put a portion of your investment portfolio in their fund, but I’d still hedge my bets with an index fund.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

Risk Allows You to Make Money the Stock Market


 

 

 

 

jerichopool

Ever wonder why you can make better returns in the stock market than you can in a bank account or even in bonds?  The reason is a four letter word you should learn to love – risk.  People are often told to avoid risk, or minimize risk.  But as many people learn life, certain risks are worth it for the reward they generate.   The scene in the picture is a pool with a neat little waterfall flowing into it at the end of a three-mile hike.  (And believe me, the picture doesn’t do the area justice.)  The hike was not risk-free.  There was poison ivy everywhere.  There were some rather steep areas on the trail, rocks that could have banged up a knee.  There were even two foot bridges, each made of a single flattened log laid across the river with a very flimsy hand rail on one side.  I could have easily twisted an ankle or even broken an arm, gotten dehydrated, gotten lost in the woods, or even been bitten by a snake or attacked by a rabid animal.

But only the ones willing to assume these risks were able to see that pool.  Take a little more risk and climb up the rocks behind the pool and there was an even more spectacular spot waiting for you.  Sometime you make the analysis and make the very valid decision that taking a certain risk is worth the reward.  There are many others who would have decided the risk was too great – perhaps they are unsteady on their feet, can’t make the walk, or are just to scared to make the journey.  They may or may not know the reward they are passing up.

Now some people take risks without really examining them and taking reasonable precautions.  On this trip we saw a family heading down the trail as we were coming out, and it didn’t look like they had any water with them (or anything else).  We had full backpacks with camping gear, fire starting materials, knives, water, water purification tools, food, compasses, and cell phones since we were planning to spend the night.  Even on a day trip I would have everything listed except the camping supplies since there was a real risk I could get lost or injured and need to start a fire and  refill on water.  It is almost certain that I would dehydrated during the two hours it would take to get to the falls and two hours it would take to get back, even if I didn’t stay at the falls at all. 

Taking a risk when it is almost certain, or even likely that bad things could happen is usually not worth the risk.  The only exception is when the bad things that could happen aren’t really that bad.  If I were hiking in a park surrounded by a city, I would only take water (assuming it was a long enough hike) since getting lost was almost impossible and if I ran out of water I would just be a little thirsty for a short time – I wouldn’t die of dehydration.

In investing, we take appropriate risks in order to extract a reward in the form of higher returns.  We do things to manage that risk, so as to put the odds well in our favor unless we are simply taking a chance that might well go badly but the reward is worth the chance of loss and the loss won’t be devastating.  You wouldn’t put all of the money you have for college into a single stock the year before tuition was due because the odds aren’t in your favor that your stock would be higher in a year and there is probably a one-in-ten to one-in-twenty chance that your stock may decline significantly in price over that year, leaving you unable to afford college.  The result would be devastating and therefore, not worth the risk.  You would put the money in a one-year CD since the risk that the bank would default on that CD is very slim, so the increased return over having your money sit in cash would be worth the risk.  You should, however, put money that you are saving for retirement while you’re in your twenties into stock mutual funds, and perhaps even put a portion in single stocks, because the risk would be appropriate and the reward would justify the risk. 

There is a reason that you get better returns when you take greater risks, and that  because of something called discounting and the risk premium.  Think of it this way:  If you knew someone who was very reliable and who had a steady income, you might be willing to lend them $1000 for a year if they would give you $1050 back at the end at year.  You would figure that the money wasn’t doing anything for you anyway and you could have $50 more for just letting them borrow it for a year. 

If there were someone without a steady income (and who stiffed a friend of yours in the past) who also asked to borrow $1000 for a year, you might not lend it to him at all.  If the terms were only for a month, however, and he would pay you $2500 at the end of the month, you might decide that the potential gain was worth the risk and make the loan.  At this point you would be speculating since the odds might be 50% that he would repay and 50% that he would stiff you (in speculating, the odds are against you or only slightly on your side), but if he did repay, you would make a $1500 profit. 

If you did this with four people of equal credit-worthiness, the odds are that two of them would pay you the $2500 and two would default and you’d lose your $1000.  This would mean would make $3000 from those who repaid but lose $2000 from those who didn’t, leaving you with a $1000 profit.  That is a lot better than you did with the trustworthy individual who was sure to pay you, but only pay $50 after a whole year.  Here you made $1000 in a month.

And this is exactly what you do when investing in stocks.  You are investing in things that do not have an assured return and therefore you are taking a risk, but if you manage those risks appropriately, you can almost guarantee you’ll do better than you did when investing in lower-risk assets.  The greater the risks you take, the greater your possible return, but at some point you’re speculating and not investing and therefore taking a large risk of losing money.  So how do you manage your risk when investing? 

1.  You invest appropriately for the time frame you have.

2.  You diversify your investments to reduce single-investment risk.

3.  You choose your investments appropriately based on your time frame and objectives.

I’ll go into these points in more detail in posts that follow.  You can also get a lot more information on risks and returns of investments – far more than I can cover in a post – in my book, The SmallIvy Book of Investing.  Please check it out and let me know what you think.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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

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

Small Investor Followers – Introduce Yourselves


Let me say I’m thankful for the large number of people who have followed The Small Investor over the years.  I still remember getting my first follower about a week after starting to write.  Today I have almost 300 followers through WordPress and email.  I also have 51 Twitter followers, which seems to be a relatively fixed number because each time I get another, I seem to tick off somebody or something and I lose one or two.

I have a few followers who comment fairly regularly, but a lot of you are silent followers.  I’d love to know a little more about you.  Please comment to this post and let me know:

1.  Your personal financial situation.  Student saddled with debt?  High school student learning about finance?  Seasoned investing pro laughing at my stock analysis?  Recently out-of-debt and looking to start investing?

2.  Where you want to be in five, ten, and twenty years, both financially and professionally.

3.  If you’re financially independent, how does that feel?  Can you tell other readers if it is worth the sacrifice?

4.  What is the best personal finance/investing tip you ever got.

5.  Did your parents teach you anything about personal finance?  What about investing?

So, who’s out there, and what do you have to say?

What Will Happen to the Low-Skilled Worker in the Self-Service Economy


OLYMPUS DIGITAL CAMERAWe are clearly seeing a movement to a self-service society.  Customers are being expected to do more and, very surprisingly, they are happily doing it.  This is especially odd given that they are paying the same prices as they did when things were full service!  You can go through the regular checkout line, have someone scan your items and someone else bag them, or you can go through the self-service, scan things yourself, bag them yourself, and pay the exact same price.  You would think no one would go through the self-service lines, because who doesn’t like “something for free,” and yet there are many people who would rather bag their own eggs.  What does this say for the service provided?

Unfortunately, I think we’re very close to having everything be self-service.  Just as full service gasoline dispensing has become a thing of the past (except in the few states where customers aren’t allowed to pump their own gas), I think soon we’ll go to the grocery store and find only self-service lines.  Note that checking at the airport has become self-serve with a ticket agent just there to slap a tag on your bags and check your ID.   Also, expect to go to fast food places (and even sit-down restaurants) and enter your orders through a kiosk.  You might even go to a window and pick up your own food and bus your own dishes, given the trend.  This is driven by the advancement of technology (which allows such a level is self-service), increases in labor cost thanks to the healthcare law (Affordable Care Act) and minimum wage laws (I’m guessing we’ll see a lot of self-service kiosks in Seattle), and a general acceptance, or even preference, by consumers to perform self-service.

 It may be that many of the labor intensive, boring, dangerous, mind-numbing jobs will be automated out of existence.  Things like fruit picking, weed pulling, garment making, and ditch digging.  With this automation, however, will come the ability for a few talented and skilled people to produce enough to provide for far more than themselves.  Imagine the capability for a single person to build a home a day due to some new machine.  Or the capability for a single person to grow enough food for a thousand people.  Or ten-thousand people.  There will be jobs for people to fix the machines and for people to run the machines.  There will also be jobs for people to design the machines, and maybe jobs to build the machines, although a lot of that will be automated as well.  There just won’t be jobs to o the things the machines can do.

It may be that there will not be many low-skilled jobs left, meaning it will be difficult for people who are not above average in intelligence and who don’t somehow get the chance to learn the skills needed to have a career.  The ability to just turn in an application and learn on-the-job may be gone.  This will mean that there will be a whole group of people who cannot break into the workforce and provide for themselves. 

Yet productivity will be so high that a lot of people will be able to just sit home and be provided for, much as the many people on perpetual welfare do now.  Currently it is difficult for the people working to pay for those on welfare because they need to produce for both their families and other people’s families.  If productivity increases enough through automation, however, maybe your home, food, and clothing will just be free if you wish, leaving work for only those who both have skills and want more than just the basic sustenance.  If providing for someone else is just a matter of pushing a button one more time, a few people could provide for hundreds or thousands of others. 

Maybe some people would think this was great – no more working dead-end jobs and  people wouldn’t need to work unless they wanted to (and had the ability to do the jobs that were still needed).  I’m not so sure, however.  When you work, even when it is in a job that some would see as easy or low-skill, you are doing things for other people.  The janitor makes office buildings and schools safe and clean so other people don’t get sick.  The short-order cook feeds hungry people.  The gardener makes homes and offices habitable and attractive.

And that is where dignity comes from.  Doing things of value for other people.  What used to be called an “honest day’s work.”   You’ll miss it when it’s gone.

Contact me at vtsioriginal@yahoo.com, or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Used Cars are the Road to Riches


Ask SmallIvy

Today we reach the last item on the list provided in 10 Dirt Simple Rules of Money Management.   (Note, as always, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar or searching for Dirt Simple in the site.) Today we cover the tenth rule:

10.  Don’t buy new cars unless you have a new worth of at least million dollars.  Otherwise, buy quality used cars that you can afford with cash. 

As I explain in Would You Drive a Used Car for A Million Dollars,  you can have a million dollars by the time you are in your fifties if you just buy a used car (four years-old) for cash instead of a new one on payments due to the savings on the depreciation and the interest payments.   By the time you are 69, you can have $4 M – enough to cover your retirement – just by buying used cars and investing the savings.  And that is just for one car.  If your family has two cars, as many do, you could have $8 M at retirement.

The reason is that cars depreciate, on average, about half of their value in a four year period.  This means that if you buy a $20,000 car when it is new and trade in every four years, you’ll be spending $2500 per year on just depreciation.  If you buy a four year-old car instead, you’ll only be paying $1250 per year.  Keep that same car from years eight through twelve and then trade-in, and you’ll only pay $625 per year for those years.   By buying used cars, you’ll have over a thousand dollars a year to invest.  This doesn’t even include savings from not paying interest if you buy the used car for cash instead of taking out a loan.

One of the big reasons that people give for not buying used cars is that they need reliability.  Perhaps they remember a neighbor with an old car that would start about half of the time.  Well, in reality, todays cars are a lot more reliable than curs in the past.  Many cars routinely go more than a quarter million miles with few problems.  Most breakdowns can also be avoided simply by making sure routine maintenance is performed on schedule.  Really, if you have the hoses checked about once per year, make sure your oil level is good each time you stop for gas, and check your transmission fluid level every month or so, your chances of having a breakdown are very low.  You can also have a mechanic check over the car before you buy it for issues.  A car with a clean bill-of-health will probably give you many carefree miles.

So stop paying the high price of used cars.  In four years, your car will be a four-year old car and you’ll have paid a lot more for it.  That new car smell might be enticing, but it really isn’t worth the price.  Once you’re a millionaire, you can buy a new car if you would like.  But even then you may decide it isn’t worth the cost.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

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

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