On Investing

Investing has changed significantly during the 25 or so years that I have been following both the market and also the tools available for an investor to participate within the market.  The following trends are key:

  • The cost of trading and investing has declined significantly.  Trades used to cost more than $25 and now are essentially free in many cases.  Mutual funds used to have “loads” of 5% or more standard when you made an investment, meaning that $100 invested only went to work for you as $95.  These sorts of up-front costs have almost totally been eliminated
  • ETF’s have (mostly) replaced mutual funds.  ETF’s “trade like stocks”, meaning that you can buy and sell anytime (mutual funds traded once a day, after being priced with that days’ activity) and they don’t have income tax gains and losses unless you actually make a trade (mutual funds often had gains due to changes in the portfolio that you had to pay taxes on even if you were just holding the fund)
  • CD’s and Government Debt are all electronic.  You used to have to go to a bank for various governmental bond products or to buy a CD.  Now you not only can buy all of this online, you can choose from myriad banks instantly rather than settle for whatever your main bank (Chase, Wells Fargo, etc…) offers up to you
  • Interest Rates are Near Zero.  One of the key concepts in investing is “compound interest”, where interest is re-invested and even small, continuous investments held for a long time can end up amounting to large sums (in nominal terms, because inflation often eats away at “real” returns).  However, with interest rates basically near zero, you need to earn dividend income or take on more risk (i.e. “junk bonds”) in order to receive any sort of interest income.  There is no “safe” way to earn income any more
  • Currency Fluctuations Matter.  When the Euro initially came out it was $1.30 for each US dollar, and then it went to 70 cents per dollar, and now it is about $1.10 per dollar.  At one point the dollar fell 30-40% against many currencies world wide (when “commodity” currencies like the Canadian and Australian dollar were surging).   For many years currencies were relatively stable against one another but that era seems to be ending, and thus the change in relationship between the US dollar and their currency can be much greater than the return that is earned on the international investments
  • Active Trading Has Mostly Been Beaten By Passive Trading.  While there are many exceptions, initially the majority of investments were “active”, but over the years many of the “active” managers have substantially under-performed the market, wilst charging investors more in fees (it is cheaper to run a “passive” index).  As a result, there has been a massive shift away from active investors to passive investors like Vanguard
  • Correlation Among Stocks and Investment Classes Is Much Higher.  Correlation means that stocks or asset classes tend to “move up” together or “move down” together.  It is not unusual for me to look at a portfolio of 20 stocks and 19 or 20 of them have all gone up or down on a single day.  This is related to active managers being unable to “beat” the market (see above)
  • The “Risk Premium” for Lower Quality Debt is Small.  The amount of extra interest required for low quality borrowers over the US Treasury benchmark is very small.  Investors are taking on a lot of risk to just earn a few more percentage points of return.  If there is a downturn in the economy (such as what happened only recently in US oil companies), there are likely to be significant declines in junk bond values that wouldn’t justify the modest risk premium you receive for holding these types of assets
  • ETF’s Provide an Easy Way to Participate in Commodity Markets.  It was more difficult to buy and invest in commodities like gold and crude in the past, and it was often limited to relatively sophisticated investors or those willing to hold on to physical commodities like gold (which can be risky since they need to be stored and protected due to high value and inability to trace once stolen).  Today you can easily buy a liquid ETF to participate in the commodity markets for key areas like precious metals (gold and silver) and crude oil / natural gas
  • Fewer Companies are Going Public and the Market is Shrinking (in terms of issuers, not total value) – It is easy for start up companies to access private capital (venture funds) and they tend to “go IPO” at high values, making a further upside (after the initial IPO) more difficult.  The total market is shrinking in terms of listings due to M&A (companies buying other companies) faster than the new IPO’s and many companies are “buying back” shares which also reduces the total value of the public markets
  • Bonds have had a Gigantic Bull Market that is Nearing It’s End – Bond prices move inversely to yield; thus if you held on to a 5% low risk bond (which would have been available everywhere in the early 2000’s), that bond would currently be priced at much more than 100 cents on the dollar today.  Interest rates peaked around 20% near 1980 and now are not far from zero; in this sense bonds are part of an enormous “bubble market” that has not yet peaked.  But given how low rates are (they are even negative), it seems like this bull run is about to come to an end
  • Ensure That You Include Dividends and Total Return.  A common mistake is to look at performance just in terms of stock or asset prices, and avoid including the compounding impact of dividends received, especially since dividends often rise each year.  Dividend income can make up a significant portion (25% and up) of total return, so selecting assets that provide dividend income is critical.  Finally, dividends provide favorable tax rates when compared to interest income

What does all of this mean?  I would sum it up in two ways:

  1. It is easy for individual investors to set up a simple and low cost way to track the market – the “basic plan” that I set up as a simple example can be used by anyone and it does what it says.  Here is a second plan that also includes some hedging of the non-US investment
  2. You will need to save much more (or take on more risk) because interest rates are low – with near zero interest rates, you can’t make much money on low risk interest bearing products (like CD’s, savings accounts, and simple government debt).  If you are earning risk income, you likely are taking on substantial risk of default because there is no “free lunch”.  As a result, you need to put more cash into stocks in order to earn dividends or see real returns, but this also could lead to significant losses if there is a market crash like 2008-9.

I try to promote financial literacy and have helped many friends and some family members when they ask questions.  Ideally we would actually drive financial literacy through school and into the university.  Even those who have a degree in finance or accounting often lack practical advice on personal finance and don’t know how to approach these issues.

One key concept is “net worth”.  Net worth isn’t how much you earn in salary, it is what remains in savings after taxes (or through long term deferral of taxes).  The only “assets” that count are those that you can turn into cash if needed, and they are “net” of the debt (such as on your house).  Most people have a negative or near-zero net worth, which is also linked to the concept that they are essentially a couple of missed paychecks away from very bad outcomes such as having to take out a payday loan or borrow money from relatives.

Another key concept is trying to avoid excessive student debt.  Unlike all other forms of debt (loans on your house, your car, or credit card debt) your student debt cannot be discharged through bankruptcy.  You essentially have no options except to repay your loans, and if you miss payments or fall behind the fees and penalties will greatly increase your balance due.  Student financial literacy is critical because they are making decisions that will impact themselves and their families for the rest of their lives and they must be made thoughtfully and with the end in mind (if you are taking out all of this debt, you must be driven in your career to make money in order to pay it off and get on with building net worth).

Cross posted at Chicago Boyz

Trends in Stocks

Investing in stocks is always hard.  You are looking at data about the past but you are betting on an individual stock in the future.  In addition, there has been huge correlation among stocks and markets and the impact of currencies and central bankers (often inter-twined) has given various world markets boom and bust qualities.

In the US, there are two markets, the NASDAQ and NYSE.  NASDAQ has traditionally been more technology focused, meaning that when these stocks go up, the NASDAQ soars.   Here is a quote on “the only six stocks that matter” about the NASDAQ from the Wall Street Journal:

Six firms— Amazon.com Inc.,Google Inc.,Apple Inc.,FacebookInc.,Netflix Inc. and Gilead Sciences Inc.—now account for more than half of the $664 billion in value added this year to the NasdaqComposite Index, according to data compiled by brokerage firm JonesTrading.

Thus the bottom line is that if you don’t have these stocks in your portfolio, the overall index may be rising (and our benchmark for performance), but your own returns will be worse.  We do have some of Amazon and Facebook in portfolio 2, but not much of it overall.

Outside the USA, foreign markets have been hurt by the rising US dollar, which makes their market values lower for us here in the USA (where the dollar is our currency).  This hurts stock investments in Europe (the Euro), Canada (the Loonie), and Australia (the Australian dollar) if you are denominated in US dollars (which we are).   The dollar is up significantly vs. almost every other currency in the world with the exception of the Chinese Yuan.

The Chinese market went crazy this year, in what appears to be a major bubble, that recently started crashing and was accompanied by strong intervention from the central authorities, who went after short sellers and even stopped stocks from trading for various reasons.   At one point almost the entire Chinese stock market by valuation (over 80%) was not trading.  The rationale is that if stocks are heading down, and you can stop trading, then this gives the market participants time to stop panicking.  This type of intervention stops the market from functioning efficiently, however, and will have many other unforeseen impacts down the road.

Mergers and acquisitions (M&A) activity also soared in 2015, which is a sign of bullishness and also likely a sign of a market peak.  A Wall Street Journal article recently summed it up:

Companies are merging at a pace unseen in nearly a decade. Halfway through the year, about $2.15 trillion in M&A deals or offers have been announced globally, according to Dealogic. That puts 2015 on pace to challenge the biggest year on record, 2007, when companies inked deals worth $4.3 trillion… In industries ranging from health care to technology to media, chief executives are rushing to make acquisitions, often either in anticipation of takeover moves by rivals or in response to them.

When acquisitions occur, you as a stock market investor typically want to be the “acquired” company, not the “acquirer”.  The “acquired” company receives a premium price to their current market value but the burden of “earning” that higher price falls on to the acquired company, and typically M&A does not pay off long term for most companies (as opposed to internal or “organic” growth).  While there have been many acquisitions, most notably in the health care / insurance / pharma industry which is consolidating under Obamacare, our portfolios had few of these acquired companies in the mix.

Finally, you had a decimation of the commodity indexes.  Commodities such as oil, some foodstuffs, natural gas, iron ore, copper, gold, etc… have seen their prices collapse, which in turn damages the stocks of mining companies, oil companies, and many other participants in the commodity value chain.  Per Bloomberg:

Almost all commodity markets have taken a severe beating lately. The aggregate Bloomberg Commodities Index is down 61 percent from its 2008 peak and 46 percent from the 2011 post-crisis high

These are severe reductions.  They impact entire economies particularly the Arab countries (which make all their export income in oil), Russia (many commodities), Australia and Canada.  There are large “secondary” impacts as well – reduced commodity prices hurt service demand in Canada and Australia and put their housing boom at risk.

So what does this mean for us and our portfolios?  We’ve been hurt by the commodity bust, the rise of the US dollar (on our foreign stocks), and we’ve missed some of the booming stocks because they were narrowly concentrated in a few names and some of the largest M&A was in sectors where we had few investments.

We are now going to look at some of the stocks and cull some prior to our next round of purchases which will occur in August – September as the beneficiaries of the various portfolios head off to school for the year, and will tie new purchases (of the cash) with additional investments that will be made soon.