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Wednesday, September 26, 2012

Farewell


"Applaud, my friends.  The comedy is over."

- Beethoven on his deathbed

Some of you already know that I made the decision a few months ago to discontinue this blog at the end of this year.  Recent events, however, have made it necessary for me to accelerate this schedule.

This will be my last post for the foreseeable future, and comments for this post are now closed.  My apologies for such an abrupt ending, and for the fact that the penultimate post was such a downer.  This was not really the way I always hoped to end this blog.

Most of you know that I am a husband, a parent, an employee, a homeowner, and a volunteer.  That alone is enough to keep me busy!  What most of you don't know is that there have been a lot of additional constraints on my time in the last five years, and right now life is presenting me with a whole new set of opportunities and challenges.

Even one hour a day of blogging competes not only with my primary responsibilities, but also with my creative side, my relaxation time, and my social life.  I've carped a lot on this blog about making hard choices - budgeting choices, investment choices, giving choices.  Simply put, continuing to spend hours a month on a personal finance blog is a luxury I cannot afford right now.  I'm sure there will be times when I will miss writing, but I believe there are other creative endeavors waiting for me in the wings.

Lastly, I wish to say goodbye to some wonderful people I have met through blogging.  I just looked through the blog roll on my sidebar and it brought a big smile to my face.  You have informed me and inspired me.  I wish you all the best.

Tuesday, September 25, 2012

My Worst Investing Mistake Quantified

As I went through old monthly statements, I was stunned by the breadth of the many positions where I sold out early.  I knew there were a few small stock positions where the end result would have been enormous had I only just held on.  However, I was not prepared to find position after position with such large subsequent gains after I sold.

In the interest of time, I cannot perform the calculations on all these positions.  Many of my stocks split over time, and many were taken over by other companies.  Although Google's search engine is amazing, it is still tedious to track down all the split dates and takeover terms for companies with defunct ticker symbols.  Here is what I had time to calculate.


Philip Morris (symbol: MO)

On Halloween (10/31) of 1990, I purchased 200 shares of Philip Morris at $47 7/8 per share.  It had a nice fat dividend of 3.6%.  But I quickly grew bored with the slow moving stock, and sold for $50 even during March of the next year.  I distinctly remember withdrawing money from this gain to take a trip to Disney World and Cocoa Beach.

Philip Morris was a conglomerate back then, with tobacco interests being only part of the picture.  Eventually, the company would be spun off into three different companies, with special dividends to disburse other interests.  Like many people, learning about the effects of tobacco was a long term process.  Based on ethical reasons, I honestly don't know how long I would have held the stock, but it would have been longer than five months.

The Kraft portion of this position in split adjusted terms would be 420 shares, or about $17,600 at current prices.  It would also have included about $55,000 worth of Philip Morris International at current prices, and about $20,000 worth of Altria.  Additionally, the dividend for all of these companies has been quite high for the last 20 years.  According to partial studies I have seen, the total return for a position introduced 10/31/1990 would be at least 15 times original investment, not including dividends in the 90's and over the last two years.

I left between $150,000 and $200,000 on the table by selling, perhaps reduced somewhat by selling out tobacco holdings as they were spun off.


Amgen (symbol: AMGN)

As bad as the Halloween purchase was for me, the stock I purchased the very next day would prove to be an even more spectacular winner for those who hung on.  Yes, back when seemingly no one had heard of Amgen, I bought 150 shares back on 11/1/1990.  I would sell it in less than two months after making more than a thousand dollars.

Some of you know Amgen is among the best performing stocks of all time.  I was in very early.  And out very early.  Since my purchase and sale, the stock has split four times for a combined total of 24 to 1, and now trades around $84 a share.  My position would be worth about $300,000 plus dividends.

I left more than $300,000 on the table by selling.


American Power Conversion (defunct symbol: APCC)

This was one of the first stocks where I tried to hang on for a while.  I bought 200 shares of American Power Conversion on 2/8/1991 for $18 3/4.  But when it was getting close to a triple nine months later, I sold it on 11/20/1991 for $47 1/4.  However, the company was really only getting warmed up.

The stock would split 2:1 four different times and was eventually sold in 2006 to Schneider Electric for $31/share in cash.  My tiny $3,750 position would have been worth $99,200 by the time of the takeover, plus APCC had initiated dividends along the way.

I left more than $100,000 on the table by selling.


InVision Technologies (defunct symbol: INVN)

During the year 2000, I purchased 1,100 shares of INVN, a maker of advanced bomb detection scanners for airports.  They had excellent technology and a very strong cash position, but earnings were basically breakeven because there was not much demand for their products.  Still, I was convinced the FAA would continue to drip orders to them because they did not want them to go out of business.  I specifically bought the stock as a hedge against geopolitical events, noticing that when the market went down a few hundred points due to some skirmish, INVN would rally on fears of potential hijackings and increased security.

In March of 2001, I lost patience with this hedge and decided to sell my holdings for a gain.  My purchase price was $1.09 per share, and my sale price was $2.31 per share.  Wow!  I doubled my money and made more than a thousand dollars.  Yippee!

Of course I could not have foreseen the magnitude of the events that occurred only six months later, but still there was no real rationale for selling.  I wrote tersely in my notebook: "Selling.  Moving on to something more exciting."  When trading resumed after the 9/11 closure, the stock opened near $20 and never looked back.  In 2004, General Electric bought the company for $50 a share in an all-cash transaction.

I left more than $50,000 on the table by selling.


Terra Industries (defunct symbol: TRA) and Terra Nitrogen (symbol: TNH)

In 2004, I purchased two related fertilizer companies: Terra Nitrogen and Terra Industries.  The fertilizer business is deeply cyclical and after a lot of analysis, I believed the industry was poised for a dramatic turnaround.

I purchased 500 shares of Terra Nitrogen on 8/5/2004 at $12.37.  When the price doubled in less than two months, I sold on 9/28/2004 at $24.60.  I also bought 1,000 of Terra Industries at $6.45 around roughly the same time period, and sold it six months later for $8.20.  I could never have imagined how right I was about the fertilizer industry and how wrong I was about selling.

Today, Terra Nitrogen trades for more than $220 a share.  The yearly dividend now exceeds my purchase price in 2004!  Terra Industries was purchased by CF Industries in 2010 for $37.15 a share in cash plus 0.0953 shares of CF for each share of TRA.  The Terra Inustries position would today be worth $37,150 in cash plus more than $20,000 worth of CF stock.  The Terra Nitrogen position would today be worth more than $110,000 plus very large dividends.

I left more than $150,000 on the table by selling, plus a dividend income stream of more than $15,000 a year.


Takeovers

You may find it strange that so many of my investments were taken over by other companies.  This is not entirely unexpected.  I was trained to buy companies with high margins, large cash positions, and strong management.  Those traits are characteristic of companies that are bought out.  Yet even I was surprised to discover that well over half the stocks I bought during the first few years of my investing career were eventually taken over.

Alza and Centocor were both bought by Johnson & Johnson.  Mylex was acquired by IBM.  Trigon Healthcare was bought by Wellpoint, Mid Atlantice Medical Services was bought by United Health, and U.S. Healthcare was bought by Aetna.  Mycogen was acquired by Dow Chemical.  Chiron was bought by Novartis.  Pixar was bought by Disney.  Triton Energy was bought by Amerada Hess.  Key Petroleum merged with another company to form Cimarex Energy.  U.S. Surgical was bought by Tyco.

I owned all of these stocks, and sold them for moderate profits.  I don't have the time or energy to calculate what all of these positions would be worth today.  Most would probably be $10K or $20K higher than I sold them, but there are clearly some exceptions.  The Chiron stake was probably quite large at acquisition, as well as the three HMO takeovers.  But I think I've already made my point.


Index Funds

In my retirement accounts, I also jumped in and out of S&P 500 index funds for most of the 1990's.  My personal returns trailed the benchmark index badly with this approach. 


Coda

I don't sit around moping about these facts.  Life has still been very good to me.  But I don't want to pretend I didn't make these errors, and I want to learn from them.  I've made all sorts of investing errors, but in my mind, this was the biggest, even though it did not involve direct losses.  It involved tangible, missed opportunities, which any economist will tell you is a real cost.

Monday, September 24, 2012

My Worst Investing Mistake Revealed

"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!"

- Jesse Livermore, Reminiscences of a Stock Operator

Sometimes it was individual stocks and sometimes it was index funds, but the pattern was always the same.  After I made some money on a position, I sold out.  Many times I sold because I was scared, but in my early investing days (i.e. the late 80's and 90's), I often sold positions just so I could spend the money.

So in that sense, the guess of "not starting early enough" was partially correct.  I started investing in the late 80's, but didn't get my spending under control until the late 90's, and I didn't stop arbitrarily cutting off winning positions until just a few years ago.

In the next post, I will list some actual examples of purchases and sales.  To be clear, I'm only going to list actual purchases and sales and compare those positions with current market prices.  In other words, no wishful thinking about how (for example) I knew Apple would soar, but I didn't actually purchase it.  And no saying how I would have made so much more if only I had taken a bigger position!  And no imagining I could make spectacular profits by unrealistically selling out at the top of some bubble.  I'm only going to calculate what the position would be worth today had I just held on to the actual position I had.

Also, I'm only going to look at the positions I sold at a gain.  I'll assume that if I sold at a material loss, I didn't consider the prospects bright, and so it would just be cherry picking to track later gains in losing positions.

A number of years back, I was floored to discover how much money I would have made on one small stock position had I only just continued to hold onto it.  Unfortunately, even after learning of this debacle, I still continued to sell rising positions with good prospects, in order to spend the money or to feel more relaxed about my investments being in cash.

Wednesday, September 19, 2012

Guess My Worst Investing Mistake


Fool me once, shame on you; fool me twice, shame on me."

- Chinese proverb
This is going to be a three part series, and the last part is not going to be fun to write.  But I need to remind myself why I am still slaving away in my cubicle each day.  Although we've all made many different investing errors, I've made one colossal error that is mainly responsible for me still being part of corporate America.  And I am sorry to report, I have made this same error more than once.

There are so many investing mistakes one can make: buying rumors, paying big fees, overtrading, being too conservative or too risky, failing to diversify, panic selling, etc.  I'm sure we could make a taxonomy of hundreds of different kinds of errors.

I'm going to write a second article discussing my error and a third part quantifying how much money was involved.  But for now, I'm curious whether any long time readers might be able to spot the issue.  I've never written about it directly, but I wonder whether it might be apparent given some things I've discussed in the past.  Keep in mind this is a fairly concrete issue and not something vague like "I didn't invest enough in myself".

Anyone have a guess?

Monday, September 17, 2012

Why Defer Spending?

Starbucks Coffee (Yet Again)

Yesterday I was reading one of these typical blog posts where someone discussed how he had "opted out of consumerism".  As proof, the author does not purchase daily morning coffee at Starbucks like his friends.  The article was mainly about how the money saved from not buying coffee will produce gobs and gobs of money that will eventually enable him to retire early.  We've all heard that story thousands of times now, so there is a certain fatigue to reading it, but overall I certainly don't have a problem with the idea of saving money this way.


Delayed Gratification

Interestingly enough, one commenter politely asked whether the delayed gratification was worth it, given the record low interest rates.  This person was immediately attacked by another commenter as "the nonsensical ramblings of an idiot" who needed to examine how his "depressingly low standards" would allow him to view Starbucks coffee as gratifying.  Our second commenter closed with the taunt that when he was in his 70's, the first commenter would be serving him at Starbucks due to his wasteful spending.  (Isn't internet civility wonderful?)


Inflation

As I thought about this exchange, I eventually began to see the original question as quite serious, perhaps even profound.  To make it worthwhile to simply defer consumption of the Starbucks coffee, you will need to beat the inflation rate of coffee.  You can save your $2 on coffee and invest it.  If you take it out next year to buy that coffee you didn't have last year, you'll probably be surprised to find that while the amount of your savings is slightly more than $2, so too is the price of coffee.  If you invest that $2 for 25 years, it will grow considerably, but so will the price of coffee.  If your investments don't exceed coffee inflation, you will never have more than the price of one cup of coffee, whether you save the money for one year or 30 years.


Beating Inflation

So is it really possible your investments won't materially exceed inflation over time?  For many people, I doubt they will.  If you put your money into safe places like savings accounts, CD's, and government bonds, it's a very good bet the return won't exceed inflation significantly.  With TIPS, the rates are negative, so you are pretty much guaranteed they won't exceed inflation, although I can't necessarily claim coffee inflation will track the consumer price index.  Now with stocks and certain other higher return investments, you certainly have a good shot at beating inflation.  However, a lot of people don't achieve market returns because they jump in and out of the market at the wrong times.  They may also have a low risk tolerance, or may simply have the bad fortune of living during a period where the market essentially goes sideways for years and years.


Deferred Spending

A logical conclusion to this whole line of thinking is to ask why we defer the spending of anything?  Is it really just to invest the savings so that we can withdraw the money later and spend it on the same inflation-adjusted item?  The scenario painted by the second commenter is not really true.  If someone enjoys their cup of coffee now and chooses not to enjoy another one later, in isolation it's not much different than waiting and drinking it in retirement.  By waiting, he may indeed enjoy his Starbucks coffee at age 75, but he's not likely to served by the first commenter if that person chooses not to require coffee in his own retirement.  In this case, one person drinks the cup of coffee at age 45, the other at 75.


Needs versus Wants

I'm sure most of you can see where I'm going with this idea.  Let's be honest.  We don't forego Starbucks coffee now so that the savings will compound and enable us to have many more cups of Starbucks coffee later.  I wish people would stop making that argument.

The reason we cut back on Starbucks coffee is that it is a total luxury.  We do not need coffee to live.  And we do not need the best.  And we don't need someone else to make it and conveniently serve it to us on our way to work.

The real narrative behind the latte effect is not compounding, but shifting consumption away from luxury goods to things we truly need.  Even if you save the money, it affords you the opportunity to later spend it on something more critical.  By having a lot of savings, it enables you to withstand adverse financial events in your life.  For when the problems come, you will not be spending your savings on luxuries, but on necessities.  Thus, the shift in consumption from wants to needs was started at the time you saved and completed when you later needed the money for necessities.

There is an additional benefit from having a solid household balance sheet.  Over the last generation, Buffet has shown the world that having a fortress balance sheet gives you opportunities only available to a few.  This is also true of households with high savings and low debt.

Sunday, September 16, 2012

Why I'm Never Buying Facebook

Facebook now has a ton of cash from their IPO and the stock has fallen considerably.  The percentage of cash to market capitalization has risen dramatically.  The valuation is still too high for my taste, but I've already started to think what I would do if the price fell a lot further.  I do agree with the quote, "There are no bad stocks, only bad prices."  Almost anything is a good value if it's priced low enough.

In the case of Facebook, however, I've decided I'm going to take a pass no matter how low it goes.  Because of the two-class stock structure, a single person still controls 57% of shareholder votes.  This is not a governance situation I can accept.

I understand Mark Zuckerberg is a smart man and there will be enormous pressure on him to make good choices for the company.  Nonetheless, there is a universe of other stocks out there that don't have this significant problem.  Unless and until the voting issue is changed, I'm staying away from Facebook at any price.

Saturday, September 15, 2012

Beware Pseudo-Arbitrage

Pure Arbitrage

Arbitrage is the process of profiting from price differences in the same item in two different markets.  In order to have true arbitrage, you must be able to simultaneously execute these trades to eliminate the risk that the prices will fluctuate.  With pure arbitrage, there is the possibility of risk free profits at zero cost.  For example, if gold is selling for $5 more in New York than London, then you could generate amazing profits by simultaneously buying gold in London and selling it in New York.

In the information age, however, most pure arbitrage opportunities have been rendered obsolete.  There is simply too much information flow for things to be priced differently in different markets.


Statistical Arbitrage

A related strategy to profit from imbalances is statistical arbitrage, otherwise known as risk arbitrage.  The main difference of statistical arbitrage is that the transactions cannot be executed simultaneously, so there are a number of things to go wrong.  Unlike pure arbitrage, the retail investor can easily find risk arbitrage opportunities because they are common.  However, many investors who participate in such pseudo-arbitrage do not understand the variety of risks that can come into play.  Let's examine a few typical risk arbitrage opportunities and what might go wrong.


Closed-End Fund Discounts


Many closed-end funds trade at a discount to NAV (net asset value).  A 10% discount is common.  That means that if the fund were liquidated, the underlying stocks would be worth about 10% more than you paid for them by purchasing the fund.  Hence, people may feel that they are "purchasing these stocks at a 10% discount".  Is this a sure thing?  No.

The fund may never liquidate and the 10% discount may continue indefinitely.  It's not really helpful to "purchase stocks at a 10% discount" if they must also be sold at a 10% discount!  You may think that you could purchase the underlying stocks, short the fund, and wait for the 10% difference to close.  But again, the discount may never close, and the holdings of the fund may change at any time.  The fund discount may also be partially attributed to the fees that the fund charges,


Merger Arbitrage

This is actually one of the better opportunities because usually there is an expected closing date to the merger.  However, the terms may change or the merger may be cancelled.  This strategy is best left to professionals who can monitor the terms of each merge, but retail investors can invest in funds that use this strategy.


Pairs Trading

Pairs trading is a type of relative value arbitrage, where investors hope to profit from short term aberrations between similar companies.  Typical examples would include GM and Ford or Coke and Pepsi.  For example, one might hope to profit by waiting for Coke to be overvalued by 5% relative to Pepsi.  The idea is that the companies are so similar and so correlated that past history suggests this relative valuation difference will narrow back to zero soon.  However, there is no guarantee this will happen.  Coke may stay overvalued relative to Pepsi for years.  Even if the relative valuation does eventually return to parity, a 5% investment return is not attractive when spread out over several years.

Friday, September 14, 2012

Experts


Niche Experts

The Wall Street Journal published an article a few months ago about cocoa graders who work for the agricultural exchanges.  These people are true experts on cocoa beans.  They must be able to quickly identify the country of origin, the quality of the bean, and any bacterial issues by sight and smell.

In order to become a certified grader, you must pass a rigorous exam that has a pass rate only one fourth that of the New York State Bar exam.  The article discussed how one applicant failed the test because she was not able to correctly distinguish between beans from Haiti versus beans from the Dominican Republic.  Now it is rather remarkable that people would even be able to do that because Haiti and the Dominican Republic share the same Caribbean island.


Familiarity "Experts"

The trouble with experts is that usually their field of expertise is really narrow.  We don't have a lot of polymaths these days.  This can get many people into trouble because we tend to fancy ourselves to be experts in areas which are only tangential to our real niche.

I recall how one day I was putting sealer on the driveway.  The mailman came by and informed me that I was using the wrong stuff.  However, I quickly became skeptical of his expertise because he was only able to articulate to "use the other stuff, the stuff that comes in the bigger containers".

I asked him tongue-in-cheek how he knew so much about driveways.  He replied with a straight face, "I'm a mail carrier.  I see hundreds of driveways every day."  Unfortunately, daily familiarity with something does not make one an expert.  I see hundreds of cars each day on my way to work, but I am not an expert on cars. 


Consumer Product "Experts"

One of the more dangerous areas where familiarity bias is a problem is in financial decisions.  People often assume that if they use and enjoy a particular product, then the company that makes that product must be a worthwhile investment.

People who follow this strategy often cite Peter Lynch's advice to "invest in what you know".  However, people need to understand the context of this advice.  Peter Lynch held more stocks in his portfolio than any other active manager I know.  He sometimes held thousands of stocks.  So in context, sticking with companies that make things you know only meant not to get involved in fly-by-night operations.  Buying the companies that make your 3 favorite products is an entirely different matter.

Thursday, September 13, 2012

Secret Giving


Secrets

Everyone loves a secret.  We love to know them, and we love to hear them.  But there is often a dark side to things concealed.  A lot of destructive behavior such as substance abuse and shoplifting have a component of secrecy to them.  In fact, part of the allure of such behavior seems to be the secrecy that is involved.  Shoplifters are sometimes willing to risk a criminal record and even jail time for a $10 item!  Why?  Many people say that the thrill of not knowing whether they would be caught was a powerful temptation.  In other words, it wasn't the $10 item that they wanted.  It was the thrill of doing something secretive.

I'd like to suggest a more positive outlet for our clandestine fascinations: secret giving.

Examples of Secret Giving

I'm not talking about making an anonymous donation to a charity or performing a random act of kindness by paying the bridge toll for the car in back of you.  I'm talking about helping someone in secret.  It's exciting to do, and it also builds character because your motives are not corrupted by the praise you might receive if your actions were public.

For example, suppose it's wintertime and there's been a heavy snow.  Perhaps you have a friend that cannot easily shovel because they are elderly, or have a disability, or have small children to watch.  You could just drop by and help...or you could have some fun with it.  Maybe you know this person won't be back from work until 6 PM.  You could arrange to leave your own work early, hurry over to their house, and shovel the walks and driveway.  There will be a bit of a head rush as you hurry to finish and leave before your friend arrives.  Later, your friend may excitedly say, "You'll never guess what happened today while I was at work..."  Now you know a secret, a positive secret that you created.

Another example might be to help someone you know who is out of work.  You might anonymously mail them a package with something they really need, or perhaps you might send them cash in the mail.  Perhaps you might even enlist the help of someone else to address the envelope so the recipient does not realize you were the source.  You can be as creative and elaborate as you want.

The next time you feel bored, don't head to the movies for an escape or to the mall for a shopping spree.  Instead, try the excitement that comes from giving in secret.  You will not be disappointed.

Wednesday, September 12, 2012

Personal Finance Unforced Errors

Forced Errors vs Enforced Errors

In the tennis world, they talk of forced errors and unforced errors.  Forced errors occur because of your opponent's skill.  Unforced errors, however, are simply due to poor judgment or execution.  Put another way, forced errors are caused primarily by external factors, while unforced errors are caused entirely by internal factors.  This means that unforced errors can be minimized through practice and discipline.


Personal Finances

In your personal finances, some problems arise that are primarily external in nature.  You may unexpectedly lose your job, the stock market may decline 50%, or you might become disabled and unable to work.  These are the forced errors of personal finance and are largely out of our control.

But then there are the unforced errors of personal finance.  These are the times when the ball comes right at us, but we hit it into the net.  These are the spending sprees, the investment gambles, the easy career opportunities that came our way that we flubbed.


Control What You Can

People often spend a lot of time trying to control the external factors, which is not nearly as productive as minimizing the unforced errors.  In any endeavor (sports or finances), minimization of unforced errors rests on two pillars: knowledge and practice.  We must know the right things to do, and we must practice them so that they become an instinctive way of life.

Tuesday, September 11, 2012

Remembering September 11th with U2

I was quite moved as I watched the video below of U2's halftime performance at Super Bowl XXXVI.  Keep in mind that Super Bowl XXXVI was played on Feb 3, 2002, less than five months after the 9/11 attacks.  People were still in pain and in fear that another attack was imminent, perhaps even at that very event itself.  Watching this video triggered a rush of memories of that day in September eleven years ago.

The imagery is powerful, with the names of the victims soaring into the heavens, the motif of love over hate, and Bono fighting back tears during the surprise display of solidarity in the last few seconds of the song.  Full screen viewing recommended.


Monday, September 10, 2012

Investment Checklists

Order Entry Checklists

When you read discussion boards or even books on investing, you'll notice that a lot of people have stories about how they've messed up trade orders.  People enter the wrong stock symbol and end up inadvertently buying something they don't want, or they sell existing shares when they mean to buy more.  Fortunately, I've never actually messed up a trading order, and the main reason is that I've always used an order entry checklist.  I started doing that right from the start because I had no other choice.

You see, back in the late 80's when I started investing, you actually called a broker over the telephone to place your order.  I have no idea how I got hooked up with the brokerage place I used because it was primarily for institutional investors and everything went really, really fast over the phone.  They wanted you to go through the whole order in about 20 seconds.  I was so frazzled by this process that I wrote everything down - even my own phone number!  (Back then they took your phone number to call you back when the trade went through.  How quaint, right?)

Investment Selection Checklists

Another common type of checklist is one that contains a list of things to validate or investigate before you buy or sell a stock.  For example, you might only buy stocks with a certain dividend yield or expected growth rate.  I don't tend to buy stocks based on screens, so I don't have a list of criteria that a stock must have before buying.  Instead, what I've found helpful is to embed my past mistakes in my investment checklist.

Ever buy a stock or a fund and then a few weeks later you fume about something you should have known?  I never would have bought this company had I known they had so much debt!  Good.  Add that to the checklist: Verify debt level.  What was I thinking buying this fund the day before their yearly distribution?  Lesson learned.  Add to the checklist: Know distribution date.

Checklists and Risk

Some people resist checklists of all sorts because they're usually filled with obvious items.  However, the point of a checklist is not to inform you that these items are important.  The checklist is there to help you reduce the chance of oversight error, especially when you may be tired or preoccupied or rushed.  Pilots, mechanics, and many other professionals use checklists to help reduce risk.  Why not apply those same lessons to your investments?

Sunday, September 9, 2012

How I Got My Blogging Groove Back

I've now written 25 posts in 25 days, which is something I never thought I'd be able to do.  That is more posts than I wrote during all of 2010 and 2011 combined.  If nothing else, it says that people generally work better with a deadline and I am certainly no exception to that rule.

But I think it also shows the power of framing things correctly.  I had previously made a number of attempts over the past few years to start blogging on a daily basis.  These attempts all failed, as I fell back into my usual bad writing habits.  I'd write for 5 or 10 minutes and then get stuck.  I'd stop and come back to it a few days later.  I'd then write for another 5 minutes, get stuck, and repeat the process.  This is why it usually took me weeks of calendar time (not actual writing time) to write a single post.

My previous attempts at solving this problem all framed the solution in the wrong way.  I always started with the idea that since I could write a decent article in a few weeks, I just needed to find a way to gradually shorten that timeline from a few weeks down to one day.

The breakthrough for me was to frame the solution in a different way.  Instead of trying to shorten the time to write a good article, I just decided I would write something in a half hour each day and direct my effort into writing the best article I could in that time.  I don't know if this will work for everyone, but it worked for me.  If you're a blogger and you're having trouble writing as often as you would like, you might want to consider this approach.

Saturday, September 8, 2012

Exaggerations of the Financial Blogosphere

The Childhood Game of Telephone

Remember the "telephone" game you played as a child at a birthday party or at elementary school?  One person whispers a message to another person, who likewise whispers the message to the next person.  The last person in the room tells the message out loud and then this is compared to the original message.  Invariably, the versions are much different, with the final version often being a caricature of the original.  It's a fun game, and it also teaches us about the dangers of relying on second hand information.

A lot of misinformation in the personal finance blogosphere propagates this same way because bloggers love to write about what others are writing about.  One blogger writes a story about something, and soon another blogger writes a new version of the same story.  Down the chain of bloggers goes the story, often accumulating more and more errors on the way.

Living on $21 a Day

In the past few days, I've seen a number of blog articles chattering about a woman in a urban area living on $21 a day!  The virtues of frugality are extolled, congratulatory remarks are made, and discussions of how to possibly emulate this behavior ensue.  Some people are skeptical.  Why the rent alone must be difficult to manage on $21 a day!  Is she living on the street?  Others applaud her ability to pull this off and suggest how they, too, might be able to live on this amount, although it will clearly be difficult.

Tracing the Story Back Through the Broken Telephone

As I began to trace the story back through the chain, I soon noticed that $21 a day was not her entire living expenses as the article I read had purported.  Instead, $21 a day was her grocery expenses.  When I eventually arrived at the original story, I was in for a real surprise.  The women did not even claim to spend $21 a day on groceries.  In fact, she specifically said that $21 a day for groceries was "ridiculous", "pretty much impossible", and "seriously bad for your health".

What the woman had actually done (and was espousing for others) was to "save money" for one week by limiting grocery purchases to $21 and eating the food already in the refrigerator and the pantry.  Wow.  This is quite a difference from living on $21 a day, isn't it?  And while the idea does have some merit as a one time cash flow helper, I have written in the past that this sort of behavior is nothing more than household inventory drawdown.  It is not saving money.  Buying $100 worth of groceries each week is the same spending level as buying $200 worth of groceries every other week.  The alternate weeks are not "zero spending" weeks for groceries.

An Appeal for Professionalism

If the personal finance community wants to be taken seriously, we had better start accurately reporting stories, statistics, and ideas without each person in the chain adding their own embellishment.  Omitting or changing critical details to sound more exciting or attract more readers is highly misleading.  As a community, we can and should do better.

Friday, September 7, 2012

The Market Will Always Be There For You

"There are no bad stocks, only bad prices."

- Unknown

I wish I had a dollar for every time someone told me over the years that some high flying stock would never have a P/E of 10 or 12.  Amgen.  Cisco.  Microsoft.  Walmart.  These stocks and many others had P/E ratios over 25 for a long, long time.  But eventually they all fell into value investor range.

And so it was that in June of this year I found Google selling at $565.  Sure enough, subtracting off the net cash on hand, Google had a trailing P/E of about 12 and a forward P/E of about 10.  I bought a small amount: $5,000.  The stock has had its ups and downs since then, but I don't lose any sleep when I buy at price levels like that.

Many years ago I read a statement about investing that has always stuck with me.  (I wish I could remember who said it.)
"The market will always be there for you." 

This is brilliant on many levels, but the main point is that you don't need to force trades.  The idea that any open market situation is "the opportunity of a lifetime" or that "you must act now" is completely erroneous.  Have patience!  Let the prices come down to you.  Pass on many opportunities; more will come along shortly.  Trust me...the market will always be there for you.

Thursday, September 6, 2012

Ginger and Pickles

Have you ever read Beatrix Potter's book entitled The Tale of Ginger and Pickles

In this whimsical children's book, Ginger is a tomcat, and Pickles is a terrier.  Together they run a small general store that eventually shuts down due to poor management.  As I was reading this book to my children the other day, I couldn't help but notice that it covers many major business ideas in one very short book.  I've listed these ideas below with relevant quotes from the book.  Enjoy!


Too Much Debt Is Dangerous
Ginger and Pickles gave unlimited credit.  Now the meaning of "credit" is this - when a customer buys a bar of soap, instead of the customer pulling out a purse and paying for it - she says she will pay another time.

Keep Track of Your Inventory
As there was always no money, Ginger and Pickles were obliged to eat their own goods.

Take Care of Your Customers
"I have the same feeling about rats," replied Pickles, "but it would never do to eat our own customers; they would leave us and go to Tabitha Twitchit's."  "On the contrary, they would go nowhere," replied Ginger gloomily.

Beware the Tax Man
"I am afraid it is a summons," said Pickles.  "No," replied Ginger, who had opened the envelope, "it is the rates and taxes, £3 19 11 3/4."  "This is the last straw," said Pickles, "let us close the shop."

Monopolies Raise Price Levels
The closing of the shop caused great inconvenience.  Tabitha Twitchit immediately raised the price of everything a half-penny.

Listen to Your Customers
And when Mr. John Dormouse was complained to, he stayed in bed, and would say nothing but "very snug"; which is not the way to carry on a retail business.

Advertising Works
Sally Henny Penny sent out a printed poster to say that she was going to re-open the shop - "Henny's Opening Sale! Grand co-operative Jumble! Penny's Penny prices! Come buy, come try, come buy!" The poster really was most 'ticing.  There was a rush upon the opening day.

Everyone Loves a Bargain
She has laid in a remarkable assortment of bargains.  There is something to please everybody.

Wednesday, September 5, 2012

Constancy Of Purpose

"The secret of success is constancy of purpose."
- Benjamin Disraeli

How much time do you think employees waste at the company where you work?

You might look around and see that most people are reasonably competent and are working hard.  Maybe there are a few people goofing off now and then, and maybe there are some inefficient processes.  You might be inclined to think that the waste is small - maybe 10% or 20% of the hours worked.

But I'd be willing to bet the real percentage of wasted time is much, much higher.  I'd guess it's over 50% in many places, and for some corporations, a number of 70% or 80% wouldn't surprise me.  Yet you won't see this waste by just observing your immediate group of coworkers.  For in order to waste truly staggering amounts of time, we need something else: lack of constancy of purpose.

Constancy Of Purpose In Corporations

I've seen companies where, unbeknownst to each other, three different parts of the company spent large amounts of money building nearly identical computer systems.  Two thirds of that labor was wasted.  And I've seen a marketing director craft production, advertising, and sales all around the idea that their product should be a high margin item.  But when the new marketing director was hired, they abandoned all that effort and pushed for market share at all costs.  And I've seen executives who were compensated based on short term profits that come at the expense of long term profitability.

The incentives of key people are often not aligned with the company at all.  So people pursue their own interests instead of those of the company.  Sometimes large parts of a company duplicate, cancel out, or undermine the efforts of other parts of the company.

When everybody is trying to row a boat in the same direction at the same time, you may still waste small amounts of effort due to inefficient strokes or warped oars.  But when everyone is pulling the boat in different directions or the group keeps switching directions constantly, then nearly all of the effort is wasted.

Constancy Of Purpose In Your Own Life

While we may get a chuckle out of how dysfunctional corporations are with respect to constancy of purpose, we often make the same mistakes in our own lives.  We start new projects, and yet before they are hardly off the ground, we abandon them and move onto something else.  And just like businesses, there are parts of our lives that undermine other parts.  Worst of all, we may not even have a purpose in our lives or be deliberate in how we approach our goals.

Constancy Of Purpose In Your Finances

Especially in the area of finance, we often need to step back and look at things holistically.  A lot of people have a list of financial goals written down, and that is a good place to start.  Look through your list of goals and see if any of them clash just at face value.  The sooner you recognize these differences, the sooner they can be corrected.  Next, take things to a deeper level.  Ask yourself why you have each of your financial goals, and write those reasons down.  Do any of these reasons conflict?

If you can achieve constancy of purpose throughout your life, your chances for success will increase dramatically. 

Tuesday, September 4, 2012

Chipotle Rounding Controversy

Have you read about the brouhaha over Chipotle rounding bills to the nearest nickel in some locations?  In order to speed up the lines, Chipotle was rounding bills so that cashiers would not have to handle pennies.  At first they were rounding both up and down, but after a few irate customers starting creating bad publicity, they decided they better only round down to keep everyone happy.  For some reason, I found this whole controversy to be amusing.  Some quick thoughts:
  • The most that could have been added to a bill was two cents.  It's amazing how much people care about one or two cents while they are spending $1.75 for their soda.
  • Unless you always order the same thing, your rounding costs will tend to sum to zero over time.  Sometimes it'll round up and sometimes it'll round down.
  • Chipotle didn't run this idea by the PR department?  As insignificant as rounding seems to me, it would be easy to predict people would not like to see "ROUND....+0.02" at the bottom of the bill.
A more serious question I have is why fast food restaurants and other high traffic retail stores don't just set their prices (including tax) to easily handled numbers.  How many times have you ordered a typical combo, and then it comes out to something like $5.03 at the counter?  Why couldn't they price that at $5.00?  This is a common practice at ballparks and amusement parks.  Why not extend this idea to other retail locations?

Monday, September 3, 2012

My Reasons for Individual Stocks

Why buy individual stocks?

That is the question I asked a couple of weeks ago in a post where I explained that for certain kinds of portfolios, the costs of individual stocks can be equal to or less than funds or ETFs.  A reader asked if I wouldn't mind addressing a more complicated concern about individual stocks: the widely discussed fact that most investors substantially lag the market.

I will warn you up front that this whole post is probably going to sound evasive.  Like a lot of financial questions, I don't like how it is framed.  The purpose of this post is to show the complexity of the question and the backdrop behind it.  If reading this article puts a lot of uncertainty in your mind, then I've done my job.  My argument is not that individuals can or can't beat the market, because frankly I don't know and I tend to think a "yes" or "no" is not a helpful answer.


My Personal Biases

I have been a student of the markets for more than 25 years, and I respect the price discovery mechanism in markets immensely.  Thus, I am not the kind of person who thinks "investing is easy".  You have no idea how much I cringe when I read articles purporting to tell people it's simple and straightforward.  I also believe most lists of "5 Stocks To Own Now" are misguided (at best).  Worst of all, I'm especially irritated when I read articles where people brag about how they started investing a year ago, how they bought a half dozen stocks that have outperformed the indexes, and how this proves that they're amazingly smart and investing is really easy.

And yet...

I confess that I buy individual stocks myself.  So do I think I'm smarter than the market?  No.  Am I just emotional and can't practice what I preach?  No.  Am I just delusional?  I hope not.  Let me try to explain...


How People Underperform The Market Indexes

Although there are a thousand reasons why people mess up, the mechanics of what happens can all be generalized to just a few problems.  This is not rocket science.  If someone underperforms the indexes, one of the following issues occurred:

  • Bad Timing.  This is the major reason.  Index returns assume continuous holding of your investment.  In contrast, a lot of people jump in and out of the market, and most of those people time the market very badly.  Note that this mistake is not limited to individual stocks.  Many people jump in and out of index funds or other vehicles as well, usually reducing their returns substantially.
  • Bad Selection.  You would think that stock picking would be easier than market timing, but evidently it's not quite so easy either.  Actively managed funds have every incentive to beat the markets, have the resources to perform extensive research, and (usually) have a mandate to avoid market timing.  Yet almost none of these funds perform better than the indexes over long periods of time.
  • Bad Diversification.  While I agree that in some ways this is just a variant of bad selection, I believe it's a slightly different scenario. If someone picks 100 stocks and they return far less than the market averages, then I think it's fair to say that person is just not good at picking stocks.  But if someone only picks one stock, how do we really know if they are skilled or not?  We have almost no sample size.  In my mind, the person who picks only one stock has only gambled, and has not really tried to pick stocks.  If someone thinks they are really so skilled at picking good stocks, then why can't they pick 25 good stocks instead of one or two?
  • Bad Allocation.  Yes, this is also bad selection in a way because it's the selection of different asset classes.  In the case of asset allocation, however, we generally do not assume that one should even be attempting to find and pursue the combination of assets that has the highest return.  Individuals may pursue different asset allocations based upon their age, risk tolerance, tax circumstances, and other factors.  Hence, we often don't know what the baseline should be.  If an investor outperforms the S&P 500 because he purchased small caps when they were in vogue, is this a sign of superior investing, or would we see underperformance if compared to the S&P 600?  Individual investors often do not state their asset allocation objectives, making performance comparisons difficult.  Yet many investors do intuitively gravitate towards allocation strategies with which they feel comfortable.

How People Outperform the Indexes

So in order to outperform the indexes, someone needs to reverse the items above.  We need superior timing, selection, diversification, allocation, or some combination thereof.  I agree most people will probably not find a suitable combination.  However, I would also guess that if someone was serious enough to understand the basic ideas above, they might very well get a lot closer.

Clearly people do outperform the indexes.  The question is not only how long it can be sustained, but more fundamentally, whether the outperformance is simply luck.  With enough investors on the planet, surely some people were just lucky.  In some cases, this may be obvious.  For example, if someone just happens to invest 100% in stocks during a bull market, and then puts all the money into bonds at the top of the stock market at retirement, this would generally be considered luck.  But what about the person who does well researching and selecting stocks?  He, too, may just be lucky...or he may have skill.  I don't think we can really know.  Statistically, the number of years it would take to prove someone is skilled (instead of lucky) is simply too much for one lifetime.


Why I Buy Stocks

So here are my personal reasons for buying individual stocks.  They will probably surprise.
  • I enjoy constructing portfolios from scratch.  It is fun for me.  Hence, if I only duplicate the return of the indexes, I don't feel like I wasted all that effort.  Now if I thought I would substantially underperform, that would be quite an expensive hobby, wouldn't it?  But I am fine with achieving the market returns after all my work.  I am not swinging for the fences.
  • What I'm really looking for is lower risk.  I'm not attempting to achieve higher returns at market risks, but market returns at lower risks.  This is not a typical objective for small investors, and it is not well served.  For example, the DVY ETF is interesting, but why should I pay 40 basis points in annual fees and allow them to put 1/3 of the portfolio in the utilities sector?
  • Hand selected portfolios bring greater clarity and confidence.  If I could buy funds where the 10 top holdings always included names I could believe in, I probably would stop buying stocks myself.  But invariably, I see things I don't want.  This makes it harder to avoid the timing and other issues mentioned above.  If you truly believe in your own diversification and selection, perhaps you will avoid subpar timing and allocation.  On the other hand, investors are notoriously overconfident, aren't we?  At any rate, these are my reasons.  I'm well aware that the jury is still out.

Sunday, September 2, 2012

Bogus Valuation Indicators

Want to know an easy way to spot bogus valuation indicators?  Here are two great rules of thumb:
  • If an indicator doesn't have the current price of the security in the numerator or the denominator, it's not a valuation indicator.
  • If an indicator has one price in the numerator and another price in the denominator, it's also not a good valuation indicator.
How can you possibly value something if you don't factor in the price? That's why normal valuation measures include the price. For example:
  • P/S Ratio  (Price / Sales)
  • P/E Ratio  (Price / Earnings)
  • Dividend Yield  (Dividends / Price)
  • P/B Ratio  (Price / Shareholder's Equity)
Valuation ratios become meaningless when they don't include the current price.  Indicators also become useless for valuation when they include the price in both the numerator and denominator, thereby cancelling out the price information.  Here are a few indicators you may have seen used as valuation indicators at one time or another:
  • Yield on Cost  (Dividends / Price you paid when you bought the stock.  Huh?)
  • Market Value / Enterprise Value  (A nonsensical measure that includes the price in the numerator and denominator.)
  • Last Year's Return  (Current Price / Price one year ago)  The price cancellation in numerator and denominator is telling you this is not a valuation indicator.  "Past performance is no guarantee of future results."
  • Total Cash on Hand  (Not relevant as a valuation indicator by itself without price.)
  • Mutual Fund Performance Rankings  (Essentially price movement of one fund relative to other funds.)
Now I do want to point out that there are many financial indicators that are useful that are not valuation indicators.  There are many accounting indicators (e.g. quick ratio), opinion indicators (e.g. analyst opinions), risk indicators (e.g. beta), and profitability indicators (e.g. return on equity) that do not factor in price.  These indicators are very helpful to assess the financial health of a company.

Without a price anchor, however, an indicator is not a valuation indicator.  By definition, a valuation indicator is attempting to pass judgment on the value of a company.  On other words, is it worth paying the current price of a security?  If an indicator does not include the price (or cancels it through division), then the price is not embedded in the indicator.  This means the indicator would stay the same if the security doubled, tripled, or fell 90%.  Thus, it tells me nothing about the current valuation of the security.

Saturday, September 1, 2012

Trailing and Forward Dividend Yield

Dividend yields can be forward looking (forward yield) or backward looking (trailing yield).  The forward dividend yield estimates the yield over the next 12 months, while the trailing dividend yield tells you what the yield actually was over the last 12 months.  Each measure has its advantages and disadvantages, and I'd like to explain why I prefer to use both measures.

Trailing Dividend Yields

The primary advantages of trailing yields are that they are certain and easy to find.  The dividends paid by listed companies are a matter of public record.  Since this is historical data, there are hundreds (or perhaps thousands) of free data sources for this information.   But data aggregators do make mistakes, so I would cross check with more than one source before using the data to make any sort of decision.

The disadvantage of trailing yields is that stocks are not priced based upon past results, but based upon estimates of future results.  We tend to think of that fact with respect to earnings, but really it applies to all corporate financial information.  The people with the deepest pockets are not looking at the dividend from last year.  To the extent that they care about dividends, they are buying or selling based on their best guess of future dividends.

Forward Dividend Yields

Estimates of future yields are obviously uncertain.  No one really knows exactly what they will be.  Unlike past dividends, which can be automatically aggregated from public documents, substantial analysis must be done to arrive at a decent estimate for future dividends.  This means that, in general, either you will have to expend a fair amount of effort yourself to arrive at these estimates, or you will have to pay up for them.  There are not a lot of good, free sources of future dividend estimates.  One notable exception is the IndexArb list of DJIA forward yields.  (This site also used to have forward yields for the entire S&P 500, but due to a dispute with Standard & Poor's, this information is unfortunately no longer available.)

Notwithstanding the uncertainty and potential cost of estimating forward yields, I feel strongly that trailing yields should not be used exclusively.  Relying on past data alone can result in amateurish mistakes in analysis.

For example, two roughly similar companies (e.g. Coke and Pepsi) could at times have dissimilar trailing yields simply based on the fact that they tend to hike their respective dividends at different times of the calendar year.  Thus, you may look at one company and see a 3% yield and see a similar company with a 2.7% yield.  You may erroneously conclude that the 3% yield is more attractive, only to discover that the company with the 2.7% yield hikes their dividend 10% next month and levels the playing field.  The difference in yield was only a mirage, as the market anticipates the fact that the increase was coming soon.  Forward yields will tell you that information; trailing yields will not.

Another mistake made with trailing yields is to assume that it is a more conservative measure than forward yields.  This is not necessarily the case, as more certainty does not always equate to more conservative.  When a company begins to do poorly, good analysts may begin to predict a dividend cut.  In this case, the forward yield is more conservative, while the trailing yield may still be trumpeting this large, unrealistic number.

In summary, I advocate looking at both trailing yields and forward yields.  Using just one measure is yet another case of trying to unrealistically simplify things to one number.  Both measures tell you something different and useful.