Archive for February, 2010

What To Do With Your Tax Return

Posted By damien on February 26th, 2010

A few days ago, a friend and I were talking about filing this year’s taxes, and the conversation drifted to what to do with our returns. My friend asked a very common question:

Should I use my tax return to pay down debt or invest?

This is a pretty common question and one that can be generalized to “What should I do when I receive a lump sum of money? Pay down debt or invest?” I’ve already told you how to invest a lump sum of cash, but here let’s talk about how to decide between dumping debt or buying stock. Before I tell you the right way, let’s look at the conventional wisdom, because it’s wrong.

The Conventional Wisdom

Here’s what most people would say: compare the rates of return, and put your money on the higher one. If your credit card charges you 8% and you can invest at 11%, put your money in stocks. If your credit card charges a higher rate than you can earn by investing, then pay down the debt. Sounds good, right?

Wrong! If you play this game, you walk a dangerous line. So where does this way of thinking go wrong?

It disregards the element of risk.

A Better Approach

This comparison is not apples to apples. A credit card rate is pretty much guaranteed. Sure, it could go up or down, but only at the discretion of the credit card company. For our purposes, the credit card interest rate is guaranteed.

Stocks, like most investments, are inherently volatile. In the short-run, the rate of return from stocks is anything but guaranteed! In the long-run (20+ years) the stock market has averaged around 11%, but once again, this rate is not guaranteed.

Comparing the interest rate on stock investments to credit cards is comparing apples to oranges. A risky investment (stocks) versus a guaranteed obligation (credit cards). In order to compare apples to apples, we have to adjust the stock’s rate of return down.

Now, I’m pretty good with a financial calculator, but the formulas for adjusting for risk are a bit outside the scope of this blog and my mathematical skills. Suffice it to say, you will almost never find a guaranteed investment offering a higher return than what your credit card charges.

Let me say that again, because it is the point of this post: you will not find a guaranteed investment with a higher return than what your credit card charges.

So my advice to my friend (and to you) is to pay down debt before investing your tax return.

Unless you find a guaranteed 11%+ return. Then I’m all ears.

Posted in Dumping Debt

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Why Can’t Top Stock Pickers Predict the Future?

Posted By damien on February 23rd, 2010

As explained before, I do not place unblinking trust in any sort of “expert”. Frankly, I don’t think most experts deserve the credence or deference we are wont to give them. In today’s internet-based world, many self-proclaimed experts are better at self-promotion than at giving expert advice.

When it comes to incompetent experts, the realm of stock picking is no exception. Keeping with the theme that index funds are good and actively managed funds are bad, let’s look at three reasons why stock pickers have such a hard time picking stocks that will outperform indexes.

Random Events

Let’s face it, the future is just too murky to predict. Who could have seen the most recent stock bubble coming? Virtually none of the professional stock pickers did. Jim Cramer from CNBC’s Mad Money certainly didn’t. The day before Bear Stearns went under, he was telling people to most definitely not sell their stock; that Bear Stearns was A-OK. The next day Bear Stearns went belly up.

There are just too many random variables that go into the price of a company’s stock: natural disasters, defects in a product, new discoveries, terrorist attacks, the list of variables outside of the company’s control goes on and on. A popular saying among investors is that stock market predictors exist so that meteorologists (weather predictors) can feel good about themselves.

Falsified Financial Statements

A firm’s income statement may be likened to a bikini—what it reveals is interesting but what it conceals is vital.

–Burton Malkiel

One way today’s fund managers decide which stocks to buy is through a process called Fundamental Analysis. It pretty much means they look at companies’ financial statements (balance sheet, income statement, etc.) to determine if the stock is undervalued or overvalued. The problem with this approach is the rise in “creative” accounting procedures. Accountants are very good at manipulating reports to make everything look rosy.

Here is just one example of creative accounting, taken from A Random Walk Down Wall Street:

Eastman Kodak availed itself of “big bash” accounting write-offs. Kodak took six “extraordinary” charges during the 1990s totaling $4.5 billion, equal to all the company’s profits over the preceding eight years. By charging off years of expenses at once, the company could make future earnings look that much better. It’s like an individual making several years of mortgage payments in advance and then claiming that his income has grown.

Conflicts of Interest

Perhaps the biggest reason stock pickers are unable to accurately predict the future is the inherent conflict of interest that exists in the big brokerage houses. Individual investors like you and me are the small fries in the investment arena. For stock analysts, the real money is to be made from investment banks. Investment banks move billions of dollars every month, so stock analysts want to keep them happy.

One indicator of how much analysts want to keep the big guys happy is in their reluctance to give advice which paints the bug guys’ stock in a bad light. The analyst is torn: he knows he should tell you to sell the lame stock, but his brokerage house has a relationship with that company and it will hurt their relationship if even hints that their stock is stinky.

Here’s a famous example, once again from A Random Walk Down Wall Street:

In one celebrated incident, an analyst who had the chutzpah to recommend that Trump’s Taj Mahal bonds should be sold because they were unlikely to pay their interest was summarily fired by his firm after threats of legal retaliation from “The Donald” himself. (Later, the bonds did default.)

Trust No One…

When it comes to predicting the future, no one has a harder time than stock fund managers. Even your local weatherman (or woman) gets it right more often. There are just too many variables: random events, creative accounting, and conflicts of interest. So what is an investor like you or me to do? Choose index funds!

Posted in Building Wealth

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How to Invest in Stocks: Investment Tools

Posted By damien on February 18th, 2010

In the previous post, we looked at my investment philosophy, meaning the principles I use when choosing what to invest in. Since I am investing for the long-term (retirement) I want stock funds that are easy to understand, have a slow and steady track record, and have minimal fees.

Using these criteria, let’s look at the actual stock funds I invest in and recommend. In a nutshell, index funds are good and actively managed funds are bad.

What to Invest In

When it comes to the three principles outlined, index funds can’t be beat. Before explaining how they meet the criteria, let’s talk about what index funds actually are.

A stock index is a listing of the largest companies in the various stock markets, ranked by market capitalization. The most well known index is the S&P 500, a listing of the 500 largest stocks on the New York Stock Exchange. These 500 companies account for about 75-80% of all US common stocks.

An index fund is a grouping of stocks that follows one of the indexes (such as the S&P 500). They invest in stocks proportional to the amount of each company’s stock in the market. So an index fund would have more of GE’s stock than, say, Apple’s. If you were to invest in an S&P 500 fund, you would own a little stock of all 500 of the largest companies in the US market.

Index Funds vs. Our Philosophy

So how do index funds stand up to our investing philosophy? First of all, they are simple to understand: I just explained one to you in the preceding two paragraphs. You are investing in a large group of common stocks. No alphabet soup here.

Secondly, index funds have the least volatile returns available (of common stock). In fact, this is where index funds really shine. Since they are so diversified (across hundreds or thousands of companies), when measuring the return of an index fund, you need only be concerned with how the overall stock market is performing. The performance of any one company is so small (some even negligible) in the aggregate. This leads to smoother, more consistent returns.

Last of all, let’s consider fees. Once again, index funds take the cake. Since index funds simply track an index, there is no advanced analysis needed when picking stocks to include. Index fund fees are rock-bottom.

What to Avoid

Now that we know what to invest in, let’s look at what to avoid. As I said in the beginning of this post, actively managed funds are bad. An actively managed fund means that some smart person or complex computer software is picking the stocks to include in their funds. Active managers look at financial statements, stock charts, and Wall Street gossip to help them choose stocks. In future posts, I will go into detail about the methods that are used, and how ineffective they are for our purposes.

Managed Funds vs. Our Philosophy

How do actively managed funds hold up to our three criteria? Oftentimes, fund managers will invest in all sorts of tools, regardless of our understanding. The attitude here is “trust me, I’m a professional”. Most active managers are buying and selling stocks so often that even if you did figure out all the tools you were putting your money into, a month later it would have changed.

Historically, actively managed funds, in the long run, never outperform index funds. For stretches of 5- 10- or occasionally 15-year periods, actively managed funds have returned more than comparative indexes. But in the long-run, active managers have not outperformed index funds. In fact, many managed funds, following the concept of mean reversion, after a period of outperforming the index go on to underperform. For a more detailed explanation of this argument, I refer the reader to The Four Pillars of Investing or A Random Walk Down Wall Street.

Actively managed funds are the main culprits when it comes to high and hidden fees. The reasoning goes that if a smart person or sophisticated computer algorithm is picking your stocks, you should pay them more for their efforts. Managed funds came up with wrap accounts, 12b-1 charges, and a plethora of ways to take your money whenever you buy, sell, look at or think about (not yet, but they’re working on it) stocks. Here’s the real kicker with managed funds and fees: Any higher return you may receive from them gets eaten up by the higher fees they charge.

Recap

Let’s go over what we’ve talked about today: Since I am investing for the long-term, I look for funds that are easy to understand, have a steady track record, and low fees. Index funds fill all of these requirements, so we love them. Actively managed funds (ex: mutual funds) fail on all three and are to be avoided. Now that we have laid the groundwork for our investment philosophy, we can zoom in and look at specific aspects of investing for retirement.

Posted in Building Wealth

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How to Invest in Stocks: My Investment Philosophy

Posted By damien on February 16th, 2010

While working on new posts this three-day weekend I realized that I have chosen all sorts of nuts-and-bolts investing topics without yet discussing my overall investment philosophy and approach. IPO’s, asset allocation, stock picking, these are all topics that I can’t write about without first providing an investment philosophy foundation.

What I invest in, what I avoid, and why I do it will be the subject of this post and the next. Then we can discuss investing practices and tactics; after theory comes practical application. Let’s talk about the principles and factors I consider when choosing what to invest in.

No Alphabet Soup

I want an investment that I can understand. This means I avoid exotic investment tools cooked up by fancy stock brokers. Options, futures, MBSs, and other members of the alphabet soup; these are all investment tools that my Business School professors tried to explain to me, but I never really understood. It seems that the more complicated an investment tool becomes, the easier it is for the stock broker to include fees without me noticing.

The recent real estate bubble is a good example of exotic investment tools gone haywire. Mortgage-Backed Securities (MBS) lose most of their value and Credit Default Swaps (CDS) can’t cover them. We all lose lots of money and few people understand why. Perhaps you understand these exotic investments, but a tool I don’t understand is one I can’t use or recommend.

Slow and Steady Wins the Race

Since I am investing for the long-term (more than 20 years) I want an investment that is tried and true, with a track record of steady performance. This means I avoid the “hot tips” given by stock pickers. Any time I come across articles such as “Top 10 Stocks for the New Year” or the like, I ignore them.

Investing magazines have to sell, so they often put these hot stock tips on the covers, with headlines such as “Top (insert number) Stocks to Watch for (insert year or sector)”. Some professional investors call this type of drivel “investment pornography” meaning it looks good but just leaves you (and your wallet) feeling empty. Tips like these may lead to short term gains, but I want to smooth out the ups and downs for a more steady return.

You Get What You Don’t Pay For

Fees over the long term can kill your investment return. Financial services (stock brokers) compete very handily with phone service providers as kings of hidden fees. When you step into the world of investing, fees are expertly camouflaged to look like anything but fees. A fee by any other name still stinks. Front-end loads, back-end loads, wrap accounts, 12b-1 charges…enough to make your head spin.

Which is exactly what your stock broker wants to do, so he can make you just that: broker. When it comes to investing, you cannot control your return (the stock market is inherently volatile) but you can control your costs by choosing wise investments. And among investment tools (mutual and index funds), there is a wide spectrum of fees and charges.

Where Do We Go From Here?

So there is a brief summary of my investment philosophy: tools (funds) that are easy to understand, grow slow and steady, and have the lowest fees possible. Using these principles, in the next post we will consider what to invest in and what to avoid.

Posted in Building Wealth

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Market Terms: More Ways to Sound Intelligent at Dinner Parties

Posted By damien on February 4th, 2010

dinner party

Every once in awhile, I write about terms and jargon used in the professional investing community. From what I’ve seen, often professionals will throw around sophisticated-sounding phrases in order to impress or even intimidate their customers. Since personal finance and investing are passions of mine, I enjoy taking time to learn what the pros are saying.

And 90% of the time, the concepts and jargon are relatively easy to understand. So today I’m going over four of the basic terms used to describe types of stocks and stock funds. Stick with me, they are really easy to understand. They will be worth learning, especially when you want to impress others at a dinner party.

Small Cap vs. Large Cap Stocks

One way that investors measure and compare stocks is by market capitalization (market cap). Market cap is the value of all the company’s outstanding stock, otherwise put, the value of all their stock on the market. So, if all the funds on the stock market were listed from lowest outstanding value to largest, the top half or third would be labeled large cap funds. Conversely, the bottom half or third would be labeled small cap funds.

Small and large cap are the most general market cap designations, investors also identify mid-cap funds and more recently, micro-cap funds. So why use market cap when talking about stocks? It turns out that certain trends and patterns follow market cap. Historically, small cap stocks have had higher rates of return than large cap ones. If we remember the relationship between risk and return (higher risk = higher possible return and vice-versa), it makes sense that smaller companies, which are (in general) riskier than large ones, would offer a higher rate of return.

Value vs. Growth Stocks

Another way investors stratify the thousands of stocks and funds is by the distinction between value and growth. Put simply, “good” companies are labeled growth stocks and “bad” companies are “value” stocks.

Now for the most counter-intuitive statement in this post: good companies have bad stocks and bad companies have good stocks. Follow me as I walk through the reasoning and hopefully you’ll agree by the end.

In The Four Pillars of Investing, William Bernstein uses Wal-Mart and K-Mart to illustrate the point. Wal-Mart is a good company: constant growth, stellar management, lots of cash reserves for hard times. K-Mart is a bad company: history of poor management, a recent bankruptcy, and irregular earnings.

Remember the relationship between risk and return that we just talked about? Since K-Mart is a riskier company, it offers a higher rate of return. Think about it: if K-Mart’s stock offered the same return as Wal-Mart’s, then no one would buy it! Why buy a riskier stock when a safer one offers the same return? So, value stocks (bad companies) are riskier than growth stocks and they offer a higher return.

Wrap-Up

Small vs. large cap. Growth vs. value funds. These are just a couple of the ways professional investors slice and dice the stock market. Weren’t they easy to understand! Next time you’re at a party, drop a few of these terms. You are no longer a member of the ignorant, unwashed masses. I guarantee you’ll make friends and influence people.

Posted in Building Wealth

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Will Outsourcing Kill Your Brand? 4 Things to Consider: Part Two

Posted By damien on February 2nd, 2010

courtesy of flickr.com/photos/markhillary/

As we discussed in the last post, outsourcing is all the rage nowadays. All the cool companies let their virtual assistants in Bangladesh handle SEO, blog content, and even sending flowers to their significant others after a fight.

But can outsourcing ever be bad for your company? Could outsourcing actually kill your brand? According to many business strategists, the answer is a definite yes! I’m here to give you some factors to consider when deciding whether to do it yourself or delegate it to your pal Manesh in India.

In the last post, we looked at resource-based analysis, which pretty much states you should continue doing whatever gives you competitive advantage, whatever sets you apart from others in your market, and outsource the rest. That’s a decent rule of thumb, I say. But the academics have come up with another way to examine your options, what is called “transaction cost analysis”.

Transaction Cost Analysis is considered to be the more nuanced and sophisticated approach. It is composed of three parts:

Asset Specificity
Frequency of Transactions
Uncertainty

Let’s look at each in detail.

1) Asset Specificity

Asset specificity has to do with how unique your product is, or rather, how unique the inputs to your product are. The reasoning goes like this: if the supplies needed for your product are common, then there are probably an abundance of suppliers. The more unique your supplies become, the fewer suppliers there will be in the market. As the number of suppliers in the market decreases, the power of remaining suppliers increases.

And supplier power is bad for you and your company. The more power a supplier has, the more control they have over the price you pay. So, according to the rule of asset specificity, if your asset is specific, then there are probably few suppliers available (and these suppliers will have great power), so you will want to make it yourself instead of outsourcing. On the other hand, if your inputs are a common commodity, then it is probably more cost-effective to buy them (outsource) rather than make them yourself.

2) Frequency of Transactions

How often do you need inputs from your suppliers? The answer to this question will determine whether to outsource or make it yourself. If you are planning on ordering the product often, then it is worth the effort to invest in resources to make it yourself. However, if your product will only be sold for a short time, it’s better to outsource.

3) Uncertainty

To define the factor of uncertainty, ask yourself these questions: How much will the wants of my customers change? How often will I need to innovate and change my product? If your product is constantly changing and adapting to customer desires, then it’s better to make it yourself; do not outsource innovation to a third party.

Why not? Two reasons: It is more expensive to pay an outsider to drive the innovation of your brand and once your creativity is outsourced, face it, it’s not really your brand anymore. On the other hand, if the product does not need to change very often, then outsourcing is a good idea.

I hope you’ve enjoyed this examination of the arguments for and against outsourcing. After reading The 4-Hour Workweek, I wanted to outsource my whole life (well, just the boring parts). But a closer look has taught me that if you aren’t careful, outsourcing can kill your brand. Stick to the two methods I have shown you (resource-based and transaction cost analysis) and outsourcing will take your company (or life) to the next level!

Posted in Business

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Archive for February, 2010

What To Do With Your Tax Return

Should I use my tax return to pay down debt or invest?