The following is a guest post from Rob Bennett, who writes for A Rich Life. He aims to put the “personal” back into “personal finance” by focusing on the role played by emotion in saving and investing decisions.
Everybody loves the high returns obtained by investing in stocks. Nobody likes taking on the risk that comes with doing so.
The happy reality that few know about is that risk is today almost entirely an optional element of the stock investing story.
Current General Belief
Our belief that stocks are a risky investing choice goes back to the days when investing in stocks meant picking individual companies that would perform well in days to come. That is a difficult business. To pick individual stocks successfully you need to do enough research to figure out which companies have good managers and which companies have a strong product pipeline and which companies produce products and services coming into fashion and on and on. Few of us possess either the ability or time to pull it off.
Everything changed when John Bogle founded the Vanguard Group of funds in the mid-1970s and made index funds available to the average investor. Index funds do well when the U.S. economy does well. Which is pretty much always. The U.S. economy has been generating enough growth to support an average index-fund return of 6.5 percent real for 140 years now.
So the first thing you need to do to eliminate stock investing risk is to invest solely in index funds. You won’t earn as high a return investing in index funds as you would picking the best stocks. But you will never make bad picks. Going with index funds insures that you will always obtain a “good enough” return.
And that’s what most of us are looking for.
Here’s one more step you need to know about.
If stocks were always priced at fair-value levels, indexers would see that 6.5 percent real return every year.
That would be investor heaven. We are not there quite yet.
Stock valuations often go crazy. And the price you pay for stocks makes a huge difference in the long-term return you obtain from buying them. The most likely annualized 10-year return on an index fund purchased in 1981, when valuations were low, was 15 percent real. The most likely annualized 10-year return on an index fund purchased in 2000, when valuations were sky high, was a negative 1 percent real. Even index funds become risky if you fail to take valuations into consideration when setting your stock allocation.
So take valuations into consideration!
My Stance and Shiller
I am the co-author of peer-reviewed research showing that investors who buy only index funds and who take valuations into consideration when setting their stock allocations thereby reduce stock investing risk by nearly 70 percent. That really is investor heaven!
You can never eliminate risk entirely because short-term returns are not at all predictable. But there is now 33 years of peer-reviewed research showing that long-term returns are highly predictable for those who consider valuations. Risk is optional! Go with a high stock allocation when prices are low, a moderate stock allocation when prices are at fair-value levels, and a low stock allocation when prices are high and you cannot lose. That’s not just my opinion. That’s what the entire 140 years of U.S. stock market history available to us today tells us.
This new approach is called “Valuation-Informed Indexing.” It is rooted in the research of Yale Economics Professor Robert Shiller, who won a Nobel Prize last year for his work in this area. It is solid stuff. And it is a very simple strategy to implement. You need to check valuations once per year. And you need to change your stock allocation because of a big swing in valuations perhaps once every ten years. That’s it.
Making that one change in the conventional advice to stick with the same allocation at all times reduces risk by nearly 70 percent. That’s exciting. I think this is the future of stock investing.
Last Friday, I posted about choosing between our want list and buying a new rental property. Well, we’ve decided to postpone everything for at least a few months.
Patience for the Win
I usually love making money decisions, but this time around felt different. I felt awkward. Then I realized that every time we squirrel away a large nut, we spend it or invest it nearly immediately. We always keep a solid emergency fund, but the rest seems to flow in and out like water.
For example, when we had saved up $50,000 at age 23 in 2007, we invested $15,000 in a friend’s business (that failed miserably) and $25,000 into our first home. It took us about 2 years to save it and was gone within 4 months. When my online work started taking off unexpectedly in 2011, the money I brought in started adding up quickly. Within 9 months, we had paid off the remaining $23,000 left on our first house and started building our new one which used up about $50,000 for the 20% down plus the closing costs by October 2012. When we got a large tax refund this past April 2014, we threw the majority of it to our Roth IRA’s as soon as it touched our account.
We are not patient people by nature. And we fear missing out on opportunities the first time they present themselves even if there is a good chance that they will be back. Generally, I love that about us. But in this case, waiting 3-6 more months to see what sort of cash we can really hide away will probably be the least stressful idea.
We already have an easy $20,000 set aside for a future investment. That’s not touching any of our emergency or backup accounts – just what we were going to use for investments or property anyway. We’re going to see what we make over the next 3-6 months with our online endeavors. If it’s enough to cover our average of $7000 a month for taxes and bills (you can check out our budget for all of the details), then we will put aside all of my pet sitting income and the sports officiating income that Mr. BFS earns into the investment savings. Then we can check out our cash-for-investments account again in early 2015 and see if we indeed put enough aside to buy and fix up a rental property. With any luck, we will have put $40,000+ aside total, which would be more than enough to buy a $100,00-$125,000 rental property AND get hubby’s Lasik, get him signed up for that college reffing camp, buy some media room furniture, AND take another cruise.
I have always been a fan of having my cake and eating it too. This makes me happy. This makes hubby happy. I love it when we both come to the same conclusion. And I should try using patience a little more often anyway.
Everybody wants something. I get that. Mr. BFS and I are no different. We’ve had an ongoing want list that we add to and subtract from for years. The problem is that we keep prioritizing other stuff, investments, and trips before some of the things that have been on the want list for as many years as we’ve had it.
Our Want List
Here are the things that we were specifically, consciously spending on this year…or so we planned:
- Lasik – Mr. BFS has had glasses since elementary school and would like to move along now. He’s been putting it off for years only because of the small risk to his eyes, but he wants to pull it off this time.
- Media room furniture – We have a specific plan for 6-7 media room seats/recliners. But we keep putting off this purchase in favor of everything else.
- College Referee Training Camp – It’s about $2000 for a one week camp, but if they like you, you get hired to be a college sports official for football. Mr. BFS would love to move up to college level reffing (which pays more too), but paying for the $2000 camp doesn’t guarantee anything at all. So he has procrastinated for 2 years…
- Yet another cruise – I always want to book our next cruise…that’s just the way it is…
None of those things is an actual need, although I would place the training camp and Lasik above the other two myself simply since one could lead to more money and the other is health-related in my opinion. But we were going to knock-out all 4 in the next 4 months…
Another Rental Property?
Despite us knowing exactly what we want, life has happened and we aren’t sure we can pass up a good opportunity to build our rental property income streams. Exxon has built an administration complex near our home. That complex will employ 10,000+ people, but they only built enough housing for about 2500 of them. That means all of the property in our area is increasing in value.
Sadly, that means our property taxes will be increasing every year for a while. We may actually have to move in 5-10 years if our property tax gets as high as our mortgage.
BUT, it also means that buying a rental property may make sense. A 1700-2100 sq. ft. home right now with 3 bedrooms and 2.5 baths can be purchased for around $100,000-$150,000. That would be $25,000-$35,000 since you need to put 20% down plus 3% for closing costs. But it could be loaned for 4-5% over 30 years for about $500 a month. Those sorts of homes are renting out for $1300+ a month. Even when taking into account property taxes, home insurance, and home owner’s association dues, we’d be bringing in at least $300-$400 extra per month. We would use that to build a maintenance fund and to pay off the home in less than 10 years.
The only kicker is that $25,000-$35,000 up front just to buy a place and get it into rentable condition. That would once again eat a huge chunk of our padding and all of our extra money for the want list. But we’d still have 3-4 months of expenses on hand.
What would you do? Buy the house and put off the want list? Finally take care of the want list and put off rental properties for a couple of years?
I just realized that I hadn’t posted an update of our stock portfolio holdings for about a year and a half! Stocks and market stats still seem foreign to me, so Mr. BFS does most of our direct investing. We sold about half of our holdings late last year when we bought our new home. So here are the current stocks we are investing in via Scottrade, their current dividend yield, and what Mr. BFS said about them:
Conoco Phillips (COP) – 3.93% Yield – “They still have a good dividend based on what rate we bought at. And they haven’t had to spend the money on exploration that other companies have, so they put that money back into share repurchases and dividend growth.”
Intel Corp (INTC) – 3.92% Yield – “Good yield and a solid company. They’ve gotten a lot better in the last year or two with competing with their major competition, AMD, with their processors. They are still the #1 installed chip in pre-built computers. As long as they have that market share, we’re in.”
Johnson & Johnson (JNJ) – 3.04% Yield – “Bought it at a steal and has great payouts. We managed to buy when they were going through the Tylenol recall stuff and they’ve bounced back.”
People’s United Financial Inc (PBCT) – 4.55% Yield – “They have a fairly good dividend and regional banks are doing very well – better than national banks. Although this bank hasn’t done as well as I’d have hoped, but their dividend is keeping us in a holding pattern. We may sell since their financials have not done as well as I thought they would.”
PepsiCo Inc (PEP) – 2.83% Yield – “Great price at the time and we’re getting an excellent return.”
So there you go for straight-up stocks. My 401(k) is in the Vanguard 2035 target date mutual fund and was fully vested before I quit in July 2011, so it’s staying put for now and growing at about 11% per year.
One of our Roth IRA’s is in the Fidelity 2040 target date mutual fund that I selected (it’s returning about 12% a year), and Mr. BFS uses our other Roth IRA to invest in more dividend stocks (these dividends are auto-reinvested). Here are those:
Energy Transfer Partners (ETP) – “They are an energy pipeline company that are big players in the Trans-American pipeline. They also have an amazing yield.”
General Mills (GIS) – “I purchased this during the big crisis, so I assumed they wouldn’t suffer as much. It worked. They also had a good yield and they’re a solid company.”
Johnson & Johnson (JNJ) – “Solid company at a solid price when I bought in here too. I saw the huge price drop and said YES, PLEASE!”
Coca-Cola (KO) – “This is the most recent one that I’ve bought. It seems to be getting into the healthy drink options side of soda more than other companies – like Coke Zero is more successful than other diet sodas, and they have Vitamin Water. We also already had Pepsi in Scottrade…J&J was too hard to pass up twice, but I decided to branch out here.”
Microsoft (MSFT) – “When I bought it, the next generation consoles were going to be released. Then they flubbed with the Xbox 1. But they’ve recovered. Windows 8 was also a really big push into the mobile market (yeah, I know it sucks). But they are also on about 80-90% of home computers, so they’re worth keeping.”
Nokia (NOK) – “Nokia had taken a lot of flack and their stock plummeted, so I jumped on it at $6 a share. I bought it as a speculation bet on the idea that is had been oversold. That didn’t quite work. It was delayed a year and I am basically hoping to break even at least. I’ll give it another 3-6 months to see what happens after this new Nokia phone release.”
Walmart (WMT) – “This was another recession play. Even when people are broke, they shop at Walmart. And they had a great yield when I bought in.”
What are you investing in lately?
**This post is not to be used as a suggestion for investments. This is simply what we own. Make up your own mind and don’t whine to me if something tanks, thanks!**
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Today I’m writing about “My Scariest Money Mistake and What I Learned From it” for the Yakezie Blog Swap. A group of Yakezie Finance and Lifestyle Network members all write about the same topic on another website. Check out all of the contributors (at the end). And be sure to visit Barbara Friedberg Personal Finance for Crystal’s post!
The mid 2000’s were a golden era in the U.S.A. Interest rates were low, there were enough jobs to go around, and investment values were trending upward. Finally, there was hope that all American’s could finally own their own homes.
The American Dream Turned into a Nightmare
Mortgage companies were thrilled with the abundance of capital and low rates and began giving out mortgages like candy. If a buyer didn’t have enough income to qualify for the loan, no problem, the mortgage company tweaked the numbers a bit! Their consciences were clear as they believed that home appreciation would up the principal value of the borrowers home. And, the mortgage companies sold the loans they made so if there were a few loans going out to unqualified buyers, it would soon be someone else’s problem.
All of these mortgage loans were repackaged by investment banks along with Fannie Mae and Freddie Mac, the “reputable” quasi government agencies. These repackaged loans were combined into marketable securities called collateralized debt obligations (CDO), similar to bonds and sold to the public.
Sounds great doesn’t it? Anyone can get a home. Investors have lots of great new bonds in which to invest.
The Investment Markets Tanked
The belief that home prices only go up was slammed. In 2006 home prices began to decline and by 2008, values were dropping at a level not seen since the Great Depression.
When home values fell, home owners who wanted to sell were facing prices lower than their mortgage amount and the prospect of big losses. Many homeowners defaulted on their loans and lost their homes. Others faced growing mortgage payments as their adjustable rate mortgages increased.
On top of this debacle, those wonderful CDO bonds were mis-rated by the trusty investment rating agencies. Investors thought they were buying top rated debt when in reality, the underlying mortgages in their CDO’s were defaulting. This caused the investor’s bonds to decline in value. Since no one really knew the worth of the underlying investments in the CDO bonds, their values tanked.
The once rosy economic picture became bleak. Homeowners lost their homes and investors lost money on their investments and investment banks went under or faced government bail outs.
In 2009, as the housing market tumbled and the S & P 500 Stock Index fell from a high of 1549 in August, 2007 to a low of 735 in February, 2009, the country sank into a recession. Investors, homeowners, and consumers were scared!
No one with money in the stock market was spared.
Fear Took Over in the Markets – I Stayed the Course
Investors did not believe that the financial institutions knew the true value of the bonds they were issuing or the extent of their own corporate losses.
Investors panicked, sold their investments, ran for the hills and the financial markets crashed.
During this period, I did not panic, nor did I sell. As the overall markets fell, so did my portfolio!
Although the S & P 500 dropped 50 percent; due to a diversified portfolio, I only lost 30 percent of our family’s investment portfolio.
Many investors got really scared and sold-at the bottom! This was not a good idea! I was freaked out, and scared, but knew my market history. Luckily, having invested for decades and studied finance and investing, I knew history was on my side. I remember hearing lots of folks talking about pulling out of the markets completely!
I knew that was the wrong approach. After all, when you pull out, how do you know when to get back in. You are much more likely to miss out on potential future gains if you sell.
How I Increased our Portfolio 160% Over the Next 5 Years
I believe in the strength of not only the U.S. Industries, but also the global marketplace. Although I was upset, scared, and worried about the value of our families assets going down. I did not panic. I used my knowledge to hold on.
Then I did something counter intuitive.
During the market lows in 2009, I took some of our cash assets and plowed more money back into a diversified pool of index mutual funds. While many people were scared, I figured the valuations were so low, that even if they fell a bit more, they were likely to rebound eventually.
I followed my own advice and maintained a diversified asset allocation in line with my risk tolerance. When the stock investments fell in value, I rebalanced by investing more in the underperforming asset classes. And then I went in even deeper by investing more cash especially in Real Estate Investment Trust (REIT) index funds, because those funds in particular got clobbered during the mortgage meltdown.
I was scared and nervous when our assets fell. But I remained rational and acted on years of investing history and financial background. Could I have been wrong? Absolutely, history does not need to repeat itself.
Fortunately, my confidence in world markets was well placed.
The Financial Lessons Learned
- Do not follow the crowd.
- Do not panic.
- Create a sensible investing plan, preferably investing in diversified low cost index funds, and stay the course.
- Investments go up and down, stay the course.
- If you are far from retirement (or needing the invested monies) then continue to invest through down markets, because that is when the greatest profits are made.
- If investing declines are intolerable for you, put a small percent of your investable assets in stock type investments, because their prices go up and down!
This wasn’t really a money mistake, but a scary financial scenario. By remaining calm and sticking with a sensible investing plan the inevitable fluctuations in the stock market didn’t ruin my financial future.
Barbara Friedberg, MBA, MS is a portfolio manager, former university finance instructor, author of How to Get Rich; Wealth Building Guide for the Financially Illiterate, and owner of Barbara Friedberg Personal Finance.com.
Image credit; Yahoo Finance
Participants in the Yakezie Blog Swap
The following is a guest post from William Cowie, a previous contributor to BFS. He blogs about successful investing at Bite the Bullet Investing and you can get his free Investing Basics series here.
Photo: Roger Kidd, Wikimedia Commons
Who doesn’t like to have fun? The only problem, though, is finding both the time and money. Remember the old Willy Nelson tune: If you’ve got the money, honey, I’ve got the time?
I remember thinking in graduate school how cruel life is that we either have time, or money, but rarely both simultaneously. As a student I had lots of time for fun things, but no money. Then, when I got a nice job, we had the money, but no time.
So… is it possible to have both the money and the time to have fun?
1. Understand Your Income Possibilities
You have only two possible types of income to live from:
- Income from a job or business
- Income from your investments
Some people get upset when they hear this. Take Betty for example (not her real name). “Surely there are other ways of getting money!” When I asked her to name one, though, all I got was one of those looks: a scowl on the face and smoke pouring out of her ears.
“Well, what about an inheritance?” she finally blurted out.
What about an inheritance, indeed? Can you make a living off receiving inheritances — how many rich relatives do you have, ready to die very few months to keep your bills paid? Okay, she probably was referring to one inheritance. Let’s take that possibility: would you spend it all? After you spend it, how do you continue making a living off the inheritance?
The answer of course is when you receive the inheritance you would invest it and live off the earnings. Right?
Bingo, you’re back to your #2 on that list. No matter how you slice it, you end up with only those two possible income sources.
What about Social Security? If you’re under 50 years old, your chances of benefiting from Social Security are probably right up there with the tooth fairy. Or, what about that pension? Have you noticed how many employers, even government employers, are cutting pensions of people already retired? It’s even worse for people still working. Do you really want to put your trust in something as iffy as Social Security or a pension?
Worse, do you want to wait till you’re 89 to get anything? Because the age at which those benefits kick in moves every year.
2. Decide On A Goal
Way back in the day there was a word they used: retirement. Over the last decade or so, though, that word has slowly been going the way of the 8-track, because of three things:
(a) Longer Life
Healthier eating, better physical fitness and better health care make all of us live way longer than previous generations.
(b) Better Quality of Life
No only are we living longer, we’re able to do many more things than was previously possible. Gone are the days when you received a golden watch and spent the rest of your life playing golf and bingo, with an annual group bus tour thrown in.
(c) Earlier Start
Gone, too, are the days when you had to wait till the magic age of 60 before you could escape your job. Breaking out at 50 or even 40 is moving from the exception to the mainstream, The internet is allowing people to embark on what they REALLY like doing while they still have The Job (Crystal herself, for example) and build up income to support them doing what they like.
The next step of course is getting to the place where you don’t have to do anything for an income, where the income takes care of itself.
THAT is your goal: where you can do anything you want, without HAVING to put in any hours.
That goal is only attainable if your main source of income is your investments.
3. Make a Plan
Your plan has only three components:
- Learn how to invest
- Find money to invest
- Do it
If you’re like us, you didn’t win the lottery of the womb, so you didn’t start out with a mill or two to invest. That means you have to save up to get it. Enough has been said about that, you know what works for you.
The learning part is probably the most daunting for most people. This is where you hear arguments like:
- Wall Street is just a casino, loaded to screw us individuals
- Investing is just too complicated
- I barely have time now, where am I going to find time for that?
With all due respect, that’s all nonsense. Plenty of people have a rental home (Crystal, again) so there’s no need to make it complicated or involve Wall Street. There are plenty of good investing options.
All it takes is a desire and a commitment.
Good News/Bad News
Bad news first: there is no way around it: your future depends on your investing. Period. Sorry to join the person who broke the news about the tooth fairy, but it is what it is.
But there is plenty of good news:
1. Investing is not rocket science
Granted, it’s not doing dishes, either, but millions do it successfully every day. It’s like shopping: just learn the basics and you’re good to go.
2. Learning Is Free
This is the age of the internet: there are countless free resources to learn from.
3. The Miracle of Compounding Gives You Free Money
Also called “interest on interest” — the earlier you start, the more free money you get.
4. It’s Never Too Late
Even if you start investing at 60, you still have a 15-20 year future. (Bet you never thought of it like that!) How much more if you start at 40, or even 30!
5. You Don’t Need Money To Start
You can start learning before you invest your first dime. In fact, that’s probably the best way to go. As you learn, you’ll find yourself getting comfortable with the notion of investing, as well as the concepts that make for success.
Just Do It
Even if you don’t have money this very minute, start learning now. Learning is free for the most part. And the sooner you get started, the sooner you can answer Willy Nelson back: I’ve got the money, honey, AND I’ve got the time!
Crystal’s Comments: I really like the last section’s title – Just Do It. That is the only way any accomplishment is attained, from investing to personal goals. Please figure out your priorities and jump in!
The following is a guest post is from my younger sister, Ambi (short for ambitious). She’s a recent college graduate, started her first post-college career here in Houston, and has been living with us since January. Please give her a warm welcome!
Maybe I am an adrenaline junkie, but here’s my latest radical decision.
Currently, I am very actively looking to invest in Groupon stock. After hearing its disappointing last quarter’s numbers and reading former CEO Andrew Mason’s blunt exit email, I want in. No, I don’t have an emergency fund that is 6 months worth of my earnings. No, I have no experience with stocks. No, I have not even held my job for 3 months.
I understand how choosing to invest in a tanking company that just fired its CEO, based on an unproven coupon business model, may seem unwise. Here are my three justifications:
1) I see a great opportunity.
Groupon stock held a high of almost $20.00 a share at one point in time, and while I do not even pretend that Groupon stock will ever be worth that much again, I do see it rising above its $5.30 a stock current price.
2) I feel secure in my current financial state.
I don’t have debt. Additionally, I have no dependents I am supporting, nor do I have any other fiscal responsibilities other than my personal living costs (rent, groceries, transportation, and savings). While I do have a sales job, my base salary is not effected by my additional commissions, and I live comfortably off my biweekly checks. I even save. And when the time comes I do start earning commissions, I intend to save each part of those checks, building a nest egg.
3) I will personally enjoy the highs and lows of my stock.
I think people want to avoid making investments effect their emotions, but this is where I gamble. I do not go to casinos – I do not like losing my money on games that are rigged for the casino to win more often than not. But as I watch the stocks plummet on Bloomberg, I want to be a part of the Groupon ride. With a new CEO, I have no idea what will happen, but that is why I am investing a very small amount that I do not care if I never see again. Everyone I know uses Groupon, so if it does tank, honestly…I will more effected by the loss of actual deals than the amount I invested. And should Goupon do well, I would love for its stock to be my first portfolio stock.
So, I am currently looking at purchasing 60 or so shares. If I never see that money again, I won’t cry. And should Groupon turn around, I will be thrilled.
What do you think? Is this stock just too risky for your financial taste?