On Prognostication

investing image

|We tend to brag about our most recent brilliant investment while conveniently forgetting our more frequent whiffs.|

Chapter eleven from the first book of essays by Michel de Montaigne serves as a welcome reminder that some truths are beyond debate. A minor noble, occasional public servant and prolific reader Montaigne began writing short works of critical self-reflection around 1570. He referred to these works as essays and, effectively, created a novel genre. (As a side note, 400 years later the Argentinian Jorge Luis Borges would, effectively, perfect the essay.) 

The title of chapter eleven is deceptively perfect as it relates to our theme herein, investing. This brief essay covers two important topics often overlooked by individual investors; survivorship bias and forecasting. As to the first, we’ll quote Montaigne, “Besides, no one keeps a record of their mistakes, inasmuch as these are ordinary and numberless; and their correct divinations are made much of as they are rare, incredible and prodigious.” As has been often reflected upon here at Invest-Notes, when reviewing every stock transition I’ve made over a 12-month period, the many bad trades are inevitably left in the dark, overshadowed by the occasional big winner. We tend to brag about our most recent brilliant investment while conveniently forgetting our more frequent whiffs.

Millionaire-Next-DoorThe glaring error in an otherwise interesting book on the wealthy, The Millionaire Next Door, is this failure to acknowledge the losers. We meet a few very successful businessmen, owners of dry cleaners, who have quietly amassed meaningful fortunes. But no mention is made of the thousands of dry cleaners who not only didn’t make a million dollars but went broke trying. Montaigne tells the story of a skeptic in ancient Greece shown a chapel filled with votive offerings from sailors who survived shipwrecks to prove the beneficence of the gods. The skeptic observes, “Those who were drowned, in much greater numbers, are not portrayed here.”

More importantly, we talk about the records of Warren Buffett and Peter Lynch though never discuss the vast majority of professional investors who went broke or settled into quiet mediocrity. There is a reason books that discuss the “habits of super successful investors” all seem to talk about the same people. Not that many people are successful over a meaningful period of time. Of course, there are big winners, but always remember that the losers are “numberless.” Only with hindsight do we know who survived. This applies equally to individual stocks and hedge funds – no one talks about the ones who didn’t make it.

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“…there is no use in knowing what is to be, for it is wretched to be tormented to no purpose.” -Cicero

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PrognosticationAs to forecasting, we should all know better. The idea that we can tell what is going to happen to the price of any individual stock over a period of a few months is self-deceptive. An analysis showing where a stock price will be 5-years from now is a lie. It has been demonstrated that over meaningful lengths of time the equity markets go up more often than they go down, so while dips can be ferocious, recovery has proven a relatively safe expectation. But this is based on the movement of a cohort of equities, not an individual stock.

As Nassim Taleb has said repeatedly, if the author of that glowing 5-year analysis doesn’t have at least half his net worth invested in the stock under discussion don’t believe anything being said.

The follow-on is our tendency to look at how much we can make instead of how much we can lose. Yes, there is money to be made if an investment increases in value. But when a company you invest in goes bankrupt (as recently happened to me with a private equity deal) being able to write-off the loss is small consolation. At the time I did the deal it never occurred to me that a total loss of invested capital was a possibility. But the lesson learned was a confirmation of one of the most important rules when investing; never make a bet so big that a loss can leave you with a permanent impairment of capital. While painful, and embarrassing, financially there is no change to my lifestyle or future prospects.

So, since we can never know the future we must avoid prognostication. Because when our bets on future outcomes start going off track, or derail completely, the best we can do is reflect wistfully on what might have been. This, in turn, can lead us to fear the future. What if we are wrong again? Opportunity becomes something to be feared, best to avoid. Instead, focus on the here-and-now, what we know and not what might be. I’ll be doing more private equity deals but now with a focus on risks, not just rewards.

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When is a profit or a loss not really either one?

 

Investment I-N Horizontal Invert Bright

|Successful investing is almost always a result of critical thinking and patience. When you decide to purchase any financial investment the reasons you would sell are just as important as why you are buying.|

An unfortunately common story heard from investment managers is about the tendency for people to panic during market drops. The problem is multifaceted with otherwise sober investors suddenly trying to time the market, taking losses on stocks, giving up dividend income and possibly generating unnecessary tax bills. And when the panic ends? How to determine when to start purchasing equities again, yet another opportunity for market timing – an activity long demonstrated to be harmful to your portfolio.

This is not to say an investor should never sell, just that any decision to make changes in the holdings of a portfolio should be a result of planning, done deliberately and with intention. Not during a time of emotional and financial stress. And while tax implications don’t apply to IRA or other retirement accounts, we must still be mindful of what an unrealized gain means.

investment AE Coin AAPL VertSo, let’s do a thought experiment today. We’re going to look at a gold coin (let’s make it a one-ounce American Gold Eagle) and ten shares of Apple stock (AAPL). Let’s assume that these assets are in a retirement account that is unlikely to see any withdrawals for another decade. Today that gold coin is worth about $1,450, and the ten AAPL shares around $2,000. Now for the fun…

In 2016 that gold coin was valued at $1,100, but in 2011 it was about $2,000. It is the same coin and has never been removed from the safe deposit box since 2006 when you originally purchased it. With a current value of $1,450, have you made $350 or lost $550? Yes, a trick question, since you only paid $600 for that American Gold Eagle in 2006. Same with AAPL; in 2016 the ten shares were worth about $950 and in 2012 they were worth $750. But in 2006 you paid $150 – yes, one hundred and fifty dollars for ten shares.

In summary, for both the coin and the stock over the last ten years each has been worth more and less than their value today. Selling in a panic could mean you create a tax liability further diminishing any gain. In a taxable investment account, if you sell the coin or the stock you immediately owe tax on any gain but can deduct any losses against profits from other equity sales. In a retirement account, you don’t owe taxes, but if you sell at a loss, you cannot use that loss as a tax credit to offset other winners. In theory (and real-life) you can buy a stock, sell it for what you paid for it, and still lose money. Or take big losses that can’t be used to offset profitable trades.

Until you sell an asset it is only worth whatever anyone will pay for it. Gold has demonstrated an ability over very, very long periods of time to be an asset that holds its value. Consider that Benjamin Franklin wrote that in his lifetime an ounce of gold would buy a very nice suit. And a bespoke suit can be had today for $1,500. Holding gold in your portfolio is a way to preserve wealth rather than create it.

As for AAPL, well, the first iPhone was sold in 2007 spurring a revolution in communication that led AAPL to become (on-again, off-again) the most valuable company on the planet. But whether a share costs $12 or $200, it still represents only a minuscule ownership stake of a publicly held company that has demonstrated a highly volatile price history. AAPL has also shown, that like the overall markets, while the water is often choppy, it has historically gone up more than it has gone down and continues to seek a higher level. A poor earnings report can mean a dive in the value of individual shares but is as likely to be temporary as not. Until such time as AAPL begins to underperform consistently or suddenly faces formidable competition, a snap decision to sell could prove to be an expensive mistake. AAPL is in your portfolio with an eye towards making a profit.

Whether either investment should have a place in your collection of assets is determined by your goals. And when you decide to purchase any financial investment the reasons you would sell are just as important as why you are buying. Successful investing is almost always a result of critical thinking (don’t panic as markets move dramatically up or down) and patience (it’s a marathon, not a sprint). Heaven is not the day after tomorrow.

 

How to Navigate Market Drops

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What is your portfolio’s credit score?

credit score of investments grayscale

|The analogy of keeping credit risk low coupled with the value of dividends as a potential income stream suggest it is possible to move the odds, as much as possible, in your favor with some thoughtful analysis…. or put another way, you want to create a steady income by only using financially solid stocks.|

When loaning money for a home or automobile purchase lenders rely heavily on a person’s credit score (also known as a FICO score). The idea being, that certain behaviors and traditional spending patterns can determine risk levels – the higher the score, the lower the risk of default. Traditionally scores were based on things like your history of timely (or not) payments on other debts; the length of your credit history and how much you currently owe; other types of credit you have (or had) including charge cards, loans, mortgages, and banking history.

Credit Facebook Location requestRecently, in an effort to improve predictions of creditworthiness, some new information is being collected and aggregated. Gathered mostly from digital sources, it’s worth considering how you might stack-up against these new data points: uses both names in contact information forms; consistent travel patterns; limited contact with few entities; uses Uber; and, no regular contact with people who have bad credit. Now you really know why they want you to keep that location finder activated on your mobile device and check-in at Facebook regularly.

The reason I bring this up is due to shifts in the investing landscape which makes some traditional metrics used to measure value not so effective and suggests we might need to reconsider what criteria to use in scoring our investment prospects. Traditionally there have been three go-to metrics to make a quick, back of the napkin assessment of a potential equity investment. In other words, what’s the fastest way to determine the creditworthiness of a business you are thinking of owning part of? This, in turn, allows you to focus on learning more about only stocks that fit your investment profile.

A prime example is the price-to-book (P/B) ratio. Essentially the P/B value of a company is a measure of debt to assets – which when divided by the number of shares gives a ratio that might be a reasonable measure of financial soundness. An example of how this works is to look at a million-dollar piece of real estate owned by an individual.

When what looks good is bad.

If you own (hold the title) on a property valued at a million bucks, there are a couple of scenarios that can make this good or bad. If you hold a clear title (no mortgage or commercial loans) then you have an asset that reflects positively on your total net worth. On the other hand, if the property was financed by a loan of $1,00,000 and due to the vagaries of the real estate market it is now worth less than a million, you are at-risk – the property is a liability. This same concept was for a long time a significant marker for making investment decisions. The value of the tools a company uses to make its products can ensure the ability to survive hard times. If a factory and the land it sits on, are mostly paid for, this can make for an attractively low P/B. A business that owns a fleet of company vehicles has a liability, not an asset. The vehicles are depreciating items needing to be insured, maintained and ultimately replaced. The fleet can only be sold for less than the acquisition price and incurs an ongoing expense. Your loan to this company (through the purchase of stock) carries greater risk and would have a high P/B.

With outsourcing, a now standard practice, a company like Amazon (AMZN), that absolutely requires delivery vehicles, can operate just fine without actually owning any trucks. Uber (UBER) is now the biggest taxi service in the world, and they don’t own vehicles. The drivers who use Uber’s software to operate as individual contractors are the ones responsible for purchasing and bare all associated expenses. So, with hard-to-value assets like intellectual property being the driver of value, P/B might not provide much insight into a company’s cash value. And when a company gets in financial difficulties or goes bankrupt, fixed assets can often be the only way investors can recoup even a fraction of their investment. For our discussion, let’s compare AMZN and Apple (AAPL). P/B for AMZN is over 18, for AAPL 8 and generally speaking a good ratio is less than 4. This could imply that your investment in AMZN has a greater credit risk than AAPL, even though AAPL carries a P/S double the average.

credit score of Investments AMZN vs AAPL

Another classic metric is the price-to-earnings (P/E) ratio. Assuming that a company is profitable – that it makes more money than it spends – the P/E is a reasonable way to calculate how much owning part of that profit stream will cost. A low P/E implies that the cost to buy some of a business’s profits is reasonable and that at some point in the foreseeable future you will have paid off the cost of your investment and the profits can become income. This might be best understood by thinking about dividends. If you buy a share of stock for $20 and get an annual dividend of $1 (5%) at some point you will get back what you paid for the share (which is then an asset, like a loan-free piece of real estate) and the dividend becomes income (like receiving rent from that loan-free piece of real estate).

But when a company isn’t profitable either there is no P/E or the gap between what the company is spending versus what it is earning becomes untenable. The P/E for amazon is north of 70, where the average long-term ratio for the market as a whole is around 18. This implies that it could take up to 4x longer for your investment in AMZN to become profitable than one in AAPL whose P/E is 16. One excuse investors use to justify stocks with a nosebleed P/E is that they have “momentum.” The assumption is the company is growing so fast that eventually, they will make more money than they spend. One culprit of the dot-com crash at the start of the new millennium was this kind reasoning.

In a similar vein, the price-to-sales (P/S) ratio can help identify stocks whose price offer compelling value. Using a formula that includes the total value of a company (the market capitalization) and the number of shares outstanding divided by 12-months of sales or revenue the P/S is like the P/E since it is intended to quantify the value of individual shares. The biggest limitation of the P/S is it doesn’t take into account if a company is profitable, or will ever be profitable. Using our example one more time, both AMZN and AAPL have a P/S of 3.5, which is considered high, but not unreasonable.

Now a quick summary. AMZN has rarely been profitable and continues to spend more than it makes. According to our traditional metrics, its P/B suggests it is a risky investment; the P/E suggests the stock is expensive and doesn’t offer much value; but, the P/S implies the stock is not grossly overvalued. AAPL has long been profitable by making things like phones and computers for both business and retail use. The P/B reflects less credit risk than AMZN, but more than average. The P/E says this is a good time if you want to buy some stock, while P/S urges caution around equity purchases. All of which points to a merely average credit score for AMZN and a slightly better one for AAPL which also gets points for paying a dividend (making for a quicker payback on that initial purchase of stock). One last point here, now that Microsoft (MSFT) had got its groove back it scores between AMZN and AAPL using our criteria here.

What does all this mean to you?

The most widely held exchange-traded funds are SPY and VOO, both indexed to the S&P 500. Passive investors and their retirement accounts (401Ks and IRAs) should be anchored with a large position in one of these index funds. The primary reason being that in any given year most of the stock market gains will come from just a handful of stocks. By owning a fund composed of the 500 biggest and usually best companies in America you get to take advantage of the fact that stocks go up more often than they go down. Investors get the benefit of upside in the winningest equities and at the same time hedging the performance of struggling stocks while still earning a modest dividend.

Hopefully, you have accounts intended for both short-term needs and long-term goals. These should be structured to meet your investment objectives and would likely vary in composition. Specifically, outsized risk should play no part in a retirement account, especially as you get older and the opportunity to rebuild after a significant loss becomes more daunting. The analogy of keeping credit risk low coupled with the value of dividends as a potential income stream suggest it is possible to move the odds, as much as possible, in your favor with some thoughtful analysis.

As it currently stands, of all 500 companies in the S&P index funds, MSFT, AMZN, and APPL make up a full 10% of total shares. The benchmark index is structured so that stocks with the largest market capitalization have a heavier weighting. The alternative for an S&P index is an index fund that is equal-weighted – meaning regardless of company size, all components in the fund have an equal percentage of shares. An example is the Invesco S&P 500® Equal Weight ETF (RSP) where the total shares of each company are around .23%. So, the MSFT-AMZN-AAPL triad makes up less than 1% of this index. I own two of these funds in a ratio of 65% VOO to 35% RSP and regard the combo as a single holding.

credit score of investments AMZN AAPL MSFT

Personally, I still find the idea of weighting as criteria for fund composition a bit uncomfortable, which explains why S&P index funds are only 25% of the equity holdings in my retirement accounts. If you subscribe at Morningstar, one of their more valuable tools is a program that aggregates all the holdings in a portfolio and compares them to the S&P index. By comparison, my IRA is composed of 14 individual investments, not all of which are index funds, with several holdings having been in the account for a couple of decades. The idea is to increase the dividend stream without using riskier equities. Or put another way, I want to create a steady income by only using financially solid stocks. According to Morningstar analysis, my IRA has both a lower P/E and P/B ratio and almost twice the yield of the S&P 500 index. In an account intended for the long-term, I aim to keep my portfolio credit score high.

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Finance is a Brain

Finance is a Brain-Invest-Notes

|An interesting quote from The Economist: “Finance is a brain for matching labour to capital, for allowing savers and borrowers to defer consumption or bring it forward, for enabling people to share, and trade, risk.”|

For most of us, the second part of this elegant description of basic capitalism is what drives us to pursue investing in general, and the equity markets in particular. As savers, we defer consumption (save rather than spend) for many events; a first home, a second home, college funds for our kids, retirement for ourselves, etc… As borrowers we bring consumption forward (using loans and credit), for good reasons and bad; the mortgage on our homes, a really expensive watch that we quit wearing after a few weeks, etc…

Strike a balance.

The trick is to strike a balance between what we have and what we owe. Few people are able to buy a new home outright with cash, so a mortgage is usually inevitable. But as long as there is growing equity – a meaningful down payment and the shortest loan period manageable – the house feels more like an asset than a liability. The same idea applies to equity investments. Striking a balance between conservative, income-producing investments and riskier, but potentially more lucrative bets. Through this process, we strive to end up with more assets than liabilities, with more cash than debt, with more peace of mind than useless stuff.

And this gets to the heart of many financial problems, which is a failure to adequately balance assets and liabilities. Owning a million-dollar home isn’t all that great if it cost $1.1 million and was purchased with no money down and a 30-year mortgage that doesn’t begin to create equity until after the first dozen years of monthly payments. This home isn’t a person’s biggest asset but their biggest nightmare.

Over time, with much work and patience.

While enjoying an interview with jazz guitarist Pat Metheny this weekend a comment germane to the discussion of how to be a better investor – or, steward of personal assets – loomed large. He was talking about the changes he has seen while touring worldwide with his band (since 1977) of how people treat time. Metheny stated that people have become, perhaps, too cognizant of how they manage time. Everything is now expected to be accomplished quickly and efficiently. But, he said, to reach the level of expertise required to become a professional musician requires a lot of time and practice – and this cannot be done quickly or efficiently.

Warren Buffett once wrote: “It is not necessary to do extraordinary things to get extraordinary results.” An interesting observation from a guy who did not become one of the richest people on the planet quickly and efficiently, but over time and with much work and patience.

The markets we face today are some of the most volatile in recent memory. Previously reliable correlations between asset classes have broken down. Investment options never before available to individual investors now come in several varieties. We can invest in businesses located and operating, almost any place on earth. And corporate malfeasance, government intervention, currency fluctuations, communications interruptions, disruptive technologies, and irrational behavior still remain challenges to profiting as an investor. Being able to operate in this environment is not a skill that will be acquired quickly and efficiently.

A good beginning.

Becoming a successful investor will not happen by reading the latest edition of Investing for Dummies, or following the weekly ramblings of a financial columnist, or spending a weekend visiting investment web sites on the Internet (though all these things executed in tandem are a good beginning). Yes, people win lotteries, but not deliberately because of their actions, or more importantly, repeatedly over time.

So remember, try and keep three or four months of cash-on-hand for emergencies, keep the majority of equity investments in conservative instruments and avoid using debt to fund a lifestyle your paycheck can’t.

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Sell in May

May-Inverted

|A market pullback is likely, maybe even inevitable, but market timing is a dangerous game.|

With lots of anecdotal evidence suggesting caution when betting on the equities markets these days, maybe we shouldn’t be. An oft-discussed subject in what passes for financial commentary is the sell-in-May-and-go-away theory. The debate is framed by the biases of the respective authors and can be used to support both action and inaction. Then again, maybe it could be a bit of both?

May Bespoke EditThe Boys at Bespoke point out that the results of market returns during May over the last 20 years has appeared to be influenced by the direction of indexes during the first part of the year – May is more likely to be up if equities had a good start to the year. June has statistically proven to be worse than May, but then July has traditionally seen relatively strong returns. And their advice seems about right for most casual investors, “hold-in-May-and-go-away.”

Looking at the views of people whose musings I tend to respect, current market valuations are higher than one might like to see as net purchasers for the long term, but certainly not unreasonable. The recent (apparent) lack of market volatility has masked an underlying trend of segment sell-offs, making last year’s high flyers today’s dogs. And investor sentiment, far from enthusiastic, seems to suggest a continued reluctance of the individual investor to earnestly commit to embracing individual stocks.

So my bias has been toward action over the last couple of months, as it will likely remain over the early part of the summer. Adding the S&P ETF (VOO) on the big down days, but also picking up smaller and more volatile stocks for the short-term. A couple of the names May Combo Image Top DownI’ve been playing with (and this is pure gambling) are IRVRF and RUTH. There are still some nifty stocks to own over the long haul (for those of you with some history in the markets, not any nifty-fifty type of opportunities) but these are intended specifically for retirement accounts due to their yield and opportunity to add a bit of upside to a basket of sector-specific ETFs (LTC and BX as examples).

 

Yes, a market pullback is likely, maybe even inevitable, but market timing is a dangerous game. Just ask Warren Buffett, successful investing is a marathon, not a sprint. Carefully and over time is the preferred method of creating wealth.

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Skeletons Walk Where Questions Begin

invest-notes-Skeletons|“Avoid the unforced error, nail the basics and don’t take outsized risks” might be the best advice the individual investor can follow.|

An often-underestimated influence on equity and bond markets is the heavy hand of luck. Frankly, you can do everything “right” and still get bad results. And since luck can’t be controlled, knowing how to react – whether that luck initially appears to be good or bad – can separate winners from losers. But just because something can’t be controlled doesn’t mean it can’t be managed.

We all know bad things happen that are beyond our control to foresee or influence. Fires, floods and financial crisis come to mind. So we buy insurance, avoiding home purchases in areas prone to flooding and create investment portfolios that are well diversified with a healthy dose of cash savings. But what else?

Invest-Notes-Michael-Mauboussin-IMG-2543One of the best thinkers on this subject, and a terrific writer to boot, is Michael Mauboussin. The man knows how to think about how we think – especially as it relates to investing. I read his terrific 2012 book, The Success Equation, when it first came out. Subsequently, the opportunity to hear him talk about his book in person helped to clarify some of his more nuanced arguments and observations.

Invest-notes-Michael-Mauboussin-the-success-equation-IMG_1249One of the many surprises that will be found in The Success Equation is an important reason why individual investors should look to exchange-traded funds as their best bet to achieving financial goals when using the stock markets. Discussed in many posts here at Invest-Notes, by choosing to invest in indexed funds smaller investors earn the market averages over time with much less risk or cost than owning individual stocks or traditional mutual funds. Remember, for as long as equity markets have been measured, they have gone up more often than they go down.

Let the Big Dogs Bark at Each Other Instead of You

As noted recently in The Economist, 70% of U.S. stock markets are now owned by large institutions like Blackrock, Vanguard, Fidelity, pension funds and hedge funds. That percentage was just 35% in the 1980s. This means the self-described investment professionals are competing against each other more fiercely than ever before. As Mauboussin intriguingly suggests, the more skill involved in a competition the bigger the impact of luck on the outcome.

As a reality check, the following is from the prospectus of an initial stock offering (IPO) for a high-tech company that went public in March of 2017. Hyped by many, including the original investors then in a position to sell their much-appreciated shares, this quote sounds like a fair warning in my books, “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.” But if this is such a great investment, why would the private owners want to sell their stock in the company? If you had purchased shares at the IPO, you paid the original investors around $26 per share. Your investment is now worth about $13. So, as two of the biggest money-losing companies on the planet begin selling shares, no names but they provide ride-sharing services, best to avoid this ride.

By being honest and observant about the outcomes of our investment strategies – repeatedly and over time – we can create mental models that help anticipate the unexpected (to minimize risk) while expanding opportunities (to maximize upside). You can easily improve your overall return just by minimizing costs like fees and commissions (nail the basics). You can stay calm and remain inactive during times of great stress (avoid unforced errors). You do not have to go head-to-head with the pros (no outsized wager on a hot stock tip).

As Rudyard Kipling noted a century ago, just ”…keep your head when all about you are losing theirs…”

More on… “The Success Equation”-Michael Mauboussin:

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Investment Advice Through the Ages

The pursuit of wealth (and then figuring out how to keep it when successful) has a long history. The wide-ranging insights below are offered without commentary. However, where additional context is available a good source has been recommended on the pundit or their life. I have read all of the books suggested.

 

Invest-Notes - Solon Circa 600 B.C.Solon
Circa 600 BC
Athenian statesman

“The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyment, or to admire a man’s happiness that may yet, in the course of time, suffer change.”

(Nassim Taleb translates this into the vernacular by quoting Yogi Berra, “it ain’t over until it’s over” in Fooled By Randomness, 2001)

 

Invest-Notes-Leonardo-Da-Vinci_1024x1001Leonardo da Vinci
1452-1519

“Do not undertake things if you see that you will have to suffer in case you do not succeed.”

“Trust only those who have exercised their minds not on proofs of nature but on the results of their own experiments.”

 

Invest-Notes-Jacob Fugger_2024x2859Jacob Fugger
1459-1525
Estimated net worth in current dollars: $400,000,000,000
(J.D. Rockefeller clocked-in at only $340,000,000,000)

“When I go to bed, I face no obstacles to sleep. I remove with my shirt all the cares of battles and business.”

“I will earn a profit as long as I can.”

“Land endures.”

For more:
The Richest Man Who Ever Lived, Greg Steinmetz, 2015

 

Invest-Notes-Jesse-Livermore_441x441Jesse Livermore
1877-1940
Netted $3,000,000 in the 1929 market crash.
(Went bankrupt twice before and after 1929)

Cut your losses quickly.
“If a trader doesn’t know his exit before he takes the entry, he might as well go to the racetrack or casino where at least the odds can be quantified.”
Let profits ride until price action dictates otherwise.
“It never was my thinking that made the big money for me. It always was my sitting.”
Control your emotions.
“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope.”

“Buy all-time new highs.”

 

Invest-Notes-Walt-Kelly

 

Walt Kelly
1913-1973
Cartoonist and creator of the comic strip, Pogo.

“We have met the enemy and they are us.”

 

 

 

Invest-Notes-Warren-Buffett_849k

Warren Buffett
Born 1930

“One investor’s two rules of investing:

  1. Never lose money.
  2. Never forget rule #1.”

“Concentrate your investments. If you have a harem of 40 women you never get to know any of them very well.”

 

Invest-Notes-George-Soros-NYtimesGeorge Soros
Born 1930

“Investors operate with limited funds and limited intelligence: They do not need to know everything. As long as they understand something better than others, they have an edge.”

“If I had to sum up my practical skills, I would use one word: Survival.”

For more:
Money Masters of Our Time, John Train, 2000

 

Invest-Notes-Robert J FarrellRobert Farrell
Born 1932
Chief Market Analyst at Merrill Lynch & Co. for 45 years

“Excesses in one direction will lead to an opposite excess in the other direction. Think of the market baseline as attached to a rubber string.  Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.”

“Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold.”

“When all the experts and forecasts agree — something else is going to happen.”

As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

 

Invest-Notes-Michael-Steinhardt-2Michael Steinhardt
Born 1940
Considered one of the most successful hedge fund managers of all time.

“Make all your mistakes early in life: The more tough lessons you learn early on, the fewer (bigger) errors you make later. A common mistake of all young investors is to be too trusting with brokers, analysts, and newsletters who are trying to sell you something.”

“Don’t make small investments: You only have so much time and energy when you put your money in play. So, if you’re going to put money at risk, make sure the reward is high enough to justify it.”

For more: More Money Than God, Sebastian Mallaby, 2010

Invest-Notes-What I Learned Losing A Million Dollars-1Jim Paul
1943-2001
Investor and author of What I Learned Losing A Million Dollars, 1994

“There is an inverse relationship between your threshold for pain and success in the markets, so as soon as you feel the pain: get out.”

 

 

Invest-Notes-Paul-Tudor-JonesPaul Tudor Jones
Born 1954
Hedge Fund Manager and founder of the Robin Hood Foundation

“I am always thinking about losing money as opposed to making money.”

“No matter how you cut it, there are enormous emotional ups and downs involved.”

For more:
More Money Than God, Sebastian Mallaby, 2010

 

Now, who and what can you add to this list? Leave your comments below…

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The World in 2019

market-global-paper

|Don’t let hubris or fear keep you from considering participation, even in a small way, in the world economy.|

It is a fact that the U.S. now accounts for only 40% of the world’s stock market capitalization. Yet a look at international rankings of market capitalization by country tells a more nuanced story and confirms that the U.S. remains the best bet, by a long shot, for equity investing. However, Invest-Notes has from its earliest days been an enthusiast of international equities. As with most asset classes, international exposure is best pursued through exchange-traded funds, such as VEU (discussed below). And with the recent drawdown in prices around the world, international stocks might be an interesting place to invest some retirement account money at the first of the new year.

After the U.S. the second spot of most valuable equity markets is held by Japan with 7.75%. Number three is China at 7.5% followed, surprisingly, by Hong Kong at 6.75%. Great Britain and France round out the top six with less than 5% each. More importantly, over the last ten years, the U.S. has gone from 34% to the current 39.81%. We are not losing ground to Asian or European nations, but instead growing at an impressive rate. Reports of our economic demise have been wholly mistaken. Japan, Great Britain, and France have all lost ground with the annual growth for China and Hong Kong at about 2% each. This bears taking a moment to think about. Hong Kong has a population of 7.5-million people in a land-locked area of 426 square miles; China has over a billion people occupying 3,700,000 square miles. Even New York City has more land and people than Hong Kong.

Looking behind the headlines, major S&P 500 exchange traded funds (SPY, VOO, RSP) remain the smartest choice for most individual investors to keep most of their long-term savings and investments. Again, get past the hype, and even after the big drop over the last few weeks, the S&P is still flat for the year (though when I originally started work on this article a couple of weeks ago, the S&P was up 5% for 2018). By comparison, the exchange-traded fund used as a proxy for Chinese equities, ASHR, is down over 25% year to date. Over the last 5, 10 and 20-year periods the S&P 500 has delivered annual returns of over 10%. The often-repeated idea that the U.S. is somehow losing its status as the big dog in global finance is wrong. However, hubris is always a bad approach to investing strategies.

Hubris is not an Option.

In their just-released The World in 2019, The Economist features three articles offering thoughts on how world markets might perform next year. On the one hand, there seems to be some level of economist-world-in-2019confidence that the current bull market in America will see at least month 121, an anniversary of what would become the longest market expansion in U.S. history. On the other hand, these same pundits all suggest our next recession will likely begin before the end of 2019.

But the most intriguing suggestion is to ask whether the gap between the U.S. and most other world markets begins to close because the U.S. economy weakens, or everyone else gets stronger or even just stabilizes. One prognosticator suggests that if the U.S. markets soften, the rest of the world will tumble in tandem. Perhaps though trade wars and U.S. federal reserve interest rate hikes could begin to bite domestically more than internationally. Reversion to the mean is not guaranteed, but it happens surprisingly often.

So, why is investing in foreign equities a good idea right now?

Because there have been and will continue to be times when in the on-going race for returns, international stocks can retake the lead position. My best bet is that most readers have not added any international exposure to retirement accounts in a long time.

An exchange-traded fund like the Vanguard All-World Ex-US Index (VEU) make very good sense as a method of diversification. First, VEU currently offers a 3.1% dividend. Second, the expense ratio is 0.1% (that’s one-tenth of one percent). Finally, the U.S. still only has 40% of the equities markets, and there are some very fine companies worth holding in your IRAs and 401Ks. Stocks like Nestle, Novartis, Toyota, Royal Dutch Shell, and Samsung are solid investments – and better owned in a fund than individually. Don’t let hubris (only local matters) or fear (the world has gone crazy) keep you from considering participation, even in a small way, in the world economy.

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By the Book

The investment books most likely to improve one’s abilities to invest successfully will not be the ones providing recommendations of what stocks to buy, and right now. Nor will a book simply offering models of fund-centric portfolios based on the age, temperament or any other attributes of their intended audience. Most valuable are books providing information to help guide intelligent decision-making. Though the classic works of Benjamin Graham and Philip Fisher are often recommended, their extreme technical orientation serves mostly to alienate less obsessive investors. Below are some suggestions for the less rabid, but no less enthusiastic investor looking to get smarter.

Investment Books - Winning The Loser's Game - Charles D. EllisA great place to begin is Winning the Loser’s Game by Charles Ellis, originally published in 1985. It is far too easy to be blinded by success stories like those of Warren Buffett and Peter Lynch. The simple reality – clearly demonstrated by Ellis – is that few people (or mutual funds and their managers, or individual stocks) manage to consistently beat the market over time. His explanation of how people can appear to be great investors when in fact their success is due to statistical survivorship bias is eye-opening. Understanding the damage we inflict on ourselves through preventable mistakes, high-risk gambles and most significantly the fees we choose to pay as investors is vital if we want to be successful as investors. How could have taken over thirty years for this message to sink in?

Investment Books - ANTIFRAGILE - Nassim Nicholas TalebA personal favorite from 2012 and one, it should be noted that several Invest-Notes readers have been less impressed with, is Antifragile by Naseem Taleb. This investment book is a refinement of his first work, Fooled by Randomness, published about twenty-five years ago. Taleb goes way beyond the idea of a “Black Swan Event” (a term he coined, and title of his best selling book, though not a favorite of mine) and discusses not only how to avoid unexpected events, but how to benefit from them when, not if they happen. As Taleb cleverly explains: experts aren’t; things that can’t happen will; and like physical exercise, stress can be harnessed for self-improvement. Don’t let his arrogance distract you from the invaluable insights being offered. Taleb’s most recent book, Skin in the Game, published earlier this year is also terrific – but more valuable if read after Antifragile.

Investment Books - The Millionaire Next Door - Thomas J. StanleyAnother good primer is the original edition of The Millionaire Next Door published in 1996. That some of the book’s conclusions have been shown to be faulty does not take away from the value Millionaire can offer would-be Warren Buffett’s. Short of winning a lottery (and that includes the genetic lottery), fortunes are most likely to be built over time, through luck, hard work, and patience. The many stories discussed in Millionaire provide practical examples of how to make the most of our current situation. This includes the single best thing anyone hoping to accumulate significant assets can do: Live beneath your means. It also helps explain why on lists of the wealthiest Americans over three-quarters are self-made, having created a fortune rather than inheriting one. Yes, you can be the millionaire next door, just not right away.

Investment Books - Money Masters of Our Time - John TrainWhile The Essays of Warren Buffett is on many lists (and is on my bookshelf), there is another text providing a more insightful overview of how great investors operate. This book from 2000 also demonstrates beyond any doubt that there is no one single path leading to success. Money Masters of Our Time, by John Train, provides provocative insights into the thinking of seventeen of the most successful investors of the 20th century. It is here you will see that Buffett’s earliest successes came with risk most of us would never consider and that he has never repeated. Also worth noting is that several of these investors, among them some of the richest people on the planet, don’t use their wealth as anything but a scorecard. If there was ever proof demanded that having all the money doesn’t necessarily equate to happiness, this book is it.

Investment Books - More Money Than God - Sebastian MallabyFinally, More Money Than God by Sebastian Mallaby can do more to explain hedge funds, what they do, and how they work than other investment books you can read. The U.S. financial system, and the Wall Street crowd, in particular, have never met a good idea that couldn’t be abused and corrupted. Read in tandem with Money Managers, the world of investing will look very different when you’re done. The origins of these curious investment vehicles (and the people who created them) are fascinating, with many of the concepts still applicable, even for the individual investors reading this note.

 

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Who Are You?

|“All card playing is not gambling, all stock purchases are not investing…”| 

– Jim Paul, What I Learned Losing a Million Dollars

What the heck is an investment plan? Open a brokerage account or interview a financial planner and you get handed a questionnaire intended to help determine what kind of investor you are – or will be, as a new client. But how do you answer a question like “Rate your tolerance for risk on a scale of 1-to-5?” A person willing to blow $1000 at the blackjack table while on a vacation in Las Vegas could be appalled at losing that same $1000 on a stock purchase. The glib advice – embarrassingly repeated here at Invest-Notes on occasion – that everyone should have “An Investment Plan” isn’t really much help.

Investors must know themselves

Creating an investment plan is not complicated, but it does involve some critical thinking. First, acknowledge we have no control whatsoever over the movement of investments like equities, real estate or gold. There is no way to know if a stock is going to go up, and if it does, how high it can go. On the other hand, how much money you are willing to lose is entirely up to you. In essence, your investment plan is simply a set of rules to ensure that you never lose more money than you can afford.

Investor-PlanningAs an investor, you can tell yourself that the stock you just bought is going to double in price, but that’s just a guess. Deciding that you are not going to lose more than, let’s just say 20%, while waiting to see if your guess is correct is the purpose of a plan. Conversely, suppose you are right and the stock does go up 100%. A decision made in advance to sell the stock anytime it drops more than 20% as the price goes up ensures you turn some of those paper profits into real ones. Prudent investors manage risk by making sure they never let emotions influence their decision making.

Second, you have to decide who you are every single time you make a transaction involving invested capital. You will not always be the same person, and if you become someone new in the middle of an investment episode your odds of failure grow exponentially. Along with a decision on what you are willing to spend in pursuit of a gain, you need to consider who you are. In the final analysis, it’s deciding in advance whether a piece of real estate, a stock, or a poker game (there are successful professionals in this field) is an investment, speculation or a gamble.

Are you an Investor, a Speculator, or a Gambler?

An investor expects a safe return of his invested capital after receiving dividends, interest payments or rent. A government bond held to maturity or the ownership of high quality commercial real estate are examples of investments. These usually require long investment horizons.

InvestorsA speculator expects to receive a gain on his invested capital through an increase in the value of the asset purchased. A return on an investment is only achieved when the asset is sold for a profit. This is not the same thing as making an investment and tends to be short-term.

A gambler uses capital to express an opinion and/or as a form of entertainment to wager on activities with unknown outcomes or with results arrived at mostly by chance. Sports events, casinos and highly speculative equities allow for effortless all-or-nothing bets.

A Cautionary Tale: The Speculator Changes Face to an Investor

It can work like this; there was a lot to like about that hot, new company, and as a speculator you took a meaningful position, buying a slug of stock that pays no dividend. For reasons you couldn’t have known the stock price drops, let’s just say 20%, but you decide to hang in there and keep your position. It takes another hit to the share price and you are now down 40%. So, you decide to hold on until you at least get back to even, and now you are a gambler.

But you tell your friends that you are, in fact, an investor with plans to hold the stock for the long-term, but without any dividends or any reasonable expectation for a safe return of your initial investment. At the same time, you’ve convinced yourself that you can’t sell now because you’ve lost too much money. It can be a long, painful ride to the bottom.

It’s okay to be an investor, a speculator and a gambler at the same time. It is not acceptable to be all three on the same trade. And when market conditions influence your identity in the middle of a trade, you are letting human nature get the better of you. An Investment Plan is intended to take the emotion out of investing, while at the same time assigning each financial transaction to an appropriate goal.

Closing thoughts for Investors

A discount broker has the account I use to gamble – currently, it holds stock in a Canadian mining company looking for gold on Japanese islands. There is nothing even remotely comparable in our retirement accounts which are mostly filled with indexed exchange traded funds and bonds. In our savings account, there is just cash, and always will be, so a trade doesn’t have to be forced to solve unexpected financial problems. My plan is to invest carefully for the long-haul, speculate on an occasional high-risk high-return activity and always have a safety net.

Your investment plan is simply a list of your current assets, each with a “Sell Now!” price (hopefully as a standing stop/loss order), what purpose it serves (long-term or short?) and a reminder about who you were when you made the investment or gamble.

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