Ask Uncle Bill: 12 - Investments - All You Need to Know

"Clueless, totally clueless." My daughter's description of her friend's knowledge of finance, credit cards, debt, careers, investments--the financial world in general. "Write a book, Dad." So I wrote a book proposal, got an agent (New York City, no less) and realized that college students and people just starting out don't have any money to buy books AND they get all their information off of the internet. Forget the book. So here is the site for all your money questions and how to get rich. If you don't see what you need just ASK UNCLE BILL.

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12 - Investments - All You Need to Know

Download 12_investments_all_you_need_to_know_.doc

Your One Stop Investment Strategy

There seems to be some perverse human characteristic that likes to make easy things difficult.

Warren Buffett

All You Need To Know

Emergency Fund

Your first investment goal is to set up an emergency fund of three months living expenses. Multiply your monthly net paycheck amount by three and this is the amount you need to save. This amount will get you through being fired, blown-up car or most any other short-term crisis.

Mutual funds have minimums, usually $3,000, so you will need to save this amount up in your bank account or bank savings account.

When you have $3,000 in the bank call the Vanguard Group at 1-800-662-2739 or go online at Vanguard.com. On the phone you will ask for a form to open an account-
in this case either a money market fund or a short-term bond fund and they will mail you the form or you can download the form from Vanguard.com.

If for any reason you do not like Vanguard you can contact Fidelity Investments, T.Rowe Price, Scudder or any other of a number of fund companies. I like Vanguard because they charge low fees and have good service so I will ‘push’ them in this chapter..

At Work

At work, your company will probably have a 401(k) program that will be explained to you by a representative from Human Resources. You and that person will probably not have a clue so do this 1) look at the investment choices available, 2) look for stock index funds, 3) follow the plan above and put 70% of your contibutions into the S&P Index, 15% to the Small Cap Index and 15% to the International Stock Index.

Contributions?

Contributions are pre-tax; they come out of your gross salary and reduce your taxes. If you make $35,000 and your contribution is 10% then your contribution is $3,500 and your taxable income is not $35,000, but $31,500. The allowable contribution amount changes as the tax code changes but the philosophy here is to contribute the maximum-tell your HR person you want to ‘max out your 401(k)’ and they will know what you mean.

Most companies match contributions to some degree or another. At one employer, they matched my contribution 2.1 to 1. I put in a dollar and they put in $2.10. That account really took off. Check for the match at your company.

If you do not have a 401(K) program, you can invest in a traditional IRA (Individual Retirement Account) or Roth IRA. The difference between the two is that traditional IRA shelters the investment from taxes until retirement while with a Roth IRA the contribution is made out of after tax wages but the earnings from the investment are never taxed. You have to decide between a traditional or Roth IRA. Call Vanguard for the form and how to set up this account. Through Vanguard you can set up regular monthly contributions taken directly from your checking account just like the 401(k) takes it out of your paycheck. Your allocation is the same as the 401(K).

You’re finished. This strategy will last for at least ten years, probably longer.

That is all you need to know, just sit back and add money on a regular basis out of your paycheck. Act now and set up the accounts and you will become rich assuming the market follows what it has basically done for the past 100 years. If you really want to know more, read on. But you don’t have to.

The Details

Setting up your 401(k) or IRA accomplishes the following-

-You are invested in stocks
-You are tax sheltering your money
-You are dollar cost averaging

And remember that finance is easy. In college they make it hard because if it were easy you wouldn’t have to go to class and take tests. There are no tests here; there are only easy explanations and instructions on what to do when. So here we go on the long but easy and usually pleasant journey to financial independence and wealth.

Why Stocks?

The simple answer is that over the last 100 years stocks have averaged an annual return of 11% versus 7% for bonds and 3% for cash.

What are stocks?

Stocks are shares of companies. Say you start a company with nine friends who each put in $10 to buy a car, or a boat or a house or whatever. The market capitalization is $100 ($10 x 10 investors) and you are a 10% owner, you own ten shares of the total stock of the company. Your company buys a house with the $100 (this is an example obviously) and the house rents for $10 a year. The return on the stock is 10% of which you get $1 dollar so your return, or dividend, is 10%. You decide to sell your stock and get $12 for it so you have a $2 gain, or 20%. If you held the investment for one year and one day, the gain is a capital gain taxed at 15%, if held less than one year the gain is taxed as ordinary income.

To summarize the financial variables, your company has
10 shares
10 shareholders
Market Capitalization of $100
The Company pays out a dividend of $10
The price earnings ratio, or PE, is 10 because a $10 price divided by $1 of earnings results in a PE of 10.

Yeah, so what?

The fact is that all companies that are publicly owned are structured like your company. The company issues shares and you, the shareholder, own the shares. The company makes a product, sells it for a profit, makes more products, sells more, makes more and the value of your stock goes up because more people see the company is doing well and want to buy it. Over time you make money.

Conversely, if a company doesn’t make money, the share price goes down…and down…and down until something happens.

A real life example. PepsiCo vs. Coke. Similar companies, kind of, but one’s stock price is up 40% over the last five years and the other is down exactly the same amount.

PepsiCo up and Coke down. Why? Coke has had pretty much stagnant sales since it only has one product coupled with management turnover including three new CEO’s and employee lawsuits over just about everything. Meanwhile, PepsiCo has grown through acquisition (Gatorade), internal growth (Pepsi and Frito Lay) and slimming down (spinning off Taco Bell, KFC, and Pizza Hut).

Do we care? No, because through our strategy of buying the indexes we own both companies. Would we have been smart enough five years ago to figure out that the Pepsi Challenge would work and Coke is not It? Maybe, but probably not. Are we stupid for owning Coke and Pepsi through our strategy? No, we are smart. Why?

Because the Market will do the work for us. Mr. Market, in the long run, will reward us for the PepsiCo’s of the world and rid of us of the Cokes. If Pepsi continues to make products people want, sell those products at a profit, and reinvest in the business to grow the business, then people buying stock will want to own the stock and the stock price will increase making us wealthier.

With our Coke holdings something will happen, something in the long run that will be good for us. If the company continues to do poorly, the stock will continue to slide and our ownership, as a percentage of our total holdings, will decrease. In the short term that is bad because we have a loss.

In the long run it is good because something will happen, guaranteed. The company could go out of business. That’s bad but at least it is gone and good riddance. Coke out of business? Not likely. So what else could happen? Somebody buys it. Who? Nestle, PepsiCo, Unilever, who cares? Whoever buys it will pay for it and for a premium, so we make money. Or they merge and we own shares in the new company that is doing pretty well because they are big enough to buy Coke. Or management gets smart or desperate or both and changes, this time for the better. Cuts costs, new products, diversify-we don’t care just as long as it works and the stock turns around and goes up.

That’s how the stock market works-over time. Good stocks get better, bad stocks become better or disappear and new stocks appear and grow. How do we know this? Because, back to where we started, stocks over the last 100 years have averaged an 11% positive annual return versus 7% for bonds and 3% for cash.

But Why Can’t I Time The Market? Why Can’t I Find The PepsiCo’s of the World?

You can but not right now. You can’t now because you don’t have the money and you don’t have the time-sorry. It is only through time that you generate enough in assets to make a difference and make market-timing pay off. In addition, you need to focus on your career now and not waste your time trying to figure out how to time the market unless your job is on Wall Street and you are being paid to do so.

Weighted Dollar Cost Averaging

For the foreseeable future (I was going to say five to ten years but that is way too long for you to contemplate right now) you will do what is known in the finance game as weighted dollar cost averaging investing. Bear with me-this is easy and boring investing. It has three components-
-asset allocation,
-regular contributions,
-time.

By setting up your 401(k) at work or the regular contributions to your IRA at Vanguard you already have an asset allocation-70% S&P 500 Index, 15% Small Cap Index and 15% International Index. Done. The first component is in place.

You have, by now, figured out the investment form at work or the Vanguard form for the IRA and settled on your regular contribution. It should be the maximum amount allowed. If you don’t know the maximum, ask. Your HR rep will know this and most certainly the Vanguard representative will know it, so ask. Our goal is always to keep things simple. Set up the transaction so the money will go directly to your investments out of either your paycheck or your bank account. This being done the second component is in place.

Now for time. This the most important element and one of which you have plenty of right now. The amounts invested each paycheck won’t seem like much at the beginning and they aren’t but they do add up. As Samuel Bronfmann said, “The first billion was tough, the second billion was inevitable.” This philosophy applies also to tens, hundreds and thousands of dollars. And then…

The market drops 30% tomorrow, or worse, stays there for five years. Again, you don’t care because you are investing 1) small amounts 2) over time 3) on a regular basis.

Dollar averaging works because if you buy into a market that is going up, your investment goes up with it. Dollar averaging works when markets go down because your investment buys more of the product when the market goes down. A simple example.

Every month for a year you invest $100 in the Vanguard S&P 500 Index. In January the Index is priced at $100 so you get 1 share. The market drops 30% in February so the Index is now selling at $70 so you now have 1.43 share plus the original 1 share for a total of 2.43 shares (good news) but the shares (the bad news) are worth only $170.10 (2.43 shares x $70=$170.10). Your total investment of $200 is now worth only $170.10. You are under water and ready to abandon the whole thing because…

In March the market dives to $60. You are too late to stop your investment and the idiots at Vanguard take your $100 and buy 1.667 shares so you now have a total of 4.0967 shares worth $245.80. You are out $54.20. Ok, lets speed this up.

The market falls to $55 in April, $50 in May, stays there in June. After half a year you have invested $600 and your investment shares total 9.9138 worth $495.69. You quit reading your statements. The market does nothing in July, August, and September. Your investment is now $900 but your shares are worth only $795.69.

The market comes back to $65 in October, $90 in November and a Santa Claus rally takes the market up to $130 in December. On New Years Eve you pull out your statement and determine that you have 19.3326 shares worth, at $130 a share, $2,513.24.

You invested $1,200 but have $2,513.24. The wonders of dollar cost averaging.

Now, most markets won’t go down 50% in one year and then come back for a 30% gain in the same year but over time such ups and downs do happen but we don’t care because of regression to the mean.

Statistics 101

I almost flunked statistics in graduate school. But there is one area of statistics that is easy to understand-Regression to the Mean meaning that Over Time Results Average Out. If a baseball player is a .250 hitter than, on average, he will get a hit one out of four times at bat. In one game he may go four for four or 0 for four BUT over the season, or his career, he will average one hit in four times at bat. OVER TIME, he is a .250 hitter which in today’s baseball guarantees him a multi-million dollar contract.

It works in football, tennis, golf-anything where an activity is repeated and recorded and averaged. The results revert to the mean, which is statistics talk for Things Average Out Over The Long Run.

Stocks revert to the mean as well and over the last century have returned 11% a year on average versus 7% for bonds and 3% cash. Put another way, stocks have, on average returned 36% more than bonds every year and 73% more than cash, cash being money market funds and bank savings accounts.

Yeah, but…

You were about to say but what about the future, who knows what is going to happen? Maybe terrorism, war, disease, famine, maybe stocks will go down. Not maybe…absolutely. Those things will all happen and maybe worse. Because they all happened in the past century and … the stock market averaged a positive return of 11% a year.

Here is the dirty little secret. To be a successful investor, to be a successful businessperson, to be a successful person; you have to be optimistic about the future. This does not mean you are a dithering idiot or hopeless Pollyanna but you do have to believe that things will continue to get better, not only for the stock market but the planet in general. Because if you don’t, why do anything?

December 18, 2005 in 12 - Investments - All You Need to Know | Permalink