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Investing

In 2006, Roberta Langtry passed away at the age of 89. In her will, she left a $4.3-million gift to the Nature Conservancy of Canada1. How did an elementary school teacher accumulate so much wealth?
 
Roberta started teaching at 16, and it took her 40 years to save $500,000. At the age of 56, she enlisted the help of investment adviser Robert Borden. He put most of her money into conservative bonds and blue-chip stocks, such as banks and insurance companies. Although Roberta wanted to invest in companies involved in anti-pollution work, Robert limited these risky ventures to 10 percent of her portfolio. Thanks to this disciplined investment strategy, and the magic of compounding returns, Roberta’s $500,000 grew to more than $4 million by the time she died.

Note that it took a lifetime for Roberta to become wealthy by investing. The bottom line is that investing is a slow way to make a lot of money, unless you’re a stock-picking genius or incredibly lucky. Don’t get me wrong—it’s important to know how to invest. Just don’t count on getting rich quick.
For millionaires, the top three investments in their financial portfolios are stocks, real estate, and fixed-income investments. In the Saving and Spending article, we learned how to get a great deal on a house. In this article, we’ll learn how to get great deals on stocks and bonds.

Money is a terrible master but an excellent servant.
-P.T. Barnum

Mutual Funds
Most Americans invest in stocks by buying mutual funds, index funds, and other investment funds through their banks or brokers. These funds account for nearly 25 percent of the typical portfolio, and almost 50 percent of the money invested in pension plans and Individual Retirement Accounts (IRAs)2. There are a lot of funds out there. In 2006, there were 8,726 funds in the United States alone.
 
It’s expensive to run a mutual fund. There’s advertising expenses; commissions for salespeople, brokers, and financial advisors; and salaries for high-priced managers to analyze and pick stocks. To cover all of these expenses, the typical mutual fund charges a Management Expense Ratio (MER) of 1.51 percent every year. This means you pay a management fee of $1.51 for every $100 you invest in their funds. You pay this fee whether or not the fund makes money for you.

Index funds are a special type of mutual fund because they don’t try to guess which stocks will go up or down. Instead, they use computer programs that “index” the market by automatically purchasing an equal weighting of every stock. This means index funds don’t need high-priced managers. They also minimize expenses by avoiding advertising and commissions. This allows most index funds to charge an MER of 0.20 percent or less, a fraction of the price of actively-managed mutual funds. Not only are they cheaper, but they also perform better. Wall Street’s dirty little secret is that index funds beat the pants off almost all actively-managed funds.

If stock market experts were so expert, they would be buying stock, not selling advice.
-Norman Augustine

Paying for Underperformance
In a study that tracked 355 actively-managed mutual funds from 1970–2006, only three funds consistently outperformed the index3. The other 352 did worse than the index, or went out of business. David Swensen is the Chief Investment Officer of Yale Unversity’s multi-billion-dollar endowment fund. According to Swensen, “A miniscule 4 percent of funds produce market-beating after-tax results, with a scant 0.6 percent annual margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.”

Morningstar is a well-known investment research company that rates mutual funds on a scale from one to five stars. To test the Morningstar system, financial editor Mark Hulbert tracked the performance of mutual funds that received their highest five-star rating. From 1994–2004, a portfolio continuously adjusted to hold Morningstar’s five-star funds generated an annual return of 6.9 percent. This was almost 40 percent lower than the 11.0 percent return generated by the stock market index.

It’s definitely possible to beat the index. Warren Buffett is known as the “Oracle of Omaha” because of his stock-picking prowess. From 1965–2006, his Berkshire Hathaway investment company returned an average of 21.4 percent every year4. This trounced the performance of the S&P 500 Index, which returned 10.4 percent over the same period.
 
Hindsight is 20:20. In retrospect, it’s obvious that Warren is a financial genius. But how do you identify the next Warren Buffett out of a universe of 8,726 mutual funds? The odds are stacked against you. That’s why Warren says, “A low-cost index fund is the most sensible equity investment for the great majority of investors.” The tragedy is that low-cost index funds only account for about 10 percent of the money that Americans have invested in mutual funds. Banks, brokers, and financial advisors have little incentive to recommend index funds because they don’t receive commissions or kickbacks.

Show me a company’s various compensation plans, and I’ll show you how its people behave.
-Chuck Ames

Future Returns
In 2003, Roger Ibbotson and Peng Chen published a study showing that the compound annual return for the U.S. stock market was 10.7 percent from 1926–20005. This is the basis of the “10 percent return” number that is cited in a lot of financial literature. But past performance is no guarantee of future results. The United States was the world’s best performing stock market over the past century. It’s unlikely that America can keep up the same rate of growth for the next 100 years. As they say on Wall Street: “Trees don’t grow to the sky.”

For the next few decades, most experts are predicting that the U.S. stock market will return an average of 6–8 percent per year6,7,8. There will be years when the market is higher, and there will be years when the market is lower. But the long-term trend is less than 10 percent. Keep this in mind when you plan your financial freedom. If you retire with $1 million in investments, you can expect an average return of $70,000 a year. Is this enough to afford the lifestyle you want?

The other consequence of lower returns is that lower fees matter even more. An MER of 1.5 percent, on a total return of 7 percent, means that 21 percent of your earnings are going to mutual fund managers to cover their expenses. With an index fund, an MER of 0.20 percent means you’re only losing 3 percent of your total return to expenses.

Diversification
In addition to investing in an index fund for the U.S. stock market, you should allocate a portion of your portfolio to bonds and international stock markets. Diversification gives you higher returns with lower risk. Also, international stock markets have the potential for greater returns. In 2003, Americans held 18 of the top 25 spots in the Forbes’ list of the world’s richest people9. In 2008, this declined to only four Americans in the top 25. This is a sign of a bigger long-term trend. Economies such as China and India are growing like gangbusters as billions of people discover the rewards of capitalism. But rapid growth carries the danger of booms and busts. Bonds and U.S. stocks generate lower returns, but their stability balances out the risk from developing markets.

A Simple Plan for Financial Freedom
  1. Cut back on your expenses so that you save money from every paycheck. If possible, aim to save 10–20%.
  2. If you have a hard time saving on your own, go to your bank and set up a program that automatically deducts a percentage from every paycheck, and deposits it in a high-interest savings account.
  3. Use your savings to pay off your debts as fast as possible. Start with debts that have the highest interest rates such as credit cards.
  4. Pay off the mortgage on your house. Pay it off faster by shortening the term, making higher payments, and making extra lump sum payments when you can afford it.
  5. Once all of your debts are paid off, invest your savings in a tax-sheltered retirement plan such as an IRA or 401(k). Maximize your contributions before investing outside of a tax-sheltered plan.
  6. For your investments, purchase index funds or exchange-traded funds (ETFs) so that your portfolio is composed of these percentages:
    • 50% in a stock market index fund or ETF
    • 30% in a bond market index fund or ETF
    • 20% in an international stock market index fund or ETF
  7. If you live in the United States, here are some low-cost investment choices from Vanguard, the inventor of index funds (https://personal.vanguard.com):
    • Vanguard Total Stock Market Index (VTSMX, MER 0.15%), or Vanguard Total Stock Market ETF (VTI, MER 0.07%)
    • Vanguard Total Bond Market Index Fund (VBMFX, MER 0.19%), or Vanguard Total Bond Market ETF (BND, MER 0.11%)
    • Vanguard Total International Stock Index Fund (VGTSX, MER 0.27%), or Vanguard FTSE All-World ex-US ETF (VEU, MER 0.25%)
  8. If you live in Canada, set up a brokerage trading account at your bank, and invest in these low-cost ETFs:
    • iShares CDN LargeCap 60 Index Fund (XIU, MER 0.17%)
    • iShares CDN Bond Index Fund (XBB, MER 0.30%)
    • iShares CDN EAFE International Index Fund (XIN, MER 0.49%)
  9. Buy and hold, and let the magic of compounding do its work.

Compounding is mankind’s greatest invention because it allows for the reliable, systematic accumulation of wealth.
-Albert Einstein

Financial Advisers
If you’re afraid of managing your finances, and you want someone to hold your hand, then find a trustworthy financial advisor. Even with their help, you still need to monitor your investments carefully because there are always a few bad apples in any profession. You don’t want someone stealing your money after you’ve worked so hard to save it. In general, your advisor shouldn’t charge more than a 1 percent fee to manage your money10. This should drop to 0.75 percent or less to manage $1 million, and 0.5 percent or less to manage $5 million. Make sure your advisor picks low-cost index funds, and isn’t getting a commission or kickback from the funds they recommend.

Picking Stocks
Most people should stick with index funds and avoid buying individual stocks. That being said, I don’t want to discourage you if you’re the next Warren Buffett. Also, picking stocks is a good way to learn about finance and business in general. Let’s discover the secrets to Warren’s success by hearing from the master himself:
  • “Price is what you pay. Value is what you get.”
  • “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
  • “Be greedy when others are fearful, but be very fearful when others are greedy.”
  • “Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.”
  • “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
  • “Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%–25% on equity, time is your friend. But time is your enemy if your money is in a low return business.”
  • “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”
  • “Our favorite holding period is forever.”
From the quotes above, we can summarize Warren’s investment strategy in two principles:
  • Buy the stocks of great businesses when they go on sale.
  • Hold for the long-term so that the magic of compounding can do its work.

Buy when there is blood in the streets.
-Baron von Rothschild

Great Businesses
How do you recognize a great business? Mary Buffett is the ex-wife of Warren’s son, Peter Buffett (a musician and composer). In Buffetology, Mary explains the six questions that determine if a business is truly great.
  1. Does the business have brand-name products or services that give it a monopoly in the market? You couldn’t compete even if you had billions of dollars and your pick of the 50 best managers in the world.
  2. Does the business have a multi-year track record of consistently growing earnings?
  3. Does the business have low amounts of debt?
  4. Has the business consistently earned a high rate of return on shareholders’ equity? This measure is known as Return on Equity (ROE). It gives you an idea of how efficiently the management team generates earnings with the company’s assets. Over the last 40 years, American companies have achieved an average ROE of 12 percent. Anything over 12 percent is above average.
  5. Is the business able to maintain current operations with minimal investment? The ideal business rarely has to replace factories and equipment, and requires minimal investment in research and development to stay competitive.
  6. Is the business free to adjust prices to inflation? If the prices of raw materials go up, the business can increase the price of its products and services with no drop in demand.
Excellent product-based companies usually share the following characteristics:
  • The product wears out fast or is used up quickly.
  • The product has brand-name appeal.
  • Merchants must carry the product to stay in business.
Examples include brand-name products such as Coca-Cola, Budweiser, Heinz ketchup, Wrigley gum, and Campbell’s soup. Excellent service-based businesses are used frequently by customers and dominate their markets. Think of Wal-Mart, McDonald’s, or Wells Fargo. No matter what happens to the economy, people will still shop at Wal-Mart, eat Big Macs, and put their money in banks.

Great Price
Now that you know how to identify a great business, how can you tell when it goes on sale? The fair value of a company may be calculated based on its Discounted Cash Flow (DCF). It’s the sum of a company’s total expected earnings over time, adjusted by a discount rate that reflects the risk that those earnings won’t materialize.

For example, suppose you own all of the shares of Acme Widget Co. The company decides to liquidate its assets, and pay you $1 per share tomorrow before closing down permanently. Therefore, DCF analysis indicates that the company is worth a little less than $1 per share. Why less than $1? It’s because there’s a small risk you won’t receive the money tomorrow. A dollar in hand is worth two in the bush. The farther out in the future, the higher the chance that something will go wrong and you won’t get paid.

DCF helps you determine a stock’s fair value today, based on estimates of its earnings in the future. By comparing the stock’s current price to its calculated fair value, you can determine if it’s on sale.

DCF Calculator
Check out this free online DCF calculator: http://www.moneychimp.com/articles/valuation/buffett_calc.htm. To see how it works, let’s do a DCF analysis of Microsoft Corporation’s stock.
  1. Go to the “Stock Research” page on MSN Money: http://moneycentral.msn.com/investor/research/welcome.asp.
  2. Look up the financial information for Microsoft by typing the ticker symbol “MSFT” into the “Get Quote” box. Microsoft’s “Earnings/Share” (EPS) is listed in the far-right-hand column. For 2008, Microsoft’s estimated EPS is about $1.72.
  3. In MoneyChimp’s DCF calculator, enter Microsoft’s annual “Earnings/Share” (EPS) in the “Earnings” box.
  4. Next, let’s look at Microsoft’s earnings history. Go back to MSN Money’s summary page for Microsoft. In the left-hand menu column, you’ll see a heading that says “Fundamentals.” Select “Financial Results.” A sub-menu will appear, and allow you to select “Statements.” In the “Statements” page, select the tab for “10 Year Summary.” This shows you Microsoft’s EPS for the past 10 years. From 1998–2007, Microsoft’s earnings increased by an average of about 14 percent per year.
  5. Go back to MoneyChimp’s DCF calculator. In the “Growth Assumptions” box, enter the conservative assumption that Microsoft’s earnings will grow by 5 percent per year for the next 5 years, before leveling off to zero growth.
  6. For “Confidence Margin,” let’s assume there is an 80 percent chance that Microsoft will achieve our conservative estimate for earnings growth.
  7. For “Discount Rate,” let’s assume a 5 percent return for a risk-free investment such as a Treasury bill.
  8. When you hit “Calculate,” Microsoft’s fair value per share is estimated as $34.40.
  9. By comparing this fair value with the current price of Microsoft’s stock, we can determine if the stock is underpriced, overpriced, or neutral. As value investors, we should only buy when there is a big discount to fair value (e.g., 20 percent or more).

Buy a dollar for 50 cents, and sell it later for a dollar. Repeat until very rich.
-Phil Town

DCF Assumptions
The DCF calculator required us to make a lot of assumptions. We had to estimate Microsoft’s future earnings growth, and the probability it would achieve its future earnings. Perhaps the biggest assumption was that earnings would continue rising, or at least remain stable. The calculation isn’t accurate if earnings decline in the future. A company must have an overwhelming advantage over its competitors to sustain this sort of track record for years, let alone the decades assumed by the DCF calculator.

In general, DCF analysis works best for companies that dominate their markets with brand-name products that people will always buy. That’s why Warren Buffett stays away from technology stocks—technology changes so fast that it’s hard to predict which companies will be the leaders in the future. Look at how fast Google and Apple eclipsed Microsoft and Yahoo. But 20 years from now, people will still be drinking Coca-Cola and eating Kellogg’s corn flakes.

Value Investing
Waiting for stocks to go on sale is known as “value investing.” Warren Buffett and many other value investors have become fabulously rich by following this investment approach. When stocks are cheap, they buy stocks. When real estate is on the bargain table, they buy real estate. When bond yields are juicy, they buy bonds. If there are no sales, they wait patiently on the sidelines and keep their powder dry.

Researchers have shown that value investing consistently outperforms the market over the long-term. Josef Lakonishok is a professor of finance at the University of Illinois. He analyzed the performance of stocks from 1963–1990, and found that value investing works because it invests in stocks that are underpriced, and underinvests in stocks that are overpriced11. Over time, the market raises the price of underpriced stocks, and lowers the price of overpriced stocks.
 
The reason that underpriced and overpriced stocks exist is because human nature is prone to fear and greed. Fearful investors oversell stocks that have fallen out of favor, and greedy investors get too excited about stocks that have done well in the past.

The intelligent investor is a realist who sells to optimists and buys from pessimists.
-Jason Zweig

Stocks on Sale
  1. Make a list of publicly-traded companies that make products or sell services that everyone will still be using in 20 years.
  2. Use the six Buffetology criteria to narrow down the candidates. Get financial information from websites such as http://moneycentral.msn.com.
  3. Use the DCF calculator (www.moneychimp.com/articles/valuation/buffett_calc.htm) to figure out which stocks are on sale. Look for stocks that are discounted at least 20% from their calculated fair value. You want a big margin of safety.
  4. Go to financial websites such as www.fool.com and search for articles and analysis on your stock candidates. Make sure there are no skeletons hidden in the closet.
  5. Only consider buying stocks that have passed Steps #1–4.
  6. For stocks that meet the Buffetology criteria but aren’t on sale, put them on a watch list and wait patiently.
For a slightly different perspective on determining a stock’s fair value, check out this book:

Patience and Discipline

Value investing requires a lot of patience. You’ll examine hundreds of stocks to find a few worth buying. As usual, Warren has some helpful advice: “When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in.”
 
Charlie Munger is Warren’s sidekick at Berkshire Hathaway, and an investing genius in his own right. Summarizing their philosophy, Charlie says, “The objective is to buy a non-dividend-paying stock that compounds for 30 years at 15% a year and pay only a single tax of 35% at the end of the period. After taxes this works out to a 13.4% annual rate of return.” Find great stocks. Buy them on sale. Hold them forever to minimize taxes and trading costs. It’s a proven strategy for market-beating returns.

Expected Value
Another way to find good investments is to estimate the “expected value” of a payout. In probability theory, the expected value of an event is the sum of the probability of each outcome multiplied by the payoff for each outcome. For example, suppose you flip a coin and someone offers you the following bet: if the coin is heads, you win $100; if the coin is tails, you lose $80. Should you take the bet?
 
The expected value is the odds that the coin will be heads (50 percent) multiplied by the payout of $100 (50 percent × $100 = $50), plus the odds that the coin will be tails (50 percent) multiplied by the potential loss of $80 (50 percent × -$80 = -$40). Since the expected value is $10 in winnings, you should take the bet if you can afford to lose $80. As mathematician and trader Nassim Taleb warns, “It does not matter how frequently something succeeds if failure is too costly to bear.”

But researchers have found that most people will turn down this bet unless the potential loss is less than $50. In other words, they need an odds advantage of 50 percent or more before they’ll bet. In contrast, casinos make millions of dollars with an odds advantage that’s less than 1 percent for blackjack, and less than 10 percent for $1 slots. The human brain is wired to avoid big losses, even at the cost of sacrificing good opportunities to make money.
 
On the other hand, people will happily bet on long shots, as long as the potential loss is very low. For example, your odds of winning the Mega Millions jackpot are about 1 in 175 million. Since the payout is usually less than $100 million, the expected value is $0.57 or less for every $1 ticket. Not a good investment. But millions of people play every week in the hopes of striking it rich. In fact, 21 percent of Americans believe that winning the lottery is the most practical way of becoming rich. As a smart investor, stay away from bad bets like this that are rigged against you. Instead, look for situations where the expected value is in your favor.

Heads, I win; tails, I don’t lose much!
-Mohnish Pabrai, The Dhandho Investor

Master Your Emotions
The rules for making money are simple: buy on sale, and hold for the long-term. The hard part is sticking to the rules. In Your Money and Your Brain, financial author Jason Zweig reviews the research about how your emotions can sabotage your investing. When everyone believes the sky is falling, that’s when stocks are the most on sale. But it takes tremendous courage to go against the crowd. Also, there’s the risk that your stocks will fall further after you buy them. Then you’ll feel like kicking yourself for not waiting longer. Zweig says, “If you think a plunge in the value of your investments won’t bother you, you are either wrong or abnormal.”
 
Your brain responds to financial losses in the same way as life-threatening events. It’s an emotional roller-coaster ride of surprise, fear, panic, and regret. But if a stock is truly on sale, the right action is holding for the long term. Companies that consistently grow their earnings will eventually see their stock price rise to fair market value.
 
It’s easier to take the long view if you’re not compulsively checking stock prices every day. Psychologist and Nobel-prize-winner Daniel Kahneman says, “If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It’s the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you’ll be miserable.”

Black Swans
The term “black swan” refers to very rare events beyond normal expectations. It originated from the fact that most swans are white. But as philosopher David Hume pointed out: “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.” Even if you observe a million white swans in a row, there is always a chance that the next swan will be black (in the 17th century, explorers actually discovered a species of black swan in Australia).

In Black Swan: The Impact Of The Highly Improbable, Nassim Taleb advises you to maximize your exposure to positive black swans and minimize your exposure to negative black swans. A positive black swan is something that has the potential to make a large positive difference in your life, and vice versa for a negative black swan. Examples of protecting yourself against negative black swans include holding some ultra-safe investments that are immune to stock market crashes, and avoiding unnecessary risks in your everyday life. It’s a bad idea to jaywalk because one freak accident will cripple you for life. In ancient times, a Chinese general said, “I fear not the 10,000. I fear the 1 in 10,000.” All it takes is one lucky strike from an enemy soldier, and the general is dead.

On the other hand, you should aggressively pursue positive black swans. Write a book, start a part-time business, audition for a movie—the risk is low, but the rewards could be enormous. If a big publisher or wealthy investor wants to talk, cancel all your other appointments because the window of opportunity may never open again. Big cities such as New York and London are particularly good for positive black swans because there are more opportunities for networking and random encounters with powerful people.

Even the most unlikely events should be prepared for if the consequences are great enough.
-Peter Schwartz, The Art of the Long View

Slow and Steady

Saving and investing is a slow way to accumulate wealth. The average American family earns $48,201 per year. If they manage to save $10,000 a year for 20 years, this results in a net worth of about $477,000, assuming a 7 percent annual return. Not bad, but definitely not super-rich. That’s why most millionaires are self-employed professionals or entrepreneurs. With hard work and a bit of luck, you can grow a business to a few million dollars in 5–10 years. Saving and investing provides the foundation, but entrepreneurship is the golden path to wealth.

Thousands upon thousands are yearly brought into a state of real poverty by their great anxiety not to be thought poor.
-William Cobbett

References
  1. Mittelstaedt M. (2006). Teacher kept her riches secret, then left charity $4.3-million. Globe and Mail. September 29, 2006.
  2. Investment Company Institute. (2007). Investment company factbook. 47th edition.
  3. Bogle JC. (2007). The little book of common sense investing: the only way to guarantee your fair share of stock market returns. John Wiley & Sons.
  4. Berkshire Hathaway Inc. (2006). Chairman’s letter.
  5. Ibbotson RG, Chen P. (2003). Long-run stock returns: participating in the real economy. Financial Analysts Journal. 59(1):88–98.
  6. Browne, Christopher H. (2007). The little book of value investing. John Wiley & Sons.
  7. Remarks by John C. Bogle at the World Money Show in Orlando, Florida. February 2, 2005.
  8. Asness CS. (2005). Rubble logic: what did we learn from the great stock market bubble? Financial Analysts Journal. 61(6):36–54.
  9. Greifner R. (2008). The death of the American billionaire. Motley Fool. April 11, 2008.
  10. Bernstein WJ. (2002). The four pillars of investing: lessons for building a winning portfolio. McGraw-Hill.
  11. Lakonishok J, Shleifer A, Vishny RW. (1994). Contrarian investment, extrapolation, and risk. Journal of Finance. 49(5):1541–1578.

Copyright © 2009 by Paul Lem, M.D.
Buy the book at www.MasterLifeFaster.com
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