Financial Literacy

The last time the U.S. Federal Reserve raised interest rates was almost 10 years ago, in June 2006. Since the financial crisis in 2008, the Fed has kept interest rates near zero. There is a possibility that the Fed may raise interest rates at their next meeting on December 16^th.

What will happen if this is the beginning of ratcheting up interest rates to a normal price? Investments and securities that are interest-rate sensitive will begin falling in price. Many have started to already in anticipation of the December 16^th announcement. These securities include bonds, bond funds, preferred stocks, utility companies, and anything else paying a fixed-rate return.

Reducing your exposure to these types of investments is the prudent financial move to make before the announcement. (If the Fed does not raise interest rates on December 16^th, or it is a tiny amount, these securities may go up in value that day because increasing rates were priced-in already.)

The consensus view among economists that the Fed will raise rates has been wrong for a long time. This December could be another wrong guess. However, sooner or later, rates will rise and these securities will be negatively affected. What is your action plan to protect your portfolio if interest rates start rising?

A business named Stockpile.com received regulatory approval to sell gift cards for individual stocks. Either online or in big-box stores, you can buy a $25-$100 gift card for stock in well-known companies such as Coca-Cola, BMW, Apple, Facebook, Hershey, and Google. You can also choose to apply your gift card among ETF’s for the S&P 500 stock index, gold, oil, sugar, and others. (Although several of their stocks are a little misleading, for example, Stockpile offers the car brand Lamborghini. But if you select Lamborghini shares to purchase, you are actually buying shares of Volkswagon, the parent company of Lamborghini plus ten other car brands that may not have wanted to purchase.)

Are these gift cards a good or bad gift item to buy? First, let’s consider other gift comparisons. What would you have bought instead as a gift of a partial share of stock, something useful or something trivial? Something fleeting like candy or something memorable like a concert ticket? At least a stock card may hold some value over time.

It is my opinion that the greatest value of these gift cards may be to expose someone young to the stock market and to understand a business P/L statement. But it is my experience that when introducing someone young to individual stock investing, it is difficult to sway their view away from speculation and daily price moves. This view is the opposite of becoming a profitable investor. A better gift idea may be an education about investing. For far less money than one of these gift cards, you could purchase an investing book that I recommend, “Unfair Advantage,” by Robert Kiyosaki, or even my own book.

Naturally, buying one of these stock-gift cards is exactly like opening a regular brokerage account, along with posting your personal information online with them for state and federal taxes. I consider these gift cards an entertaining novelty, only they come attached with fees and annual tax paperwork. These gift cards are not an efficient or profitable way to build savings or a stock portfolio, so I really do not see the value to them. I predict that many of these gifts will simply become abandoned accounts that are eventually confiscated by the state treasuries.

In 1933, the Securities and Exchange Commission made it illegal for small investors to invest in private businesses through brokers or advisors. This blocked small investors from placing money into startups, small businesses, or real estate that has the potential for huge returns never found in the stock market. At the time, it was a Wild West for investors and too many small investors were losing all of their money. So the government created a threshold for someone to invest in these companies, a net worth of $1 million or income of $200,000 per year. These investors were labeled, “Accredited Investors” and the thinking was these people were more sophisticated investors and could with stand losing 100% of an investment and still be financially Ok.

This month, it becomes legal again for non-accredited investors to place money directly into startups and small businesses. So now small investors can act just like a venture capitalist. However, there is a cap on how much that non-accredited investors can invest in these businesses, up to 5% of your annual income.

If you choose to get into this investing arena, be aware that 90% of start-ups fail. So you need to be bright and lucky enough so that one of your 10 investments will perform so well it will offset the losses from all of the other failing startups. There are websites already to match investors to opportunities, some perform due diligence as well. Like any investment, there is a whole lot to learn before you can intelligently invest in any area. However, start-up investing is even more challenging because the company is normally not started or run by a professional and experienced management team.

An investor’s dream is to receive a 20% cash return on his or her investment. For example, invest $1,000 and receive a cash payment of $200 per year, forevermore. Wouldn’t that be great?

There is a way to do it, with relatively safe stocks, however, there are two requirements. First, you need a stable company with a long history of paying dividends. This company, however, must also have a history of increasing their dividend every year. This requirement will whittle down thousands of potential stocks to only a few dozen very solid companies.

Once you purchase a stock that meets this first qualification, you are going to be receiving dividend payments in your brokerage account. Most brokers have a feature that permits, “Automatic Reinvestment of Dividends.” By making this election on your stock, then your dividend payment will be used to purchase more shares of that stock. By doing this, you are adding to your position and therefore increasing your dividend payments each pay period.

Now, let me explain how you move from a normal 3-5% dividend to earning 20% with your dividends. In today’s economic environment, stock candidates that have a long history of increasing their dividends typically yield around 3-5% from dividends. However, you are employing two drivers to compound your cash dividend payments:

1. Reinvesting all of the dividend payments to purchase more shares.
2. The company will continue to increase their dividend payments each year.

If a company you selected never increased their dividend, then it would likely take 15 years for your cash payments to double, and then another 15 years to double again. So your 5% return would increase to 20%, but it would take a long time, roughly 30 years. But when your stock continually increases their dividend, depending upon how fast they increase it, it can reduce the time period to surpass 20% in cash dividend payments to less than 18 years. And if there are some larger increases, it can be less than 10 years.

Other dividend candidates include companies that routinely increase their dividend more than once a year or those companies that routinely make an extra dividend payment each year (note that these do not show up in the stock’s normal yield calculation because these are extra, non-regular dividends).

A more advanced strategy is to turn off your “dividend reinvestment” election, and instead sell puts on shares you want to purchase. This is a strategy called writing naked options and can boost your brokerage account with options income, while you wait to have shares ‘put’ to you that you wanted to buy anyway.

This is a very brief introduction for tactics to utilize dividend-paying stocks to ratchet up your cash income by thinking in a longer time-frame. While other investors might ignore a 2.5% yield on a stock, you may employ these tactics to create a substantial 20% yield much sooner than you’d expect.

When the stock market drops or becomes volatile, investors become anxious and consider ways to protect their money. One method they consider is subjectively trying to buy near price bottoms and sell near tops, called market timing. Unfortunately, all of the academic evidence points to both professionals and amateurs being very poor at timing stock market purchases and sales. This means that engaging in market timing is most likely to reduce your stock market returns by making ill-timed sales and purchases of their funds and stocks. This is the opposite of what investors are trying to achieve.

But this doesn’t stop investors from trying to use volatility to profit or minimize losses.

So what are some rules about getting into and out of the stock market that might be helpful to investors?

I use a rule for a portfolio that is otherwise for “Buy and Hold Investing” that I call The Emergency Brake. The rule is: Anytime the stock market falls by 15% from its most recent high point, I exit everything.

The stock market is in constant flux, this is the nature of the market. But this volatility also includes price drops of 25%, 50%, and a whole lot more. These are crushing financial losses that can take decades to recover from and many people don’t have decades to wait. Since the 1970’s, a new stock market low has been followed by a new all-time-high within 20 years. So a “Buy & Hold” investor will eventually recover, if this pattern holds in the future.

By selling everything, you are protected from any further losses beyond 15%, and many of these larger price drops do occur. By eliminating these significant losses, your portfolio value will be far higher than it would have been if you had taken no action. For example, I have details on 401(k) plans where two people would periodically ask me for advice. One of them used the Emergency Brake twice while the other one took no action. A few years later, having a side-by-side comparison, the account that side-stepped two significant drops had nearly twice the overall return as the account that rode out both drops.

Yes, there are risks of using the Emergency Brake. For example, you may sell at a 15% drop and that may be the price bottom and the stock market may rise from there. This would confirm the classic ill-timed market timing that reduces overall returns. But this emergency brake is a form of insurance and like all insurance, there is always a cost. There are more sophisticated ways to set a brake on your portfolio, such as buying an inverse ETF that matches your portfolio, but again, you need to have the money because there is always a cost to a hedge.

If you have employed the Emergency Brake, then when do you get back in? I use two rules. First, similar to the 15% fall, if the stock market rises 15% from a more recent low, then I buy back in. My second rule is more subjective, if the stock market “calms down” with much reduced volatility and trades sideways for quite a while. To me, the longer these occur, this indicates that the risk of an immediate and continued fall has subsided and I can start buying back in; hopefully at a lower price point than when I sold out.

Partial positions: there is no rule that you must be 100% fully invested or 100% out of the market. You can scale in and out with partial positions. For example, at the first 15% drop, you can sell a third of your stocks, at an additional 15% drop, you can sell another third of your stocks, etc. And the same thing to scale back into buying stocks.

Remember that academic research points to timing the stock market as a very bad idea for investors. However, if you want to protect yourself from a protracted fall in the stock market, then make sure your ideas have been evaluated in many types of market conditions over decades, or use the simple one that was just outlined. Additionally, you may adjust the 15%, by reducing this number, to say 12%, but be aware that it will be hit many more times, chewing up your account with sales and purchases. Or you can increase the 15% to 18% and have fewer trades but have a larger loss before you take evasive action. Be careful and thorough in your market-timing analysis, be consistent in your application of any rules that you make, and then follow your investment plan.

Salespeople try to sell new investors on the fantasy of rental property as a passive investment. In my opinion, there is no such thing as a passive investment, let alone one that is a physical object that needs to be maintained.

Let’s go through a few of the elements of owning a single rental property:

• Up-to-date LLC formation, operating agreement, and ongoing paperwork.
• Up-to-date knowledge of local and state property management regulations
• Tenant marketing and tenant management
• Home ownership maintenance and repair management

Does performing any of these functions appear to be passive to you?

What are a few things that can go wrong with your rental property?

Lawsuits, changes in regulations, plus all of the maintenance problems you are responsible for handling. Some of these include: Electric system, plumbing, paint, carpet, countertops, stove, refrigerator, dishwashers, washer & dryer, anything that can go wrong is your problem. You have to manage the repair or replacement and pay for all of it.

What about getting a property manager to do all of this for you? Sure, but first:

• Do you know how to locate a reputable property management company?
• Do you know what needs to be included or excluded from the management contract?
• Do you know how to review their work to make certain things are being done and they aren’t ripping you off with inflated prices on repairs?
• Do you know how to manage the property management company?
• Do you know how to fire and replace the property management company?

When you hire a property management company because you do not want to physically manage the home, then you must actively manage the management company. One way or another, you must manage something or the investment will turn into a loss, possibly a large loss (due to leverage from a mortgage or other debts).

I own rental real estate and know several people who make their living solely from rental income. But the concept of a “passive investment” should never be linked with rental real estate. Someone who gets involved that views a rental as a hands-off investment is likely to learn a painful and expensive lesson.

Since the financial crisis of 2007, the stock market has gone up by 260% from its price low in 2009.

Have you participated in this increase?

Over any 20-year period of time, the U.S. stock market has gone up. This is one of the reasons why it is a favorable location to park long-term money.

But there is a sharp difference in stock market participation among two groups of people. Since 2007, those earning less than $30,000 a year dropped their stock market participation by 25%. In contrast, people earning over $75,000 a year maintained their stock market participation.

This participation gap, along with a rising stock market, partially explains why the wealth gap has been increasing since 2008. Is your stock market participation moving you toward the wealthier group or poorer group? The stock market is not the best place for everyone’s money, but you need to have money invested in some vehicle that returns far more than a current bank savings account; so where is your money working?

Peer-to-peer lending websites have been around for over a decade, cutting out the middle-man so you can earn higher rates as a lender and likely lower rates as a borrower. These lending websites have been growing around the world and the peer-to-peer lending industry continues to attract new companies.

As a small investor, it has never been easier to make tiny portions of loans ($25) to consumers and small businesses where you can reasonably earn 7-9% interest on your money. Get paid interest and principal, every month, just like a bank does. As in any active investment, the more you educate yourself then this type of investing will become less risky for you. For example, it is more prudent to invest in a loan with a high credit rating than a loan paying a very-high rate that quickly defaults.

There are two large companies for consumers, Lending Club and Prosper, and there are many sites devoted to education on peer-to-peer lending, such as LendingMemo.com. Two large companies making peer-to-peer loans to small businesses include Lending Club and Funding Circle. I started with small portfolios at both Prosper and Lending Club, and would also advise further diversifying your loan portfolio with small business loans as well.

When banks are paying nearly nothing for savings accounts and certificates of deposit, it is great to bypass them and access borrowers directly to earn far more interest with a little education and effort.

There is an insightful quote by Mark Twain, “I am more concerned about the return OF my money than the return ON my money.”

Many people examine and evaluate an investment’s return when it may be far more important to evaluate an investment’s payback instead. Payback refers to the time it will take to receive your principal investment back from financial benefits. These benefits can be: capital gains, dividends, interest, tax credits, tax deductions, principal payments, and other benefits.

As long as you have not yet received your principal investment amount back, you are exposed to the possibility of incurring a loss on this investment. There are several investments where getting your principal investment back is more important than an average investment:

1. Depreciating asset, you need to get your money back while it is still able to produce more income.
2. Potentially obsolete asset, you need to get your money back before market changes permanently reduce its value.
3. Weak currency risk, you need to get your money back before its home currency drops further than the potential gain on the investment.
4. Any other risk that puts the investment in peril and there is no additional income or value at all.

Another benefit of an investment payback is that: your money has been returned so now it can be placed into an additional second investment. You hopefully still have the original investment and now you have another investment – so you money is working double. Another way to view the second investment is that it will yield an infinite return – you did not put money into it, your first investment paid for it. However you view these two investments, your original investment principal is now working in two separate investments on your behalf.

For these reasons, the payback of your investment should always be a critical factor in your investment criteria. Particularly for risky investments or direct investments that need to be managed. Do not be lured with promises of high potential returns if the payback term is not reasonable as well.

Anytime there is a systemic drag on your investments, the cumulative costs that add up are staggering over decades. In the case of 401(k) plans, you may not be aware that there is a 2-3% expense each year that erodes your account balance. Compound this 2-3% for 20 years and the average account 401(k) holder has 71% LESS profit than someone investing outside of a 401(k) plan.

The extra expense that most 401(k) plans incur is from the difference between mutual funds and ETFs, exchange traded funds. For example, if you open a brokerage account, you could place money into a S&P 500 stock index mutual fund or into an S&P 500 stock index ETF that trades like an individual stock. When you add the expenses and tax consequences, the extra cost of the mutual fund over an identical ETF is 2% (according to researcher and fund manager Mabene Faber) or 3.17% (according to Forbes magazine). Most 401(k) plans only permit mutual funds to be purchased, the funds with the extra 2-3% annual expense eroding your account balance.

The expense gap between mutual funds and ETFs becomes staggering over longer periods of time. For example, using identical portfolios:

• In 20 years, the mutual fund balance would be 21.5% smaller than the ETF balance.
• In 30 years, the mutual fund balance would be 32.7% smaller than the ETF balance.
• In 40 years, the mutual fund balance would be 43.0% smaller than the ETF balance.

Why are you continuing to put your money into 401(k)s that needlessly chews up your money?

Let me show you a real example. I was asked by someone to look at their 401(k) account in which they had $167,000. They contributed a little over $500 per month and their employer matched with $250 per month. So the employee was adding $6,000 per year and their employer was adding an additional $3,000. Now, let’s look at the extra expense of 2-3.17% in mutual fund fees and taxes each year. At $167,000, 2% is $3,340 lost to the broker. So on one hand the employer is putting $3,000 into the account but the brokerage firm is taking at least $3,340 out of the account each year – for a net loss of $340 per year. (At 3.17%, the brokerage loss is a staggering $5,300 per year to fees and extra taxes).

Yes, there are other issues to consider with 401(k) plans like the size of matching contributions, tax deferral, the quality and type of funds that are available, etc. But every analysis that I have done for others on their specific 401(k) plan points to it being a money losing-location for your money compared to placing it into an IRA or Roth IRA.