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The Dangers of Using Derivatives in Investing

dangers of using derivatives in investingIn the context of investing, leverage means using additional money that’s taken out as a loan to invest into a product that is expected to produce higher returns. If someone takes a bank loan of 4% interest to create a coffee shop that can produce 20% return within the year, they will have made successful use of leverage.

There are also other forms of leverage available such as using options and futures within the stock market. By buying these derivatives, an individual can create a stake in a company that amplifies a bet times 100. Someone can purchase a call on Apple (AAPL) stock at $200 and when the price increases by 10%, they can cash in on the call for a sizable profit (representing 100% gain – the cost of the call). The potential to produce substantial returns by the use of derivatives may explain the proliferation of “options or future(fx) traders” out there. It’s a way to get involved in the stock market with relatively low sums of money and potentially produce significant income. While the potential for higher income is available, there are multiple risks that become present once you introduce derivatives into your investment portfolio.

1. Derivatives amplify your potential for profit…and loss.

Sure, you can make a lot more money with derivatives but you now also have the potential to lose a lot more money. If you’re wrong on a specific bet, then you could end up with a derivative that is worthless. The potential for your portfolio to go to 0 becomes much more steeper. Even if you are using derivatives in a way that is meant to lower the risk of short-term volatility, you pay extra for that type of insurance. If you end up being wrong even 3-5 times in a row, which can be very easy to do, you may find out that your entire portfolio gets wiped out.

2. Once you take a major loss, your psychology will highly encourage you to continue…much like that of a gambler.

Assuming at some point you do lose a major portion of your money by taking a higher risk bet on a derivative, that type of loss will incentivize you to take even riskier bets. Once your portfolio is down 40%, you would need to make 66% on your money to hit break-even point again. With a need to hit break-even again, you’d realize that the fastest way to get back there again is an even bigger risk. This type of psychological reasoning keeps you in the game until you have no chips left to play.

3. Once you take a major gain, your psychology will be influenced to take risky decisions as well.

Let’s assume you gain 40% or even 100% within a very short time period. The risk and bet you have taken will prop up your psychology to become more confident and take even bigger risks, as you might reason that it will continue to be that easy. After increasing your money by however much, you may find that you get attached to that larger number. Then, assuming you lose a good sum on a wrong bet (which would be inevitable the longer you are “playing the stock market”), you become incentivized to play out the psychological dynamics discussed in #2.

4. Derivatives can expire over time ranging from a few days to years, introducing a market timing element to the investing.

Because there is an expiration date on the derivative, you not only have to be right but you need to be right about when it will happen. The timing aspect of derivatives can cause a rushed feeling within your psychology, causing you to take bets that backfire inappropriately. Time works against you when it comes to derivatives, which is unlike buying and holding securities for the long-term (longer holding periods is associated with increased returns).

Thus, there are many potential dangers to using derivatives in investing. For a long-term investor who desires to increase their earnings without the influence of nefarious psychological tendencies, a simple buy and hold approach would suffice.

The Down-Side Of Modern Diversification Strategies

downside of modern diversification strategies

Recently, there has been a strong push within the investment community towards passive diversification of investments through the use of ETFs and index funds. With programs that offer incredibly low cost-basis fees, down to even 0 fees, it can seem quite enticing to own such broadly diversified securities.

The rationale behind general passive investing (through ETFs and index funds) is predicated on two factors. The first factor being that individuals will not be able to beat the stock market as a whole as it is highly efficient (aka efficient market hypothesis), where the securities themselves reflect true intrinsic value at any given moment. The second factor is that the economy as a whole will continue an upwards trend over the long-term, as innovation within a capitalist society will spark general prosperity. Given these two factors, we have emerged with a general consensus that leaving a bulk of your net worth within a broad-based investment fund such as the SP500, a target date index fund or a robo-advisor is a generally safe option. While it is true that the economy as a whole is mostly efficient with processing recent information into the price of a security, there are unspoken downsides with a traditional passive investment strategy.

Here are the downsides of traditional diversification through passive investment strategies:

1. Through the use of broad-based passive investments, your portfolio will be highly correlated with the general outlook of the stock market at all given times. While this protects you from the downside of being a poor “individual stock-picker”, your portfolio will also have a slim chance of being able to beat the market on a consistent basis. There are a number of quantitative strategies proposing to beat the market through analysis of macroeconomic factors or past data of volatility within various classes of securities. These types of predictions amount to shaky guesses at best. If someone was able to consistently “guess” the market’s direction in the short-term on a repeatable basis, they would be trillionaires. It is also equally suspicious to assume the next 10 years of a certain asset class will be similar to the last 10 years.

If we were to look at who is able to consistently beat the market over the long-term, we would find that it is not the “top-down” macro people who are consistently beating the market over the long-term. The people beating the markets consistently are often completing “bottom-up” fundamental analysis of individual securities. This makes sense because it’s much easier to figure out how an individual security will do over a long-term period than it is to figure out the entire direction of an economy over the short-term on a repeated basis. Basically, using ETFs and index funds, even if you have “specialized” strategies, makes it very difficult to beat the market, not factoring in the luck of educated macro guesses. The lesson here: broad diversification through ETFs and index funds is very likely to lead you to average results and prevent you from being able to achieve consistently better investment returns. If you’re fine with average results (and most people should be as it is difficult to beat the market), this should not be a problem. But for those with the ability to identify securities that will provide larger gains, or an ability to identify individuals who are capable of doing so, the average path would not be a reasonable option.

2. Because a traditional passive investment strategy is exclusively focused on the “long-term”, it is often rationalized that an individual could dump their entire excess cash into the stock market at any point and forget about it. However, if you were to dump your excess cash into the stock market at the peak of 2007 for example, you would find that you would have broken even by 2017/2018, after over a decade. While it is arguably true that over a long-term period of 30-50 years, this would be irrelevant but why lose out when this could have been avoided? This is the rationale that many investors ironically take when looking at these long-term investment strategies.

When resigning to a broad-based passive investing philosophy that invests in the market as a whole, the investor has a negative incentive to focus on the short-term and try market timing because their investments are recognizably subject to short-term macroeconomic factors. This incentive explains why many people are proposing in 2018 to put less money overall into investments because they are worried about a market crash. Overall, this reasoning is limiting because there could be good deals out there for individual securities that would not be as susceptible to market crashes, and would offer opportunities for stable dividends and future potential growth. Being able to identify individual securities that are already cheap would remove a need to try market timing. The other limiting factor is that the market as a whole may continue to keep increasing for a few more years despite all the predictions. Look at how many people were able to predict the Great Recession in 2008, has anything changed with our forecasting abilities since then?

While a lot of this writing was spent criticizing modern diversification strategies, it remains a good option for investors who want to automate the investing process and are truly in it for the long-term. But for those who are particularly susceptible to short-term fluctuations within the stock market or are interested in pursuing better than average market results, they would be better off with strategies such as value investing. This rationale is a large driver for the investing philosophy at Taher Financial Planning.

Lessons For Executives From Warren Buffett’s Company Letters

lessons for executives buffett berkshire hathaway letters

Warren Buffett is the most distinguished investor in existence today. Often ranking somewhere in the top 4 of the Forbes 100 list through a large ownership stake in the Berkshire Hathaway company, we can assume that he knows a thing or two about business. Within the book “The Essays of Warren Buffett: Lessons For Corporate America“, we receive a first-hand account of the way Warren Buffett perceives the responsibilities of corporate management. Buffett presents as a remarkably lucid investor and businessman. He frequently offer rational, yet strangely simple insights into how a business should be run. Below are the most interesting arguments I have found within the book:

#1: Management’s first priority is to the company’s shareholders.

The actual owners of the company are the shareholders. Management is entrusted to execute business plans that create more value by the owners. If management is recklessly wasting resources, they are a detriment to the company. Management should be held accountable for achieving business results. If they are unable to effectively operate with the hand they’re dealt, they should be removed. The best companies to invest in, are the ones with managers who have this priority in mind.

#2: Franchise value is what really counts.

While achieving business results are important, they should not come at the cost of franchise value. For example, you can raise the prices of your product or service by 20% this year and enjoy momentarily increased profits. It will look good on paper but by doing so, you could harm your brand’s value and destroy good relations you may have with any of your customer base. Some people might leave and never come back. They might tell their friends and family not to associate with your business. It’s a huge mistake to sacrifice your long-term brand to achieve short-term objectives. The reputation of the business is important to maintain.

#3: Bigger doesn’t mean better.

Just because a company has consistently increasing revenues, doesn’t mean that it’s a great company. If the business’s cost structure grows at the same rate that revenues do, then the company itself is never creating true growth. While increased revenues for a company might look good for the managers who can claim they have increased sales by x%, the more holistic look would be to check how operating profits have changed for the better.

If a company has a great business segment that is operating efficiently, management may also deal with a ‘corporate imperative’ to rationalize a dive into a new venture with their net profits. It would be very easy to create a rationale on how a new project will add value to the company but Buffett’s take is that the claims are often larger than the reality. Managers should critically evaluate the extent that new business projects will create true additional value for the company. If there are simple alternatives such as share buybacks or even distributing dividends, these actions would be preferable to speculative, ego-driven projects.

#4: Be discerning of who you associate with.

Having someone who is merely smart on your team is not enough. There are plenty of intelligent people out there. It is much more rare to find an intelligent person who is energetic and ethical. According to Buffett, if someone isn’t ethical, you may as well forget about intelligent or energetic. If you’re going to work with someone, you should make sure their first concern is doing the right thing, otherwise you run the risk of them making poor decisions on your behalf. Finally, life itself is enhanced along with the quality of our business matters when working with people we admire, like and trust.

#5: Focus on business economics, not business accounting.

Many managers become understandably focused with the “bottom-line” results of the work that they complete. Some executives may engage in accounting schemes to cover up their business mishaps.For example, selling a profitable business unit to maintain the image that a company is continually bringing in profits every quarter, even at the cost of long-term potential is a terrible move. Some executives may shy away from decisions that would look poor on paper but great in reality. If a company is losing money and requires more cash to make the appropriate investments into itself, keeping a high dividend rate for historical reasons makes no sense. The real focus should not be on how the business’s numbers would look on paper but on how the business is doing in reality. That type of focus will lead to profitable long-term results.

#6: Master your emotions.

This was a strong lesson implicitly resonating throughout the book. Buffett shows that its not just intelligence that matters for investors and business people but our ability to control emotions is a huge factor in our success. Greed can cause executives to overstate business success rather than showing reality. Fear can cause people to take actions that harms the business brand, employee morale, etc. If we can’t get past the discomfort of going against the crowd, then we can fall into group-think and make the same blunders that other people make. Our ability to think rationally and not let our pride get in the way is of the utmost importance. If we are unable to effectively control our emotions, we are bound for radical errors.

Compound Interest Explained Simply

compound interest explained simply

Compound interest is a term that many have heard often but is rarely well understood. The definition on wikipedia is as listed:

Compound interest – is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.

Well, that sounds almost simple – the money you make, will make even more money in the future. But what exactly does that mean in practical terms? This may be where most of the confusion comes in from.

Compounding effect

In the above tables, we can see an assumption of different interest rates. These interest rates are tested on the growth of just $1 over different decades. What we’ll find is that the one dollar will grow to about $1.96 to $2.59, about double growth in 10 years for 7-10% interest rates. But by the 20th year, the growth is even higher, ranging from $3.86 – $6.72. The most astounding realization is that by the 40th year the dollar becomes $14.97 – $45.25, a 15 to 45 times return.

In effect, we can learn multiple lessons from this short example:

  • For every dollar we spend, we are not just losing only a dollar but we are losing all the future potential growth that the dollar would bring.
  • The amount of time that the dollar has to grow will have a huge impact. The difference between a dollar thats been invested for 20 years (at $3.86) and 40 years (at $14.97) is extreme. It’s better by a long-shot to have money to invest as early as possible than getting started later.
  • Small differences in interest rate assumptions can have a huge impact. Meaning if you are being charged large fees such as the financial industry’s normal of 1%, it can have a huge effect on your long-term gains. Thus, it is important that you assess whether there is a true premium of investment return if others manage your money vs investing the money into index funds.

There is also another large implication as a result of these calculations. If we know that the money can grow by a large amount, even with conservative expectations in long-term growth, then we shouldn’t fret over not being able to grow the “money fast enough”. For many, 7-10% growth per year sounds unexciting and even unreasonable. Why invest if we’re not going to go for the stars while doing so? The problem is that aiming for incredibly high returns is likely to increase the chance of risk as well.

Gains needed

If you look at the above table, there is an assumption that you could start out with $10 and take an 8% return for a comparatively small 80 cents that year. Sounds unexciting right?

Some may feel tempted to aim for much more in their returns. Let’s assume this person took a huge risk and as a result, they take a substantial loss, ranging from 10-50%. That would represent $5 (50% loss) to $9 (10% loss). Now this person will have to achieve incredibly high returns to even achieve the same 8% growth as the relatively conservative investor. This can become a losing cycle because to achieve such high returns in many cases would require high risk bets, which can cause further losses. To avoid such psychologically dire situations, it would have been better to start off relatively conservative from the beginning. Even one major loss after years of relatively strong growth can cause the investment portfolio to do worse than it should have.

If we know in the long-term there will be truly high gains (despite seemingly small returns in the short-term), it will be easier to feel peace of mind as we pursue our goals. It might seem boring to some but it is a better alternative to risky strategies that are unnecessary to achieve long-term goals that most pursue in their life such as retirement.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. ” – Albert Einstein

 

7 Lessons on Investing according to “The Intelligent Investor”

 

7 lessons investing intelligent investor

The famous Intelligent Investor book written by Columbia Professor Benjamin Graham was first published in 1949. Establishing the basis for what is now called value investing, this book set out a different way of thinking about stock market investing than what was prevalent in Wall Street at the time.

Even today, when most people think about stock market investing, their initial thoughts are line graphs about stock prices, daily percentage changes and people needlessly yelling on CNBC. This type of investing is technical analysis. Technical analysis on shares of AAPL (the ticker for the Apple company) means analyzing the trends of how the stock price has moved up within the last week, month, year, etc. But technical analysis says little about the quality of the actual company. Graham reminds us that when we are buying shares of a company, we are not merely buying a piece of paper that randomly goes up or down but we are buying actual ownership pieces of a live and functioning business. Buying a share of GOOGL means that over the long-term if Google does well, so will the stock.

While there are many lessons to potentially learn from reading this book, I present my 7 big takeaways from the book.

1. Differentiate present vs reality.

When a value investor buys a stock, they are not as interested in what the future of the company COULD be. They are more interested in knowing how the company is doing NOW and with slightly less importance, how it’s done in the past. An ‘intelligent investor’ would rather buy a company with a track record and currently favorable balance sheet than a company that has yet to prove itself and can bring you major losses. Graham emphasizes that there’s a very clear line between future speculation and present reality, and that we should keep a close eye on the current reality of any company.

2. Don’t believe that price has anything to do with quality.

If the price of a company is rising, it does not necessarily mean that the quality of the company is actually rising. Inversely, if the company’s stock price falls 20% within a day, it does not necessarily mean that the actual company has lost 20% of its total value within a day. Closely following the trends of the stock price movements to ascertain whether it’s a good company can be an easy way to misread the actual quality of the company. The market is irrational in the short-term and should not be seen as a guide for long-term investing. It is better to understand the meaning behind the company’s qualitative and quantitative position rather than its price position.

3. We really have no idea what is going to happen in the future.

To claim with certainty that a company will rise astronomically in the future or crash can be riddled with error. In truth, anything can happen. Graham, having grown up through multiple financial hardships and depressions was a firsthand witness to the realities of economic change. Because anything can happen, the best we can do is understand the position of the companies we have ownership of and spread our risk among multiple companies (otherwise known as diversification). Market timing can be dangerous.

4.”Getting good returns is easier than it looks but getting great returns is harder than it looks.”

This idea was shared in the context of ‘active’ vs ‘passive’ investing. As a passive investor, you buy a broad range of companies under the assumption that over the long-term the total economy as a whole will improve, meaning so will your financial position. But Graham states that if you try to beat the market, known as being an ‘active investor’, it’s going to take a lot of work. Graham also has a very interesting difference on how he sees risk. In finance academia, it is normally taught that to get more investment return, more risk needs to be taken on. Graham saw risk as a measure of how much work you did on researching your investments. From a value-investors perspective, it is possible to achieve higher investment return with lower risk.

5. Look beyond surface appearances and delve further.

Large public companies are fully aware and capable of manipulating how numbers will appear on earnings reports. Graham strongly urges reading company reports backwards, as management will hide everything they don’t want you to read near the end. Graham also recommends that investors conduct in-depth analysis by developing their own valuation of the company’s assets and stability of earnings rather than taking numbers at face value. By building your own independent thesis, you can catch issues or even opportunities that other investors might miss from just taking the numbers as is.

6. Always invest with a “margin of safety”.

‘Margin of safety’ is buying with a small to moderate ‘safety net’ on your investment. Even if negative results occur with your stock, you will ideally be protected by a strong book value or a strong business model or conservative assumptions on the company’s growth rates. Because stocks are being bought in such conservative ways, in the event of a market downfall, value investors would fare the best as they buy in such a price-conscious way.

7. Believe in yourself and your judgement, even if others hesitate or differ in tough market conditions.

Graham ends the book with an uplifting message reminding you to believe in yourself. Provided that you have your reasoning, data and experience to support your investing decisions, you should stick with your decision, even if the market is doing poorly in the short-term. The emotional fortitude to have differing opinions from others in times of stress, is incredibly important to succeed at investing in the long-term.

Overall, Graham presented a very lucid and rational perspective on investing, illustrating principles that still remains relevant many decades later. I utilize value investing principles like these for my own client’s portfolios.

How To Avoid Taxation On Your Investments

In America, we run on a ‘progressive tax’ system. This means that your tax rate will increase for each dollar that you are making. You won’t be taxed more on your “base amount” but you will be taxed extra for each additional dollar. Let’s say you are making $50k in wages a year for example. While each additional dollar you make will get taxed at 25%, parts of your original $50k will be taxed at 10% and 15%. The table below should explain this relatively well.

2015-Income-Tax-Brackets

While you are in the lower income tax brackets, you won’t be taxed as much. But taxation can become a problem for you once you reach 28%, 33% and even 25% marginal tax. The solution in these cases would require special tax-advantaged strategies that help you avoid having atleast a quarter taken out of every dollar you make.

4 ways to avoid taxation on your investments.

Growth Stock Funds

Instead of putting money into stock funds or stocks that return hefty dividends, and therefore, cause taxation, you can invest in growth stock funds. Growth stocks don’t give dividends and instead reinvests the company’s profits back into the company in hopes of continued and higher growth. This means that the value of your fund can keep growing without you being taxed for a long time. You will usually only get taxed when you sell, triggering capital gain taxes. However, if you are very intentional about when you sell, you can save alot of money in the long-term. For example, selling growth stock funds in retirement when your taxable income will likely be much lower will potentially save you thousands of dollars in taxes.

Municipal Bond Funds

While bonds offer relatively high dividends, the taxation of those dividends is treated just like any other ordinary income. However, if you were to buy public state municipal bond funds, you would be able to get decent dividends while avoiding state and federal taxation. While these bonds can offer great cash flow for high-income earners, it is important to note how inflation may erode the long-term value of the income without a growth hedge.

IRA / 401k

A very common option for many people to save for retirement, putting money away into an IRA (individual retirement account) or a 401k (a type of defined contribution plan) can help save a sizable amount of money from tax. When you contribute to a traditional IRA or 401k, money is taken away from your paycheck before your money is subject to tax and placed into these retirement accounts. This removes sizable money from taxation. With a Roth IRA or 401k, the contributions are taxed immediately but you won’t be taxed on the growth later on. There are disadvantages with these accounts such as not being able to access the money till 59.5 in age or later. However, this can be a great option for most people who should be saving for retirement in the first place anyway.

Tax Loss Harvesting

This is a relatively advanced investing technique. I highly suggest staying away from this unless you really know what you’re doing or if you find a robo-advisor that does this for you. At TFP, our investing partner Betterment For Advisors allows tax loss harvesting for clients.

Tax Loss Harvesting works by selling a security that has suffered a loss, which triggers a capital gains loss. Having a capital gains loss can be a good thing because it offsets capital gains, meaning less taxable income. While you shouldn’t actively search for capital gains loss, being able to take advantage of opportunities when they arise can be profitable. Assuming you don’t collide with wash sales rules which would remove your capital gains loss benefit and assuming that you maintain your asset allocation, this can cause gains with substantial impact in the long run. You could potentially take up to $3000 per year in tax deductions from income with this type of strategy.

These are four ways to avoid taxation on investments.

Three Financial Things For New Parents To Do

three financial things for new parents to do

Having a baby can change your life in many ways. But in the midst of it all, don’t forget these three important things you should be doing as a new parent.

#1: Get Life Insurance

If you don’t already have life insurance to cover your spouse, getting life insurance is now very important. Life insurance is protection against the risk that you die quicker than you should. If something should happen to you, your spouse and child would receive money that would ideally replace the income and services you brought to the house.

With life insurance, your family will not be in financial danger because of your lost income in the family. While you’re alive, life insurance gives you the confidence and peace of mind in your daily life to know that your loved one’s financial wellbeing would not change with you being gone. By failing to get life insurance, you put your spouse and child at risk.

Usually “term” life insurance is the best option for most young people, as it is one of the cheapest forms of life insurance. Your insurance agent may try to upsell you on other forms of life insurance, but if you’re below 40, chances are that ‘term insurance’ is your best choice of insurance.

As for the amount of coverage you need, it will depend on the level of income you need to replace. A good rule of thumb: if you make $40,000 a year, your family will need that amount divided by 4% or 0.04 to subsist. The coverage you would need to replace $40,000 is $1M. This amount will allow your family to safely use the money to create a perpetual income stream of $40,000 through investments. This isn’t an “exact” way to calculate a need analysis but you will be relatively close to the amount of coverage that you do need. This video below will get deeper into the calculation of life insurance need analysis.

The time that you’ll need life insurance is dependent on how long the need for risk protection remains. You don’t necessarily need life insurance forever. If you have enough money in passive investments to cover the needs of your family even if you weren’t working, then you don’t necessarily need life insurance. If your child reaches 21 years of age and is working, then you won’t need as much life insurance because there is no need to cover anything.

Pick out your life insurance agent carefully and make sure you can trust them. Or have your financial planner refer you to an ethical one from within their professional network.

#2: Set Up a Will

Setting up a will is important because it keeps you from dying ‘intestate’. This means dying without a will, allowing the laws of the state you live in, guide the process for how your assets will be distributed upon your death. Not having a will also makes your child vulnerable because they can potentially end up in custody with undesirable family members as a result of legal rulings within your state.

By creating a will, your intentions will be set on where custody of the child will go and allow you to control the distribution of assets in a way that’s desirable for you.

There are some decent will generators online that will completely work but if your situation is complex, then you will want to have a will created by an estate planning attorney who can make sure that the will is done properly. Your financial planner should also be able to refer you to an estate planning attorney from within their network.

#3: Set Up a 529 Plan

The best time to start funding your child’s higher education is not 1, 2 or 5 years before they are about to head off to college. It is as soon as possible because you will want to take advantage of compound interest, the benefits of which increase with time. If you’re interested in funding the best possible education for your child, you will want to get started on funding their college education as soon as they are born. This can be achieved with a 529 Plan, which offers extra tax benefits.

A 529 Plan allows you to contribute money into an investment account that will grow tax-free and can be used directly towards higher education expenses tax-free. This makes it much easier to fund an education that may not have been possible otherwise. If your child decides not to pursue higher education, the 529 plan funds can be transferred to another person within the family for their education without consequence.

When designing your 529 plan, you will want to pick higher growth investment allocations with a time horizon of 15-18 years away. But as the child gets older and closer to college, you will want to shift investment allocations away from riskier investments to safer ones. This process can be achieved with Target Date Funds, which are usually available and shift the allocation of funds for you over time. Your advisor should also be able to tailor the 529 Plan portfolio according to your family’s situation.

If you can get these three things done, you will be more prepared than most. Your risk will be lower and you will secure your family’s ability to navigate through life without a problem.

Investments Explained Simply

investments explained simply

Investments Explained Simply

It’s surprising how many people know nothing about investments like stocks and bonds, even though these types of financial instruments are serious catalysts for the growth of the overall economy. I’m going to explain the world of stocks and bonds in the simplest ways that I can.

Stocks

Stocks are basically pieces of companies. You can own pieces of google, apple, amazon and your other favorite businesses by purchasing stocks. Typically, businesses that are as big as these have millions of shares (another term for stocks). When you purchase a stock, you’re not just buying something that you expect to magically increase in value with time, but you’re buying a piece of a business that you expect to do well.

There are two ways you make money with stocks. Sometimes this business you buy will return their profits back to shareholders (you, the owner of the stock share). When you get money for owning stocks, that is called a dividend. The other way you can make money from a stock is when you sell it. The business might be more valuable within a year, causing the stock price to rise higher. When you sell the stock, you realize profits, or capital gains. Dividends and capital gains are the two ways you make money with stocks.

Stocks can be very volatile. The value of a stock can fall completely down to zero if the business fails but it can also rise meteorically if it is doing well. It’s not uncommon for some individual stocks to fall 10-60% within a day and go right back up again. Stocks can be very good for long-term growth of your money but can be risky in the short-term because of its volatility. For this reason, you should not invest in stocks unless you expect to be in the market for at least 5 years.

Bonds

Bonds are basically contracts where you give a “loan” to companies. So, for $1000, you can buy a bond from companies, or even the government. The government and companies will use that money you loan them to fund their projects, while you get a promise to get paid a certain percentage each year.

Assuming the company agreed to give you back 4% of the 1000 every year for 10 years, you’d receive 40 dollars every year for owning that bond. You will typically get paid that total amount in pieces on a semi-annual basis, $20 two times a year. By the end of the 10 years, the government or company will give you back your original amount, the $1000.

Bonds that are qualified as investment grade are typically less risky than stocks. You will get paid for as long as the company is alive, even if it is doing poorly. The only way you may not get paid is if the business goes out of business and doesn’t have enough money to distribute to lenders (you). This is different from stocks – if your stock went down to zero, you are entitled to nothing. But a company going bankrupt means you still have claims to the money you lent them. Usually bonds are good for cash flow – you get paid money directly more consistently than with stocks which you may have to sell to benefit from as much.

Mutual Funds

You may have heard a lot about mutual funds a lot but what exactly are they? Imagine mutual funds are a grocery cart of stocks or bonds that you hire someone to pick out for you. They’ll do the hard work of figuring out the best items (stocks/bonds) to put in. You can even get specialized baskets of stocks/bonds, like one that only picks the largest companies, or one that picks the smallest, high-potential companies. Mutual funds automatically diversify your portfolio compared to individual stocks and bonds by investing in multiple companies. If you had put a large portion of your money into just one stock (would you believe how many business owners put all their eggs into one business basket?), then you are susceptible to the risk that the business goes bust and you lose all your money. By diversifying between multiple stocks or bonds, your money has less risk of volatility while stabilizing the return potential of your money.

Mutual funds employ the use of stock picking managers, meaning it is an “active” fund. Many investors buy mutual funds with an expectation that this grocery cart of stocks or bonds will do better than anything they could pick out on their own. Typically, to have someone manage your investments on an active basis, mutual funds can take up to 1% a year or more away from your returns. This can be a poor choice that eats into your returns over the long term, compared to “index funds”, which I will discuss next.

Index Funds

Index funds are a type of mutual fund. The difference is that this grocery of stocks or bonds are made to copy the market. Instead of having someone pick out the investments on an “active” basis, a broad range of many stocks or bonds are put into a basket without much thought put into it.

The S&P 500 for example, is a very popular benchmark index fund that you will see mentioned in the investment world. It’s a collection of 500 biggest companies in the stock market. No sophisticated stock picking there at all yet everyone follows the S&P 500. They follow it because it represents the “market”. The S&P 500 is typically seen as a general measure of how the entire market is doing overall.

But why would anyone be interested in any index fund if they can get a manager to pick stocks for them? Doing as well as the “market”, or basically everyone else sounds unappealing to some.

However, studies have shown that index funds, funds that follow the market in a “passive” style, often do better than general mutual funds that are managed by an active manager.

This is partly because mutual funds typically charge up to 1% in fees every year while index funds charge extremely low prices that can go as low as 0.05%. To put this into perspective, imagine you had $500k to either put into a mutual or index fund. You would get charged $5000 per year on a mutual fund that charges 1% per year, while an index fund might charge 0.10%, which would only cost $500. Because you automatically save $4500 every year, this can make a huge difference on your long-term investment returns. For this reason, index funds are extremely popular in many investment management portfolios.

ETFs

Exchange-traded Funds, are increasingly popular investments and deservedly so. If index funds are a grocery basket of stocks and bonds, imagine that an ETF is an agreement that breaks apart that grocery basket index fund into many little pieces. ETFs feature a similar portfolio style as index funds with its passive investing, with the added benefit of lower prices.

As an example, the S&P 500 index fund currently costs over $2400 in mid-2017. The SPDR ETFs, which copies the S&P 500, can cost as little $15-100+. Buying just one ETF that costs $50 means you are indirectly investing in potentially hundreds of different stocks and bonds, which may normally cost thousands to do directly. This makes ETFs a very accessible investment vehicle that naturally diversifies your portfolio beyond the risk you would normally take from buying just a few expensive stock or bonds.

As a final point, diversification between different stocks and bonds will lower your risk but it will also stabilize your return potential, meaning that you will likely produce less returns for mitigating the risk. However, consider that investment management is about helping you reach your goals within the safest manner possible rather than chasing an absolute high return without regard to risk. Many investors make the mistake of chasing high potential returns without factoring in the risk they take to do it. When investing, make sure that you are not taking more risk than necessary and that your investment strategy is in line with your goals.

By reading this, you should be able to understand the basics of investing. Let me know if you have questions.

Liked This Post? Here’s my recommendation on which investing platforms are the best to use.

Home Ownership Is Not Necessarily Path To Financial Freedom

home ownership

There’s an ongoing misconception that if you ever did want to achieve financial freedom, that you NEED to own a home. The false idea that if you’re not owning a home, you’re just “throwing your money away”. But who is sending that message in the first place?

It’s the real estate industry that’s primarily selling you this message! And of course, they want you to believe it. They make money when you buy homes. There is a clear incentive for them to tell you that buying a home is always a good decision. They want you to believe if you buy a home, that you will surely be on the path to wealth. Of course there are regular investors out there who will swear by real estate, but there are clear disadvantages and problems that they normally don’t talk about. There are times when real estate makes sense but other times when it doesn’t make sense. I’m going to disprove common misconceptions and show you some numbers.

Home Ownership Is Not Necessarily The Path To Financial Freedom!

Misconception #1: You’re throwing your money away if you’re renting.

This is just plain wrong.

If you own a house, you’re responsible for more than just rent. You need to pay off interest, home insurance, taxes and property maintenance and the closing costs as well. This all means that not only will you be paying the mortgage (which is bundled with payment towards home equity + interest), you’ll be paying towards items that don’t add value to your net worth.

Normally, these extra items such as insurance and taxes will be around 50% more than the mortgage amount. So if it costs $1000 a month for a home mortgage, you can estimate that you will need to budget around $1500 a month for the entire year to cover the miscellaneous costs. But in that scenario, perhaps only $800 is going towards building true equity out of the $1500.

The other side of this: what if you had to sell the house early? If there’s a remote chance that you would need to move in the next 5 years for the following reasons, then don’t buy the house:

  • You found a new job at a different location, or your current job forces you to move locations.
  • You lost a high-paying job where you’ll never be able to get the same income again.

If you do move early, you will very likely lose money having bought the home. The “5-year rule” for housing says that you shouldn’t buy a home unless you expect to stay there for at-least 5 years. I would push this further. You should be in that home for at-least 7-10+ years before you make a real profit.

To explain why you don’t really make a real profit on the house in the beginning years, it’s because you pay more towards interest on the mortgage in the beginning years. So if the mortgage costs $800 in the first year, it would be fair to say that around 70% ($560) of that goes towards interest and the rest towards building home equity. By year twenty, the payments would be more towards principal payments and less on interest. Considering that renting is often cheaper than housing payments, you could have used the difference towards investments that create higher returns on the money. More discussion on this below.

Misconception #2: You can just buy a duplex (2 unit apartment), rent one out to someone who will pay the bills and you live for free.

I hate this advice, since it’s so naive and misleading. If it was really that easy, then everyone would be doing it. The truth is, in most real estate markets, especially the most competitive places like NYC or Los Angeles, the real estate firms have already scooped up these opportunities. These are professionals who build complex excel sheets on property cash flows and are searching for good deals on a daily basis. What makes you think that as an inexperienced first-time homebuyer that you’re going to be able to beat them on those deals? Those same real estate firms often sell those property “deals” to people at a premium. Most properties that you buy from these crowded markets will come at a cash flow loss to you in the first few years. You’re going to lose more than you make in the beginning.

Misconception #3: The house will appreciate and make me way more money.

In general, housing price increases keeps up with inflation, meaning you’re not actually making any real profit on your “investment”. If you happen to catch a “hot market”, then maybe your housing will outpace inflation by an extra 1-3% per year. But to really be able to bank on that kind of growth, you’d need to have that property for a long time because the housing market is unstable. The housing markets growth is not necessarily a graph where the prices are always going up in a linear fashion. It’s going to go up and down along with the economy. This means that at a certain time, your ability to sell at a profit will not necessarily be guaranteed. This is the same as the stock market, at some point, every asset out there will hit a down point. When you buy a house on the basis that it’s going to keep increasing, or that you can sell it at a gain for 1-5 years, it’s just plain wrong. It’s that kind of thinking that led to the real estate markets collapse in 2007-2009.

The other factor you need to consider are the closing costs. When listing the house for sale, you can expect to pay 5-7% to realtors, lawyers, etc. just to get the house sold. Whatever gains you make past inflation on the house in the short-term could easily be offset by those closing costs.

Misconception #4: A house will get you mortgage tax deductions that make everything completely worth it.

This is like looking at everything on a pennies vs dollars basis. If it costs 800 to rent an apartment, and $1500 for all the housing costs on the cheapest house available, and you save even $100-400 on mortgage tax deductions, you’re still paying more than you would have originally, compared to if you just rented and invested the difference.

I’ve been hinting at this, but the other option instead of buying a house, is to rent and invest the difference. Why would that be a better option? Let’s look at the math.

Let’s assume you were trying to purchase a $250k 2-unit house. With a 20% down payment of $50k and an assumption of 1% closing cost for buying, at $2500, you sacrifice an opportunity cost of $52.5k towards this house. Assuming you had an interest rate of 4% on a 30-year fixed mortgage, you’d be paying $955 a month. By factoring an additional 50% to cover the misc costs, you would need to budget $1432 a month.

Let’s also assume that you lived in one unit for “free” while you rented the other unit for 650, about 300 less than the mortgage price. Not bad to have your neighbor pay more than half your mortgage right? Your net loss per month, or essentially your “housing payments”, would be $782, leading to a yearly “rent” of $9390. Let’s also optimistically assume that the house will appreciate every year by 4%, above normal inflation rates of 2-3%. By year 5, the house will have increased from $250,000 to nearly $304k. After having payed 5 years of your bills, you owe $19,104 less on your original mortgage balance of $200k and will have paid $16,950 towards your “rent”. Factoring in the gains/losses of the house’s value appreciation, mortgage payments and debt reduction, you will have a face net gain of $26,318 after those 5 years. This is the kind of number most people look at and pride themselves on when talking about their investment, after the perfect scenario of higher-than-inflation home value increase, non-stop revenue income coming from a well-behaved renter who covers nearly all of the bills, and normal housing costs.

But this is the biggest issue. Remember that $52,500 you put in as a down payment towards the house? When you put that money away into the house, you actually sacrifice an opportunity cost of having been able to direct that money into some other investment. What this means is that instead of having put that $52,500 into the house, you could have just as easily put it into investments that returned a modest 7% on average after 5 years. This means you have lost the opportunity to see an increase of your money by $21,134 in that time. If you subtract that opportunity cost, your overall net gain from buying the house at $250k and selling at $304k 5 years later is around $5,184.

Let’s assume that instead of putting the down payment money into buying a house from the beginning, you had left it inside investments that returned 7% per year. You will also settle for renting a cozy place at $650 and reinvest the difference of $132.50 that would have gone into the mortgage. After 5 years, your money will have appreciated by $31,411. That’s way more than the return your original house would bring you. Keep in mind that you could easily sell portions of your investments away with favorable taxation rates when in need of quick money, compared to being stuck with a lumpy house that you won’t see tangible cash benefit from until sale.

However, this doesn’t mean home ownership is all bad to be fair.

In these instances, home ownership can actually make a lot of sense (but not always).

  • You are able to stay in that multiple unit house for more than 7-11+ years. If you can stay past 11 years while renting out a portion of the house to cover the bills, then it will have had a good chance to pass the profit point over normal stock market returns. If you are living in that house without renting a portion to others, it brings you no added income whatsoever, meaning there’s a good chance it never made sense to own that home over investing in the stock market.
  • You did the calculations, and you found a house that makes financial sense over the stock market, even if you did sell in less than 5 years. For example, if you come across a “fixer-upper” house that could greatly appreciate in value after it’s worked on. Be warned though, the time spent fixing this house may also be less valuable than working on a different project. You need to factor in your own time spent fixing that house compared to side income that would potentially earn you more.
  • It’s psychologically easier for you to pay off a mortgage bill of $280 or whatever amount, than to consistently invest that money away.
  • You just like real estate more than the stock market. Whatever your reasons are, you’re just not a fan of the stock market. In that case, you might as well pick any type of investment than none at all. Even if it isn’t the most optimal use of your money, well at-least you’re doing something.
  • You’re buying in a hot market. But be warned, this type of thinking where “the house will just keep going up” is what caused the Great Recession in the first place. Many people lost their homes and livelihoods because of this type of optimistic thinking.

If you can meet one of these conditions, then it probably makes sense to aim for a home.

Hopefully you now have a more comprehensive understanding of the kind of thinking that needs to go behind what will likely be one of the biggest purchases, if not the biggest purchase of your life. If you have any questions, feel free to ask.