NOT just pieces of paper

Successful investing, like everything in life, requires the right approach.  Such an approach isn’t just a to-do list, but a way of thinking.  The wrong way of thinking leads one to easily stray from the correct path, whereas the right way leads one to successfully stay on track.

Weight loss programs are a great example.  If your weight loss plan is a crash diet with no thought for what happens after, you’re very likely to fail long term.  If your approach is to implement a permanent lifestyle change that includes diet and exercise, then you can and likely will succeed.  The thinking behind the approach is vital to success.

Nowhere is right thinking more lost than on investors.  Instead of thinking of stocks as partial ownership in businesses, they think of stocks as mere pieces of paper trading in a highly abstract “casino” somewhere in New York.  And that’s why most generate lousy results.

Santa Cutie, there’s one thing I really do need, the deed; To a platinum mine – J. Javits and P. Springer, Santa Baby, originally sung by Ertha Kitt

A stock certificate is partial ownership in a business.  You don’t own a piece of paper, but the underlying business.  Ertha Kitt is not excited about a piece of paper called a deed, or even what some other person is willing to pay for that deed on any given day, but for the platinum in the mine and what it’s worth in the real world.

Let me give an example to make this even more concrete.  If you have $20,000, and find four other friends with $20,000, you can buy a $100,000 house together.  If that house rents for $1,000 per month, then you’ll generate $12,000 a year of revenue.  If you have $2,000 of costs each year for real estate taxes, upkeep and management, then the house has net income of $10,000 per year.  That’s a 10% yield for each partial owner ($10,000 net income/$100,000 investment = 10%; $2,000/$20,000 = 10% for each of the five owners).

The deed to the home, or the partial deed specifying that you own 1/5 of the home, is a piece of paper.  But, what you actually own is 1/5 of the home and 1/5 of the income.

Now, suppose some bone-head comes along and offers $50,000 for the home you paid $100,000.  You and the other 4 owners are free to send him packing.  His offer is no sweat off your brow, because you have partial ownership in a stream of income–specifically: $2,000 for the $20,000 investment you made. 

The offer of $50,000 is no obligation for you.  You need not lose sleep at night or panic that such an offer is made.  You can check to make sure the home is still rented, count your annual cash intake, double check the expenses, and go about your merry way thinking very little about Mr. Bone-head.

This is the same attitude investors should have. 

Instead of freaking out when the deed to their partial ownership drops 50%, they should check to make sure the business isn’t going under and can still generate profits long term, but then go about their merry way.  There’s no need to panic if your partial ownership is generating 10% on original investment.  There’s no need to lose sleep when you own a business with profits and assets.  But, it’s very easy to lose sleep when you think you own of a piece of paper in some vault in New York and people are offering 50% less than what you paid.

Right thinking here is crucial.  If you know nothing about the profits of the enterprise, you’re likely to panic.  If you think of the deed as a piece of paper or symbol on a computer screen, you’ll probably panic.  If you think about the underlying business, you can remain calm.  In fact, you may even realize that a 50% drop means your 10% yield has become a 20% yield to the Mr. Bone-heads of the world and buy more partial ownership from them.

Most people lose their shirts investing because they panic and sell when Mr. Bone-head offers 50% off their original investment.  Sometimes businesses really do go under, but it’s much more rare than market panics.  On extremely rare occasions, countries and stock markets completely collapse and people lose everything.  The vast majority of the time, though, investors get lousy returns because they buy after things go up and then panic and sell when things go down.  They buy and sell like that because they are focused on stock symbols instead of businesses.

Stocks are not mere pieces of paper, but ownership in businesses.  Thinking of them as such can lead to success.  Thinking of them as blips on a screen is doomed to failure.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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NOT just pieces of paper

Don’t trust your gut.

One year ago, almost everyone was panicking. Stock markets were hitting new lows–more than 50% below all-time highs of fall 2007. Bankruptcy risk seemed to be around every corner with rumors flying about which companies would die next. Additional rumors were floating that the government would be taking over large banks like Citigroup and Bank of America. The fear was palpable.

Today, the S&P 500 is up around 75% (it still needs to climb another 35% to get back to Fall 2007 highs). Emerging markets and some commodities are up even more. The banks everyone thought would be taken over, Citigroup and Bank of America, are up 289% and 436%, respectively. Everyone is starting to feel calm again.

So, what have we learned? Trusting your gut feel to guide your decision to invest or not works terribly. Investing when it feels like the sky is falling is excruciatingly difficult, but generates the highest returns. Intestinal fortitude–having the courage of your conviction–is as important as sound analysis.

Or, as Warren Buffett put it: 1) you pay a high price for a cheery consensus, and 2) if you wait for the robins, spring will be over. Waiting until things feels good is a guaranteed trip to poor or mediocre returns. If you wait until you feel good, it’ll be too late.

With this in mind, where are we now? Investors piled into cash and bonds last year–precisely when they should have been buying equities. Now that the market and economy have recovered, they’re finally starting to buy equities, again.

Knowing how the stock market and human psychology works, I expect the stock market to continue creeping up until everyone is on the bandwagon. Once they are, and fund flows into mutual funds are hitting new highs again, and everyone feels nice and comfortable, it will be time for another drop.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Diversification works great…until it doesn’t

Many financial advisers tout the benefits of diversification. They reason that spreading your eggs among many baskets can protect your aggregate egg count in case one basket drops.

But, what if there is some underlying reason that causes all baskets to drop all at once? Then, of course, all your eggs drop.

Most people didn’t think this was possible, and yet it happened in 2008. Almost every asset class dropped as the market panicked. The one major exception was U.S. Treasury Bonds.

As John Authers put it in his “The Short View” column in the Financial Times, “…last year’s sell-off was so extreme that diversification would not have helped one whit.”

But, isn’t it at times like this, when everyone is panicking, that diversification is supposed to provide benefits? Yes, it is supposed to. But, that doesn’t mean it does.

The reason why is that all financial markets are linked. Just because everyone is running from one investment does not mean another “historically uncorrelated” asset is necessarily doing well. This was very clear in 2008.

Diversification seems to work best when you don’t need it. People don’t get excited about diversification during normal times. It just gives you average instead of slightly better or slightly worse returns.

If you have half your money in U.S. stocks that provide a 5% return and half your money in foreign stocks that provide a 15% return, you get 10% returns. All you manage to do is lock in mediocre returns all the time. Getting 5% returns versus 10% or 15% returns in a single year won’t ruin someones retirement. Losing 40% the year after retiring almost certainly will.

When markets really panic, everything goes down together. Even a brief glance at economic history confirms this. Diversification fails when people want it most. Like…well, like in 2008.

There is a very real benefit to be gained from this situation, though. Not all investments have bad underlying characteristics. The very fact that a panic has occurred means both good and bad investments were sold off. So, you can currently buy excellent investments for the same price as the poor ones.

But, if you diversify you’ll get both the bad and the good returns going forward. Someone down 40% will see a world of difference between getting a 67% return (being in the good investments and returning to starting principal value) and getting a 33% return (being diversified in half the good investments that go up 67% and half the bad investments that go nowhere, thus still being down 20% from starting principal value).

Or, as John Authers put it, “If there is any consolation, it is that the sell-off was so indiscriminate. The odds are overwhelming that some stocks and asset classes will now begin to outperform.”

I don’t know when, exactly, those good stocks and asset classes will take off, but I’m quite comfortable I have identified them and believe very strongly my clients and I will benefit going forward.

This may very well be a case where not being too diversified will reap great benefits.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.