A reader asks:
How can one avoid buying or owning a stock that goes badly south a la Enron?
Three thoughts:
1) Learn to read financial statements. At the very least, learn to read them to a basic level such that you can make sure a company's cash flows from operations match up with (or better yet, exceed) net income on its income statement. The issue with Enron is that the cash didn't add up: the negative operating cash flows on Enron's cash flow statement didn't make sense when compared to the positive earnings on the company's income statement. This suggested earnings were being exaggerated somehow and simply weren't legit. Also, learn to read a balance sheet, and know how to differentiate a "good" balance sheet from a "bad" balance sheet. This might mean taking a intro to managerial accounting class, or getting a couple books out on financial statement analysis. Generally you'll want to stick to investing in companies with good (or better yet, great) balance sheets, preferably choosing companies that also pay consistent dividends. Note: It's okay to speculate in riskier companies, just don't do it with investment capital you depend on.
2) Avoid cult stocks, avoid overly popular stocks and avoid popular sectors. Don't get sucked in. Pay attention to which names "everybody" talks about, and if any stock you already hold becomes too popular or too widely held, cut it back. Think about it: Once everybody owns a stock, who's left to buy more? Also, it can really help to have friends and acquaintances across a spectrum of investment experience and sophistication here, and it helps to read publications across a spectrum of investing sophistication too. An example: if you see a stock you own mentioned bullishly on, say, the Motley Fool website, you should consider trimming it back. And if you see a stock you own mentioned bullishly in People Magazine... run. Likewise, if you have a few acquaintances who previously had no experience in--or interest in--investing, and they suddenly start buying up tech stocks like it's 1999 and they can't seem to shut up about them, that's a potential sign about future investment returns in that sector. It could also be a sign about the (likely very poor) investment potential of the entire stock market.
3) Final thought: you can't really avoid all possible instances where an investment goes badly south. It will still happen to you on occasion, even if you follow all these rules. That's the game: sometimes stocks go down, and sometimes they go down a lot. Therefore, be a second order thinker: let your understanding about this always-present risk inform your investment decision-making in the first place. Let it keep you humble as an investor, and let it drive you to select a range of different ways to protect your investment capital (e.g., have smaller position sizes, own more stocks, stick to mostly great companies with great balance sheets, hold larger cash positions, buy stocks only with long term money you don't need in the near term, etc.).
***********************
You can help support the work I do here at Casual Kitchen by visiting Amazon via any link on this site. Amazon pays a small commission to me based on whatever purchase you make on that visit, and it's at no extra cost to you. Thank you!
And, if you are interested at all in cryptocurrencies, yet another way you can help support my work here is to use this link to open up your own cryptocurrency account at Coinbase. I will receive a small affiliate commission with each opened account. Once again, thank you for your support!
Showing posts with label investing. Show all posts
Showing posts with label investing. Show all posts
Money Sundays: Beware Buying Stocks on Margin
Readers: I originally wrote this post for a now-defunct website. I thought I’d share the insights here at Casual Kitchen for those readers interested in investing and personal finance.
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Margin buying is a tool that both individual and professional investors can use to boost their returns. However it can be a risky tool, and if overused, margin debt can be disastrous.
First you need to set up what's called a "margin account" with your broker. Usually these types of brokerage accounts will have minimum capital requirements, in some cases as much as US$25,000.
Let's go through a simple example of how margin borrowing works. First let's say you want to buy stock in XYZ company, which trades for $100 a share. You have enough capital in the account to buy 250 shares already ($100 x 250 = $25,000). But let's say you would like to buy MORE stock than that. With a margin account, you can borrow money from your broker to fund the purchase. This is called "buying stock on margin."
The "initial margin" required for a margin account purchase is 50%. Thus the broker will loan you funds for your investment, but you must have initial collateral in the account to equal half of the stock you want to buy. Thus a $25,000 margin account balance can theoretically give you "buying power" for $50,000 worth of stock. In return for this, the broker will charge you margin interest rates on your loan balance. Generally, margin interest rates range from 8-10%.
Let's look at an example of how using margin affects your returns. First we'll take a best-case scenario where the stock actually goes up. Let's say XYZ stock goes from $100 a share to $120 a share over the course of one year. If you had bought the stock with only your own money, your $25,000 in capital would have grown to $30,00 (250 shares x $120 per share), or a profit of $5,000 on your $25,000 initial investment. Congratulations, you just earned 20%!
But what if instead you had maxed out your margin account and bought $50,000 in XYZ stock?
First, you would have purchased 500 shares of XYZ stock at $100, using $25,000 of your own money and $25,000 of the broker's money.
After a year, when the stock was at $120 per share, you would have 500 shares XYZ at $120, or $60,000. Then you would need to subtract out $2,250 in margin interest expense (I'm assuming the broker charges you 9% interest for the margin borrowing). This leaves you with $57,750 in capital. Again, recall that you have invested $25,000 and you have borrowed $25,000 from the broker to make the initial $50,000 investment.
Let's assume you sell the stock now, and return the $25,000 to the broker. You've earned $7,750 ($60,000 minus $2,250 in interest expense, minus the $25,000 you borrowed from the broker) on your initial personal capital of $25,000. Congratulations even more! In this example you've earned 31% ($7,750 divided by $25,000). The extra borrowing power from the broker juiced your returns meaningfully, even after paying the added interest expense.
Sounds great, doesn't it? Well, like almost everything in investing, there is no free lunch. Stocks can go down too. For example, if XYZ stock that you bought in the margin example falls to $75 per share, your 500 shares will be worth only $37,500. But the problem is you still owe $25,000 to your broker. So that $12,500 loss ($50,000 minus $37,500) comes entirely out of YOUR pocket. Thus the $25,000 of your own money that you invested is now worth only $10,250, because you need to pay back the $25,000 to the broker AND pay the $2,250 in interest expense.
Thus with a 25% decline in the price of XYZ stock, you've lost 59% of your personal investment! And if-heaven forbid-the stock falls to $54.50, your investment will be totally wiped out after paying back the margin loan plus interest.
As they say on Wall Street, margin works both ways. It can eat you alive. When you use margin to buy stocks and they go down, your capital will be exposed to severe risk. Many investors learned this lesson the hard way during the 2000-2002 and the 2007-2009 market corrections.
Happy investing, and use margin with great care!
****************************
Margin buying is a tool that both individual and professional investors can use to boost their returns. However it can be a risky tool, and if overused, margin debt can be disastrous.
First you need to set up what's called a "margin account" with your broker. Usually these types of brokerage accounts will have minimum capital requirements, in some cases as much as US$25,000.
Let's go through a simple example of how margin borrowing works. First let's say you want to buy stock in XYZ company, which trades for $100 a share. You have enough capital in the account to buy 250 shares already ($100 x 250 = $25,000). But let's say you would like to buy MORE stock than that. With a margin account, you can borrow money from your broker to fund the purchase. This is called "buying stock on margin."
The "initial margin" required for a margin account purchase is 50%. Thus the broker will loan you funds for your investment, but you must have initial collateral in the account to equal half of the stock you want to buy. Thus a $25,000 margin account balance can theoretically give you "buying power" for $50,000 worth of stock. In return for this, the broker will charge you margin interest rates on your loan balance. Generally, margin interest rates range from 8-10%.
Let's look at an example of how using margin affects your returns. First we'll take a best-case scenario where the stock actually goes up. Let's say XYZ stock goes from $100 a share to $120 a share over the course of one year. If you had bought the stock with only your own money, your $25,000 in capital would have grown to $30,00 (250 shares x $120 per share), or a profit of $5,000 on your $25,000 initial investment. Congratulations, you just earned 20%!
But what if instead you had maxed out your margin account and bought $50,000 in XYZ stock?
First, you would have purchased 500 shares of XYZ stock at $100, using $25,000 of your own money and $25,000 of the broker's money.
After a year, when the stock was at $120 per share, you would have 500 shares XYZ at $120, or $60,000. Then you would need to subtract out $2,250 in margin interest expense (I'm assuming the broker charges you 9% interest for the margin borrowing). This leaves you with $57,750 in capital. Again, recall that you have invested $25,000 and you have borrowed $25,000 from the broker to make the initial $50,000 investment.
Let's assume you sell the stock now, and return the $25,000 to the broker. You've earned $7,750 ($60,000 minus $2,250 in interest expense, minus the $25,000 you borrowed from the broker) on your initial personal capital of $25,000. Congratulations even more! In this example you've earned 31% ($7,750 divided by $25,000). The extra borrowing power from the broker juiced your returns meaningfully, even after paying the added interest expense.
Sounds great, doesn't it? Well, like almost everything in investing, there is no free lunch. Stocks can go down too. For example, if XYZ stock that you bought in the margin example falls to $75 per share, your 500 shares will be worth only $37,500. But the problem is you still owe $25,000 to your broker. So that $12,500 loss ($50,000 minus $37,500) comes entirely out of YOUR pocket. Thus the $25,000 of your own money that you invested is now worth only $10,250, because you need to pay back the $25,000 to the broker AND pay the $2,250 in interest expense.
Thus with a 25% decline in the price of XYZ stock, you've lost 59% of your personal investment! And if-heaven forbid-the stock falls to $54.50, your investment will be totally wiped out after paying back the margin loan plus interest.
As they say on Wall Street, margin works both ways. It can eat you alive. When you use margin to buy stocks and they go down, your capital will be exposed to severe risk. Many investors learned this lesson the hard way during the 2000-2002 and the 2007-2009 market corrections.
Happy investing, and use margin with great care!
Money Sundays: The Efficient Markets Hypothesis Explained in Simple Terms
Readers: I wrote this post years ago for a long-defunct website. I thought I’d republish it here at Casual Kitchen for those readers interested in investing and personal finance. Feel free to skip it!
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What are efficient markets?
Perhaps you've heard the joke about the economist walking down the street with one of his students. The student sees a $20 bill lying on the sidewalk. As he bends down to pick it up, he hears his professor laugh mockingly at him and saying, "If that were REALLY a twenty dollar bill, somebody would have picked it up already!"
The intellectually intimidated student stops himself mid-bend, laughs timidly, and leaves the $20 lying right there, stealing longing glances at it as they pass it by.
Well, saying markets are perfectly efficient is just like being that condescending economics professor. He just left a perfectly good $20 bill untouched on the ground, AND he convinced his student to leave it there too. All because he believed it couldn't actually be there.
The whole notion of efficient markets has become so contentiously debated that three separate forms of the theory have evolved:
1) Strong Form Efficient Markets Hypothesis
Basically, this version of the theory says that stock prices reflect all information and there's no way you can possibly "beat the market" (or as the academics would phrase it: earn excess returns).
This version of the theory is easy to understand, elegant.. and it's pretty much been proven false by the collective weight of the evidence. But it's a good starting point to help illustrate the other versions of the theory.
2) Semi Strong Form Efficient Markets Hypothesis
This version of the theory says that stock prices react so quickly to new information (say, if a company gets a buyout offer, or if a company prints terrible quarterly results), that there's no way you can make money by trading on that information once it's out. Obviously "insiders" know about such information in advance (and are prohibited from trading on that knowledge by SEC rules), but normal investors like us who see the good or bad news will not be able to buy or sell the stock before the price adjusts.
There are problems with this version of the theory too, namely that stocks tend to overreact to news in the short term and under-react to news in the long term. Thus you can often make money by playing the other side of the trade: for example, by selling a stock after it spikes on a great quarter print, or buying a stock after it falls due to a disappointing news event.
3) Weak Form Efficient Markets Hypothesis
This version of the theory argues that you can't make money with any strategies using historical share prices or other financial information. This says basically that technical investing (using charts to make stock market buy and sell decisions), will never make you money. Furthermore, using historical financials will likewise not be useful, because that information will have already been baked into the current stock price. The theory still allows for investors to do what's called "fundamental analysis" to identify stocks that are undervalued and overvalued.
This is probably the most palatable version of the theory to most EMH adherents. Even so, there are instances where it falls on its face too. For example there are instances in recent history where company financials contained serious red flags that were notable and visible to anybody who could read financial statements. Enron comes to mind as one of the most prominent examples, as the company consistently and inexplicably ran years of negative cash flows despite showing years of accounting profits. This is one of the oldest red flags in the book.
I'll leave you with a few final thoughts, one from me and two from a couple of investors that are a bit more well-known and well-regarded.
First, it's always a bit disconcerting when a theory of markets experiences a schism--a three-way schism no less! It makes you wonder whether it, or any of the offshoots, can really stand on their own.
Second, Warren Buffet, an investor with a lot more credibility than I'll ever have, had this to say of professors who teach Efficient Market Theory: "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."
And of course it was John Maynard Keynes, renowned 20th century economist and investor, famously said, "Markets can remain irrational a lot longer than you and I can stay solvent."
So the next time you're walking with a condescending economics professor who believes in Strong Form EMH and you see a $20 bill lying on the sidewalk, bend down and pick it up! As you're putting it into your wallet, say you prefer the Weak Form.
READ NEXT: Ten Book Recommendations (Actually, Eleven)
***********************
Readers! You can help support the work I do here at Casual Kitchen by visiting Amazon via any link on this site. Amazon pays a small commission to me based on whatever purchase you make on that visit, and it's at no extra cost to you. Thank you!
And, if you are interested at all in cryptocurrencies, yet another way you can help support my work here is to use this link to open up your own cryptocurrency account at Coinbase. I will receive a small affiliate commission with each opened account. Once again, thank you for your support!
******************************
What are efficient markets?
Perhaps you've heard the joke about the economist walking down the street with one of his students. The student sees a $20 bill lying on the sidewalk. As he bends down to pick it up, he hears his professor laugh mockingly at him and saying, "If that were REALLY a twenty dollar bill, somebody would have picked it up already!"
The intellectually intimidated student stops himself mid-bend, laughs timidly, and leaves the $20 lying right there, stealing longing glances at it as they pass it by.
Well, saying markets are perfectly efficient is just like being that condescending economics professor. He just left a perfectly good $20 bill untouched on the ground, AND he convinced his student to leave it there too. All because he believed it couldn't actually be there.
The whole notion of efficient markets has become so contentiously debated that three separate forms of the theory have evolved:
1) Strong Form Efficient Markets Hypothesis
Basically, this version of the theory says that stock prices reflect all information and there's no way you can possibly "beat the market" (or as the academics would phrase it: earn excess returns).
This version of the theory is easy to understand, elegant.. and it's pretty much been proven false by the collective weight of the evidence. But it's a good starting point to help illustrate the other versions of the theory.
2) Semi Strong Form Efficient Markets Hypothesis
This version of the theory says that stock prices react so quickly to new information (say, if a company gets a buyout offer, or if a company prints terrible quarterly results), that there's no way you can make money by trading on that information once it's out. Obviously "insiders" know about such information in advance (and are prohibited from trading on that knowledge by SEC rules), but normal investors like us who see the good or bad news will not be able to buy or sell the stock before the price adjusts.
There are problems with this version of the theory too, namely that stocks tend to overreact to news in the short term and under-react to news in the long term. Thus you can often make money by playing the other side of the trade: for example, by selling a stock after it spikes on a great quarter print, or buying a stock after it falls due to a disappointing news event.
3) Weak Form Efficient Markets Hypothesis
This version of the theory argues that you can't make money with any strategies using historical share prices or other financial information. This says basically that technical investing (using charts to make stock market buy and sell decisions), will never make you money. Furthermore, using historical financials will likewise not be useful, because that information will have already been baked into the current stock price. The theory still allows for investors to do what's called "fundamental analysis" to identify stocks that are undervalued and overvalued.
This is probably the most palatable version of the theory to most EMH adherents. Even so, there are instances where it falls on its face too. For example there are instances in recent history where company financials contained serious red flags that were notable and visible to anybody who could read financial statements. Enron comes to mind as one of the most prominent examples, as the company consistently and inexplicably ran years of negative cash flows despite showing years of accounting profits. This is one of the oldest red flags in the book.
I'll leave you with a few final thoughts, one from me and two from a couple of investors that are a bit more well-known and well-regarded.
First, it's always a bit disconcerting when a theory of markets experiences a schism--a three-way schism no less! It makes you wonder whether it, or any of the offshoots, can really stand on their own.
Second, Warren Buffet, an investor with a lot more credibility than I'll ever have, had this to say of professors who teach Efficient Market Theory: "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."
And of course it was John Maynard Keynes, renowned 20th century economist and investor, famously said, "Markets can remain irrational a lot longer than you and I can stay solvent."
So the next time you're walking with a condescending economics professor who believes in Strong Form EMH and you see a $20 bill lying on the sidewalk, bend down and pick it up! As you're putting it into your wallet, say you prefer the Weak Form.
READ NEXT: Ten Book Recommendations (Actually, Eleven)
***********************
Readers! You can help support the work I do here at Casual Kitchen by visiting Amazon via any link on this site. Amazon pays a small commission to me based on whatever purchase you make on that visit, and it's at no extra cost to you. Thank you!
And, if you are interested at all in cryptocurrencies, yet another way you can help support my work here is to use this link to open up your own cryptocurrency account at Coinbase. I will receive a small affiliate commission with each opened account. Once again, thank you for your support!
How You Can Beat Inflation, Part 2
...continued from last week:
In our last post we talked about expanding how we think about competition and substitution in order to defeat inflation and shift the balance of power back into consumers' hands. Let's pivot now from the spending side of the ledger over to the savings and income side of the ledger, and try to think creatively about attacking inflation on a second front.
Labor markets: tightening
One of the fortunate aspects of inflation is it tends to coincide with lower unemployment rates and an improving economy. Remember last post when we talked about making companies compete to sell to us? Well, labor market conditions are tightening, which means, finally, employers are beginning to compete for workers.
This means a couple of things. For one, enterprising workers who are valued by their employers and willing to ask for what they want can potentially get more money for the jobs they already have. Second, other opportunities are likely be opening up for you, right now, for a superior work situation. Start looking.
Both employment and wage increases tend to lag a recovery, which means now is the time to start taking advantage of the most direct way to beat inflation: get more money.
Side hustles/additional income sources
Last week we talked about monopolies in the consumer marketplace. Here's another way to think about a monopoly: if you have one job, your employer is a monopoly provider of your income. Your employer has maximum power over you, and it can "substitute" you right out of a job under the flimsiest of pretexts, whenever it wants!
To borrow a phrase from Nassim Nicholas Taleb's must-read book Antifragile, this makes you fragile to the loss of all of your income. Not good.
You cannot consider yourself to be truly robust financially if a) you have a monopoly income provider and b) your monopoly income provider can, by terminating your job, spontaneously shut off all of your income. This is why all households ought to be thinking about what kind of side hustles they can run to supplement income from their primary job.
My domain of expertise is stock market investing, thus that's where I try to drive incremental income for my household. But there is no shortage of ways to earn extra money on the side, and plenty of resources that cover this topic better than I could. Once again, remember our primary heuristic: the more broadly we think about competition and substitution (and monopoly providers of things like our income!), the more we can eliminate various fragilities in our financial lives.
Turning an expense into an income source
One major insight from Jacob Lund Fisker's book Early Retirement Extreme is to look for ways to "monetize" your hobbies: Fisker loved bicycles, taught himself how to fix them, and gradually fell into a modest income source repairing them. Recently, I taught myself how to string tennis racquets. Now, not only have I dramatically reduced one of my largest tennis-related expenses, I'm now in a position to string other peoples' racquets for additional income!
In both these cases we've taken an inflation-prone expense and not only neutralized it, but turned it into a source of funds. I'll leave it to you to figure out where in your life you can apply this important insight.
Low overhead, low fixed costs
The late publisher Felix Dennis, in his useful book How to Get Rich, used to say "overhead walks on two legs."
I gotta be honest: that phrase makes absolutely no sense. But, well, he's from England.
What he's getting at, however, is this: never, ever, ever get yourself in a situation where you have high fixed overhead costs. Felix Dennis kept his organizations lean, mean and flexible so they could withstand anything--any kind of financial stresses. And whenever a windfall came in, rather than getting spent covering expenses and overhead, that income dropped right down to the bottom line.
Why can't we keep our households lean, mean and flexible too?
Debt = Fragility
The first and most obvious step most families can take towards making their households lean is to pay down all debts. Debt makes you fragile. It saddles you with non-negotiable monthly fixed costs that swell up your expenses, limit your flexibility, and crowd out your ability to manage inflation.
But believe it or not, debt can be an inflation fighting tool. Let me explain how.
Here at Casual Kitchen, we carry a modest mortgage on our townhome. When we first started seeing a few too many "non-beat-backable" examples of price inflation, like our auto insurance bill, our property taxes and some of the other examples I discussed in Part 1 of this post, we put a plan into place to accelerate paying off our mortgage entirely.
Our plan is to get this cost item paid off and eliminated from our household ledger for good by the end of 2018. This will create significant room in our budget to compensate for quite a bit of other sources of inflation in areas where we have less control.
A quick sidebar. Traditional economic "logic" says that borrowers benefit from periods of inflation. If you borrow money today (assuming you can do so at attractively low interest rates, a not-always-true presumption) you can then pay it back with lower-value dollars in the future. That's what the economic textbooks say at least.
The truth is debt is a fixed overhead cost burden that you are better off not having at all. The money you vaporize to service your debts could can be far better used to fund a huge savings buffer, or to fund investments in long-term, inflation-protected cash flows. Unlike a large debt load, these protect your family, making you more financially robust.
Nearly every household in our country carries a significant level of debt, which means nearly every household lights a meaningful portion of their money on fire, every month, just so they can use someone else's money to buy things they likely never needed in the first place.
Eliminate all debt. Overhead walks on two legs. Eliminate that overhead and you'll free up room in your budget to handle all sources of inflation and then some.
Now, let's move on to our final and most powerful tool for defeating inflation.
Income generating investments
A detailed discussion on investing is beyond the scope of this post and likely beyond the scope of this blog.[1] But we'll make room here for a few general heuristics you can use to diversify your sources of income using the amazing vehicle of conservative dividend paying stocks.
Remember in last week's post when we were talking about companies with pricing power? Those are the types of companies you'll want to consider for investments. Or, as I phrased it in another post here at Casual Kitchen: "Wherever you find a highly profitable company charging prices well above intrinsic value, forget buying the product. Buy the stock instead."
I'll share a couple of examples from my personal investing activities: my dividend on my Coca-Cola stock has more than quadrupled since I bought my first shares in 1999. Since the financial crisis in 2008-2009, JP Morgan hiked its dividend from a post-crisis low of 5c a share to 56c a share, an eleven fold increase.
I have yet to see a product in the consumer marketplace inflate prices at that kind of rate, not even status-signalling iPhones.
Which reminds me! Apple stock paid its first quarterly dividend in 2012, a modest 38c a share. In the five years since, the company has nearly doubled the dividend, a growth rate of some 15% a year.
I don't know if we can expect these types of dividend growth rates going forward, but you can put a relatively high level of confidence on all of these companies, and many others like them, increasing their dividends over time at rates equal to or exceeding inflation. This genre of stocks should be one of the pillars of your overall investment strategy.
Conclusion and review
Once again, let's return to Galbraith's "at-risk" households: those with no control over their income, no control over prices they pay, and "no capacity to protect themselves by increasing their own returns." While we can't control everything--here and there we will have to eat a price hike--we now have several tools we can use to increase our "capacity" to protect ourselves and our families from inflation:
* Think about competition and substitution as broadly and as empoweringly as possible
* Improve your brinksmanship: increase your ability to say "no" to more and more products and services in the consumer marketplace
* Avoid monopoly and oligopoly providers in as many forms as you can
* Ruthlessly strip out overhead ("overhead walks on two legs")
* Relentlessly pay off all debts (debt = fragility)
* Save more, both into a large emergency fund and into income generating investments
* Don't let your job be a "monopoly income source"--diversify away from it now, even if you do so in small steps at first.
Good luck and get started!
[1] Footnote: Resources for further reading:
For those readers interested in more articles and resources about investing, see:
1) Consumer Empowerment: How To Self-Fund Your Consumer Products Purchases
2) Synergies of Being an Investor AND a Consumer
3) Money Sundays: The "Stoplight Rule" For Creating An Emergency Fund
4) Ask CK: More on Emergency Funds
And, be sure to see my chapter-by-chapter analysis of Your Money Or Your Life, [full archive here], and in particular,
5) Becoming a Sophisticated Investor: Six Steps
6) The Official "Your Money Or Your Life" Reading List
7) Ask Casual Kitchen: Best Investing Books
In our last post we talked about expanding how we think about competition and substitution in order to defeat inflation and shift the balance of power back into consumers' hands. Let's pivot now from the spending side of the ledger over to the savings and income side of the ledger, and try to think creatively about attacking inflation on a second front.
Labor markets: tightening
One of the fortunate aspects of inflation is it tends to coincide with lower unemployment rates and an improving economy. Remember last post when we talked about making companies compete to sell to us? Well, labor market conditions are tightening, which means, finally, employers are beginning to compete for workers.
This means a couple of things. For one, enterprising workers who are valued by their employers and willing to ask for what they want can potentially get more money for the jobs they already have. Second, other opportunities are likely be opening up for you, right now, for a superior work situation. Start looking.
Both employment and wage increases tend to lag a recovery, which means now is the time to start taking advantage of the most direct way to beat inflation: get more money.
Side hustles/additional income sources
Last week we talked about monopolies in the consumer marketplace. Here's another way to think about a monopoly: if you have one job, your employer is a monopoly provider of your income. Your employer has maximum power over you, and it can "substitute" you right out of a job under the flimsiest of pretexts, whenever it wants!
To borrow a phrase from Nassim Nicholas Taleb's must-read book Antifragile, this makes you fragile to the loss of all of your income. Not good.
You cannot consider yourself to be truly robust financially if a) you have a monopoly income provider and b) your monopoly income provider can, by terminating your job, spontaneously shut off all of your income. This is why all households ought to be thinking about what kind of side hustles they can run to supplement income from their primary job.
My domain of expertise is stock market investing, thus that's where I try to drive incremental income for my household. But there is no shortage of ways to earn extra money on the side, and plenty of resources that cover this topic better than I could. Once again, remember our primary heuristic: the more broadly we think about competition and substitution (and monopoly providers of things like our income!), the more we can eliminate various fragilities in our financial lives.
Turning an expense into an income source
One major insight from Jacob Lund Fisker's book Early Retirement Extreme is to look for ways to "monetize" your hobbies: Fisker loved bicycles, taught himself how to fix them, and gradually fell into a modest income source repairing them. Recently, I taught myself how to string tennis racquets. Now, not only have I dramatically reduced one of my largest tennis-related expenses, I'm now in a position to string other peoples' racquets for additional income!
In both these cases we've taken an inflation-prone expense and not only neutralized it, but turned it into a source of funds. I'll leave it to you to figure out where in your life you can apply this important insight.
Low overhead, low fixed costs
The late publisher Felix Dennis, in his useful book How to Get Rich, used to say "overhead walks on two legs."
I gotta be honest: that phrase makes absolutely no sense. But, well, he's from England.
What he's getting at, however, is this: never, ever, ever get yourself in a situation where you have high fixed overhead costs. Felix Dennis kept his organizations lean, mean and flexible so they could withstand anything--any kind of financial stresses. And whenever a windfall came in, rather than getting spent covering expenses and overhead, that income dropped right down to the bottom line.
Why can't we keep our households lean, mean and flexible too?
Debt = Fragility
The first and most obvious step most families can take towards making their households lean is to pay down all debts. Debt makes you fragile. It saddles you with non-negotiable monthly fixed costs that swell up your expenses, limit your flexibility, and crowd out your ability to manage inflation.
But believe it or not, debt can be an inflation fighting tool. Let me explain how.
Here at Casual Kitchen, we carry a modest mortgage on our townhome. When we first started seeing a few too many "non-beat-backable" examples of price inflation, like our auto insurance bill, our property taxes and some of the other examples I discussed in Part 1 of this post, we put a plan into place to accelerate paying off our mortgage entirely.
Our plan is to get this cost item paid off and eliminated from our household ledger for good by the end of 2018. This will create significant room in our budget to compensate for quite a bit of other sources of inflation in areas where we have less control.
A quick sidebar. Traditional economic "logic" says that borrowers benefit from periods of inflation. If you borrow money today (assuming you can do so at attractively low interest rates, a not-always-true presumption) you can then pay it back with lower-value dollars in the future. That's what the economic textbooks say at least.
The truth is debt is a fixed overhead cost burden that you are better off not having at all. The money you vaporize to service your debts could can be far better used to fund a huge savings buffer, or to fund investments in long-term, inflation-protected cash flows. Unlike a large debt load, these protect your family, making you more financially robust.
Nearly every household in our country carries a significant level of debt, which means nearly every household lights a meaningful portion of their money on fire, every month, just so they can use someone else's money to buy things they likely never needed in the first place.
Eliminate all debt. Overhead walks on two legs. Eliminate that overhead and you'll free up room in your budget to handle all sources of inflation and then some.
Now, let's move on to our final and most powerful tool for defeating inflation.
Income generating investments
A detailed discussion on investing is beyond the scope of this post and likely beyond the scope of this blog.[1] But we'll make room here for a few general heuristics you can use to diversify your sources of income using the amazing vehicle of conservative dividend paying stocks.
Remember in last week's post when we were talking about companies with pricing power? Those are the types of companies you'll want to consider for investments. Or, as I phrased it in another post here at Casual Kitchen: "Wherever you find a highly profitable company charging prices well above intrinsic value, forget buying the product. Buy the stock instead."
I'll share a couple of examples from my personal investing activities: my dividend on my Coca-Cola stock has more than quadrupled since I bought my first shares in 1999. Since the financial crisis in 2008-2009, JP Morgan hiked its dividend from a post-crisis low of 5c a share to 56c a share, an eleven fold increase.
I have yet to see a product in the consumer marketplace inflate prices at that kind of rate, not even status-signalling iPhones.
Which reminds me! Apple stock paid its first quarterly dividend in 2012, a modest 38c a share. In the five years since, the company has nearly doubled the dividend, a growth rate of some 15% a year.
I don't know if we can expect these types of dividend growth rates going forward, but you can put a relatively high level of confidence on all of these companies, and many others like them, increasing their dividends over time at rates equal to or exceeding inflation. This genre of stocks should be one of the pillars of your overall investment strategy.
Conclusion and review
Once again, let's return to Galbraith's "at-risk" households: those with no control over their income, no control over prices they pay, and "no capacity to protect themselves by increasing their own returns." While we can't control everything--here and there we will have to eat a price hike--we now have several tools we can use to increase our "capacity" to protect ourselves and our families from inflation:
* Think about competition and substitution as broadly and as empoweringly as possible
* Improve your brinksmanship: increase your ability to say "no" to more and more products and services in the consumer marketplace
* Avoid monopoly and oligopoly providers in as many forms as you can
* Ruthlessly strip out overhead ("overhead walks on two legs")
* Relentlessly pay off all debts (debt = fragility)
* Save more, both into a large emergency fund and into income generating investments
* Don't let your job be a "monopoly income source"--diversify away from it now, even if you do so in small steps at first.
Good luck and get started!
[1] Footnote: Resources for further reading:
For those readers interested in more articles and resources about investing, see:
1) Consumer Empowerment: How To Self-Fund Your Consumer Products Purchases
2) Synergies of Being an Investor AND a Consumer
3) Money Sundays: The "Stoplight Rule" For Creating An Emergency Fund
4) Ask CK: More on Emergency Funds
And, be sure to see my chapter-by-chapter analysis of Your Money Or Your Life, [full archive here], and in particular,
5) Becoming a Sophisticated Investor: Six Steps
6) The Official "Your Money Or Your Life" Reading List
7) Ask Casual Kitchen: Best Investing Books
Why I Clip Coupons
"I don't do coupons."
I hear this statement from time to time from various people, usually middle-class consumers.
I suppose if you're really rich you don't need to bother with coupons... although nobody's stopping you. And if you don't have a lot of money, couponing might be something you need to do.
Which indirectly implies yet another point, something Thorstein Veblen might say: if you clip coupons you risk sending a signal to others that you need to. Which, perhaps, explains why people might tell everyone around them they don't.
Well, I do clip coupons. And I do so for several reasons. At the most basic level, couponing (and occasionally flipping through store circulars) helps me remember the prices of things. As a result, it helps me keep context for value whenever I'm out in the consumer marketplace. What should a given product cost, what does it normally cost, and is the price I see right now a good value or not? Is it a great value, as in should I buy a year's supply of it at this price?
There are some early retirement/investment blogs out there that mock couponing. The point usually made here is that we're better off concentrating on the income side of the ledger (see for example Wall Street Playboys), or to focus on bigger or recurring savings wins (see for example Ramit's I Will Teach You To Be Rich).
These perspectives aren't wrong, exactly. But I look at the act of couponing differently, and this brings me to the most important reason why I do it. I consider couponing a practice of the skill of recognizing value, and I use this same practice in the larger-scale world of personal investing.
In fact, to borrow a term from the martial arts world, I consider couponing a type of kata, a daily practice or discipline, and practicing it helps me stay in shape for larger investment opportunities that could impact my personal wealth on a far greater scale. I look at stocks in much the same way that I look at items in the grocery store: What should this stock cost, what does it normally cost, and is the price I see right now a good value or not? Is it a great value? The two disciplines of shopping and investing are strikingly similar in this way.
In other words, couponing doesn't just save you money. It indirectly makes you rich.
You can save a few bucks here and there with coupons, and that's great. But in the longer run, you can make tens or perhaps even hundreds of thousands of dollars with your investments as your investment capital grows. If you knew the former helped you with the latter, wouldn't you coupon too?
I hear this statement from time to time from various people, usually middle-class consumers.
I suppose if you're really rich you don't need to bother with coupons... although nobody's stopping you. And if you don't have a lot of money, couponing might be something you need to do.
Which indirectly implies yet another point, something Thorstein Veblen might say: if you clip coupons you risk sending a signal to others that you need to. Which, perhaps, explains why people might tell everyone around them they don't.
Well, I do clip coupons. And I do so for several reasons. At the most basic level, couponing (and occasionally flipping through store circulars) helps me remember the prices of things. As a result, it helps me keep context for value whenever I'm out in the consumer marketplace. What should a given product cost, what does it normally cost, and is the price I see right now a good value or not? Is it a great value, as in should I buy a year's supply of it at this price?
There are some early retirement/investment blogs out there that mock couponing. The point usually made here is that we're better off concentrating on the income side of the ledger (see for example Wall Street Playboys), or to focus on bigger or recurring savings wins (see for example Ramit's I Will Teach You To Be Rich).
These perspectives aren't wrong, exactly. But I look at the act of couponing differently, and this brings me to the most important reason why I do it. I consider couponing a practice of the skill of recognizing value, and I use this same practice in the larger-scale world of personal investing.
In fact, to borrow a term from the martial arts world, I consider couponing a type of kata, a daily practice or discipline, and practicing it helps me stay in shape for larger investment opportunities that could impact my personal wealth on a far greater scale. I look at stocks in much the same way that I look at items in the grocery store: What should this stock cost, what does it normally cost, and is the price I see right now a good value or not? Is it a great value? The two disciplines of shopping and investing are strikingly similar in this way.
In other words, couponing doesn't just save you money. It indirectly makes you rich.
You can save a few bucks here and there with coupons, and that's great. But in the longer run, you can make tens or perhaps even hundreds of thousands of dollars with your investments as your investment capital grows. If you knew the former helped you with the latter, wouldn't you coupon too?
Money Sundays: Second Order Thinking
Readers, I want to share a mental tool with you, a tool I used incessantly in my days as a professional investor--and still use today as a individual investor: Always ask the second order question.
What are second order questions? They're meta-questions, or questions about first-order questions. One way that helps me think in second order terms is to make a habit of asking myself "and then what?"
Let's look at an example. Consider the following (rather defeatist) first-order question: "Why bother with investing? The stock market's rigged anyway."
In its first-order form, this is a ready-made rationalization for not even bothering to learn about investing at all. Forget it, what's the point? Didn't you hear me say it's rigged? You could stop right there and be done with the whole domain.
Or, you could ask a second-order question: "If the stock market's really rigged, then what?"
This is the kind of question that opens mental doors, and often there's a gigantic opportunity behind those doors. For example, you could conclude "If the stock market's rigged, maybe I should invest in the companies that are supposedly 'rigging' it… I bet I could make some very good returns piggybacking on those guys."
Suddenly, a yuge cognitive door opens, which might help you discover the stocks of well-regarded investment managers like T. Rowe Price [TROW] or Legg Mason [LM]. Or alternatively, you might discover the stocks of well-regarded private equity firms like Carlyle Group [CG], KKR [KKR] or Blackstone [BX]. "Hmmm which of these companies pays consistent and attractive dividends with good dividend growth potential?"
Now you're off and running with some potentially very intriguing investment ideas.
There's more. As we saw in a recent post, you can now quite easily find investor letters and 13F filings that offer incredibly useful insights and investment ideas from some of the best hedge funds and investment funds around. You know, all those fatcats out there supposedly rigging the stock market.
Heck, why pay some hedge fund an insane "two and twenty" fee structure (2% of assets and 20% of gains) when you can borrow their ideas for free?
Never stop at the first-order question. Ask the second order question, and always try to engage in second order thinking. It's a lens for looking at reality. Using it helps you think more deeply, and it leads you to opportunity for you and your family.
For further reading:
For much more on the concept of second order thinking, see Howard Mark's book The Most Important Thing.
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
What are second order questions? They're meta-questions, or questions about first-order questions. One way that helps me think in second order terms is to make a habit of asking myself "and then what?"
Let's look at an example. Consider the following (rather defeatist) first-order question: "Why bother with investing? The stock market's rigged anyway."
In its first-order form, this is a ready-made rationalization for not even bothering to learn about investing at all. Forget it, what's the point? Didn't you hear me say it's rigged? You could stop right there and be done with the whole domain.
Or, you could ask a second-order question: "If the stock market's really rigged, then what?"
This is the kind of question that opens mental doors, and often there's a gigantic opportunity behind those doors. For example, you could conclude "If the stock market's rigged, maybe I should invest in the companies that are supposedly 'rigging' it… I bet I could make some very good returns piggybacking on those guys."
Suddenly, a yuge cognitive door opens, which might help you discover the stocks of well-regarded investment managers like T. Rowe Price [TROW] or Legg Mason [LM]. Or alternatively, you might discover the stocks of well-regarded private equity firms like Carlyle Group [CG], KKR [KKR] or Blackstone [BX]. "Hmmm which of these companies pays consistent and attractive dividends with good dividend growth potential?"
Now you're off and running with some potentially very intriguing investment ideas.
There's more. As we saw in a recent post, you can now quite easily find investor letters and 13F filings that offer incredibly useful insights and investment ideas from some of the best hedge funds and investment funds around. You know, all those fatcats out there supposedly rigging the stock market.
Heck, why pay some hedge fund an insane "two and twenty" fee structure (2% of assets and 20% of gains) when you can borrow their ideas for free?
Never stop at the first-order question. Ask the second order question, and always try to engage in second order thinking. It's a lens for looking at reality. Using it helps you think more deeply, and it leads you to opportunity for you and your family.
For further reading:
For much more on the concept of second order thinking, see Howard Mark's book The Most Important Thing.
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Synergies of Being an Investor AND a Consumer
"Consumer brands like Nike, Coca-Cola, or Starbucks all do somewhat similar things: they buy commodities (their raw materials) and sell brands. Nike's shoes and shirts might be nice, but the material isn't all that different than Russell's or Champion's, but you may not have even heard of the latter two companies and you likely have paid a 100% markup or more for Nike gear."
--John Huber, Saber Capital
Readers, the above quote is from a small hedge fund's year-end letter to clients. (Yes, I read letters like these in my spare time. For fun. Sad!)
This quote above, however, helped me crystallize an insight: think like an investor when you're a consumer. When you purchase something, who is on the other side of your trade? And how much money are they making off of you?
After all, savvy investors want to invest wherever there are juicy profit margins. Savvy consumers, on the other hand, buy products where there aren't juicy profit margins. If they want to get good value that is.
Therefore, if you think like an investor whenever you're out there buying stuff, you'll often discover both where not to buy--and where (possibly!) to invest. In other words, wherever you find a highly profitable company charging prices well above intrinsic value, forget buying the product. Buy the stock instead.
A quick final footnote: If you're interested in following various hedge funds and investment letters, and "borrowing" both interesting investing insights and specific stock ideas from many of the world's greatest investors, there's never been a better time than right now. Ten years ago, it was nearly impossible to get access to these letters. I'll offer readers few places to go to find them:
1) ValueWalk offers online access to investor letters from many well-regarded value investors. Some of the site's older, archived content sits behind a paywall.
2) Reddit has a Security Analysis subreddit with a long list of recent investor letters from a wide range of mutual funds and hedge funds.
3) At SeekingAlpha you can follow the changes in holdings of many major hedge funds (via official 13F filings at the SEC). See, for example, changes in Mohnish Pabrai's fund here. (Pabrai is a well-regarded value investor and the author of the exceptionally useful book The Dhandho Investor
.)
--John Huber, Saber Capital
Readers, the above quote is from a small hedge fund's year-end letter to clients. (Yes, I read letters like these in my spare time. For fun. Sad!)
This quote above, however, helped me crystallize an insight: think like an investor when you're a consumer. When you purchase something, who is on the other side of your trade? And how much money are they making off of you?
After all, savvy investors want to invest wherever there are juicy profit margins. Savvy consumers, on the other hand, buy products where there aren't juicy profit margins. If they want to get good value that is.
Therefore, if you think like an investor whenever you're out there buying stuff, you'll often discover both where not to buy--and where (possibly!) to invest. In other words, wherever you find a highly profitable company charging prices well above intrinsic value, forget buying the product. Buy the stock instead.
A quick final footnote: If you're interested in following various hedge funds and investment letters, and "borrowing" both interesting investing insights and specific stock ideas from many of the world's greatest investors, there's never been a better time than right now. Ten years ago, it was nearly impossible to get access to these letters. I'll offer readers few places to go to find them:
1) ValueWalk offers online access to investor letters from many well-regarded value investors. Some of the site's older, archived content sits behind a paywall.
2) Reddit has a Security Analysis subreddit with a long list of recent investor letters from a wide range of mutual funds and hedge funds.
3) At SeekingAlpha you can follow the changes in holdings of many major hedge funds (via official 13F filings at the SEC). See, for example, changes in Mohnish Pabrai's fund here. (Pabrai is a well-regarded value investor and the author of the exceptionally useful book The Dhandho Investor
.)Money Sundays: Productive Worrying
I stumbled onto this insightful quote from Seth Klarman, a well-regarded value investor[1] who I follow (and occasionally even steal from).[2] It offers an interesting perspective on how to think about the things that worry us:
What I like about this quote is how it takes the vague, undifferentiated emotion of worry--an emotion that weakens, distracts and disempowers us--and completely inverts it. The quote gets us to identify specific sources of worry and then (most importantly) it gets us to take positive action to solve those sources of worry.
Voila: we take our power, our agency, back into our own hands.
I'm guessing readers can easily come up with additional applications of the concept of "productive worrying." Here are a few humble examples I thought up on my own:
1) Worried you might not have enough money to fund a happy, healthy retirement? As painfully obvious as it might sound: save more money. Embrace the ideas of people like Jacob Lund Fisker
and Mr. Money Mustache, re-ingest amazingly useful books like Your Money Or Your Life, and crush your expenses and dramatically increase your personal savings rate.
2) Worried that it costs too much to eat well? Pick up some of the easy and healthy (and laughably cheap!) recipes here at Casual Kitchen, or from many other frugal healthy food blogs. Embrace intermittent fasting, and strip a few extra carbs out of your diet for good measure.
3) Worried about the fate of the free world now that candidate X won an election in Country Y? Stop wringing your hands, stop virtue-signalling on Facebook... and instead take actual physical action to help people in the real world. Get out of your circle of concern and get into your circle of control, and ask yourself: what can I do in my own community, among my personal locus of control, to help make the world a better place? And then go and do those things.
Finally, how about a meta-question?
4) Are you worried about the overall level of stress in your life, (essentially) worrying about your worries? Cut back dramatically on your media consumption. Remember: the media is an entire industry that profits by giving us things to worry about or be angry about. Don't give the bastards any more of your time or mental bandwidth. Also: read up on Stoicism. A good place to start is William Irvine's excellent and readable A Guide to the Good Life: The Ancient Art of Stoic Joy.
Readers, what would you add?
Footnotes:
[1] H/T to another value investor I follow, Whitney Tilson, for sharing Klarman's quote with his readers.
[2] A striking, unexpected thing about value investors: many are quite happy to share their ideas and their investing methods--and often for free or nearly free. Consider the free investor letters from Warren Buffett and Charlie Munger, or the insightful books from well-known value investors like Mohnish Pabrai (author of the readable and highly useful The Dhandho Investor) or Joel Greenblatt (author of The Little Book That Beats the Market
).
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
While we believe it is crucial to worry about what can go wrong, unproductive worrying will not and cannot make a difference. Worrying that your favorite team will lose is obviously unproductive. Worrying that you might have an ulcer could even prove counterproductive.
Productive worrying, on the other hand, enables you to identify action that reduces or eliminates the source of concern, often at little or no cost [NB: emphasis added]. Concerned that it might rain? Pack a raincoat and umbrella. Worried you will be late? Leave earlier than originally planned.
Successful investing goes hand in hand with productive worrying. Worried that a stock you hold might fall sharply? Reduce your holdings or buy some puts. Concerned that interest rates may rise or the dollar fall? Establish an appropriate hedge. Worried that the stock you bought on a tip might be a bad idea? Sell it and move on. Worry enough during the day and you can, in fact, sleep justifiably well at night.
All of us are subject to biases that can impair our objectivity in investment decision-making. Striving to overcome these biases is crucial for long-term investment success. Have we been too optimistic in our assumptions? Have we blindly ignored new information because we are clinging too tightly to our original thesis? Have we held onto an investment because it keeps going up, irrationally ignoring that it has become overvalued? Without a healthy dose of reflective worry, we are unlikely even to identify our lapses in judgment, let alone correct them. In other words, only by actively, productively, relentlessly worrying about what can go wrong can we maximize the odds that things will go right, by doing everything within our control to perfect our decision-making. You rarely, if ever, make money from worrying; it does not typically enhance return. But by avoiding loss, you are able to hang on to what you have accumulated, which is a cornerstone of successful investing.
What I like about this quote is how it takes the vague, undifferentiated emotion of worry--an emotion that weakens, distracts and disempowers us--and completely inverts it. The quote gets us to identify specific sources of worry and then (most importantly) it gets us to take positive action to solve those sources of worry.
Voila: we take our power, our agency, back into our own hands.
I'm guessing readers can easily come up with additional applications of the concept of "productive worrying." Here are a few humble examples I thought up on my own:
1) Worried you might not have enough money to fund a happy, healthy retirement? As painfully obvious as it might sound: save more money. Embrace the ideas of people like Jacob Lund Fisker
and Mr. Money Mustache, re-ingest amazingly useful books like Your Money Or Your Life, and crush your expenses and dramatically increase your personal savings rate. 2) Worried that it costs too much to eat well? Pick up some of the easy and healthy (and laughably cheap!) recipes here at Casual Kitchen, or from many other frugal healthy food blogs. Embrace intermittent fasting, and strip a few extra carbs out of your diet for good measure.
3) Worried about the fate of the free world now that candidate X won an election in Country Y? Stop wringing your hands, stop virtue-signalling on Facebook... and instead take actual physical action to help people in the real world. Get out of your circle of concern and get into your circle of control, and ask yourself: what can I do in my own community, among my personal locus of control, to help make the world a better place? And then go and do those things.
Finally, how about a meta-question?
4) Are you worried about the overall level of stress in your life, (essentially) worrying about your worries? Cut back dramatically on your media consumption. Remember: the media is an entire industry that profits by giving us things to worry about or be angry about. Don't give the bastards any more of your time or mental bandwidth. Also: read up on Stoicism. A good place to start is William Irvine's excellent and readable A Guide to the Good Life: The Ancient Art of Stoic Joy.
Readers, what would you add?
Footnotes:
[1] H/T to another value investor I follow, Whitney Tilson, for sharing Klarman's quote with his readers.
[2] A striking, unexpected thing about value investors: many are quite happy to share their ideas and their investing methods--and often for free or nearly free. Consider the free investor letters from Warren Buffett and Charlie Munger, or the insightful books from well-known value investors like Mohnish Pabrai (author of the readable and highly useful The Dhandho Investor
) or Joel Greenblatt (author of The Little Book That Beats the Market
).How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: All-Time Favorite Charlie Munger Quotes
A value investor I follow and respect, Whitney Tilson, recently shared a list of his favorite Charlie Munger quotes in a message to his email subscribers. Charlie Munger, of course, is Warren Buffett's key partner at Berkshire Hathaway, and he is in my view one of history's most insightful (and cantankerous!) investors. I thought the list of quotes and comments below would be useful to Casual Kitchen readers looking to raise their personal investing game. Enjoy!
***************************************
Favorite Charlie Munger quotes, from Whitney Tilson:
• The more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be... So the game is to keep learning.
• What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your experience--both vicarious and direct--on this latticework of models.
• Most people are trained in one model and try to solve all problems in one way. You know the old saying: To the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.
• Our experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. If you took our top 15 decisions out, we’d have a pretty average record.
• As Jesse Livermore said, “The big money is not in the buying and selling…but in the waiting.”
• There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts.
• All I want to know is where I’m going to die, so I’ll never go there.
• No wise pilot, no matter how great his talent and experience, fails to use his checklist.
• In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time--none, zero.
• We have never given a damn whether any quarter’s earnings were up or down. We prefer profits to losses, obviously, but we’re not willing to manipulate in any way just to make some quarter look a little better.
• To say accounting for derivatives in America is a sewer is an insult to sewage.
• We think there should be a huge area between what you’re willing to do and what you can do without significant risk of suffering criminal penalty or causing losses. We believe you shouldn’t go anywhere near that line.
• Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional.
• If you rise in life, you have to behave in a certain way. You can go to a strip club if you’re a beer-swilling sand shoveler, but if you’re the Bishop of Boston, you shouldn’t go.
• Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day, if you live long enough, most people get what they deserve.
Read Next: Money Sundays: Is All That Insurance Really Worth It To You?
Bonus: Money Sundays: Two Easy Rules To Value Insurance Coverage
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
***************************************
Favorite Charlie Munger quotes, from Whitney Tilson:
• The more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be... So the game is to keep learning.
• What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your experience--both vicarious and direct--on this latticework of models.
• Most people are trained in one model and try to solve all problems in one way. You know the old saying: To the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.
• Our experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. If you took our top 15 decisions out, we’d have a pretty average record.
• As Jesse Livermore said, “The big money is not in the buying and selling…but in the waiting.”
• There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts.
• All I want to know is where I’m going to die, so I’ll never go there.
• No wise pilot, no matter how great his talent and experience, fails to use his checklist.
• In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time--none, zero.
• We have never given a damn whether any quarter’s earnings were up or down. We prefer profits to losses, obviously, but we’re not willing to manipulate in any way just to make some quarter look a little better.
• To say accounting for derivatives in America is a sewer is an insult to sewage.
• We think there should be a huge area between what you’re willing to do and what you can do without significant risk of suffering criminal penalty or causing losses. We believe you shouldn’t go anywhere near that line.
• Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional.
• If you rise in life, you have to behave in a certain way. You can go to a strip club if you’re a beer-swilling sand shoveler, but if you’re the Bishop of Boston, you shouldn’t go.
• Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day, if you live long enough, most people get what they deserve.
Read Next: Money Sundays: Is All That Insurance Really Worth It To You?
Bonus: Money Sundays: Two Easy Rules To Value Insurance Coverage
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: How Much Money Do I Need To Retire?
Readers, the following conversation is entirely hypothetical. It hypothetically occurred at a recent (did I mention hypothetical?) social gathering:
“So... how much money, really, does a person need to retire?”
“This is a heavy question, it’s complicated. Are you sure you want the answer?”
“Of course I want the answer! I wouldn’t have asked if I didn’t.”
“Okay. Basically there are three steps. First, you need to know how much you spend per year. And I don’t mean ‘know’ in the ‘I vaguely know, sort of’ sense. I mean knowing it with a great degree of precision.
“Sure. Okay.”
“In my experience, this question by itself stops about half of all people in their tracks, this alone is too much for them.”
“Well, right now I’m putting one of my kids through college and the other kid is about to start.”
“Great! You’ll still want to know exactly what your expenses are, and then you can simply normalize them for what they would be when you’re done putting your kids through school. Make sense?”
She nodded.
“Okay, the next step is to think about what quantity of capital will produce a sustainable level of income that covers your expenses. You do this by using what I call The Magic 4% Number.”
“Magic four percent? Sounds interesting.”
“Four percent is generally regarded as a safe annual withdrawal rate for a diversified investment portfolio such that you are almost guaranteed to never run out of capital. This just means that 4% is what you can take out of your investments each year to support your retirement and remain highly confident that you’ll never run out of money.”
“So I can take out 4% of my investments every year.”
“Basically yes. So if you think about it, you just have a simple math problem now. You know--or you should know--your expense line each year. You therefore simply calculate what amount of capital, times 0.04, produces that level of income. See? Or in other words, take your expense line, divide by 0.04, and that gives you the amount of capital you will need. Oh, wait: remember a moment ago when I said that about half of people check out the second they find out they need to know their expenses with a great degree of precision? This, here, is where everybody else checks out.”
“I’m not checking out, I really want to know this stuff.”
“Well, just giving you a friendly warning. So, another way to think about this ‘Magic 4% Number’ is this: It means you’ll need total investment capital equal to 25 times your annual expenses in order to have enough money to retire.
“Wait, what? Twenty-five times my annual expenses? Twenty-five times? How’s that work?”
“Yep. Four percent is one twenty-fifth of something. If you can spend four percent of your capital in any given year, your total capital has to be twenty five times your annual expenses.
[Pauses, blank stare] “Oh.”
“A lot of times it helps to use a simple example. So let’s say you have a million dollars in investments, say, in various diversified low fee index funds or whatever. You can therefore spend about 4% per year, or $40,000. Forty grand is one twenty-fifth of one million. By the way, this is where most people politely excuse themselves and go talk about something else, anything else, with anyone else. You’re still here! That’s a sign of courage.”
[Looking around] “Yeah, I guess.”
“Well, the rest of this just boils down to what numbers you choose, and the degree of psychological agency and personal power you’re willing to take. There are usually two types of responses people have here. Most people, once they’re confronted with the idea that they need to save, invest and amass capital that equals 25 times their annual expense line, suddenly start spinning their inner mental hamster wheel. They start disputing the numbers or the math, or they claim they don’t really want to be so preoccupied with money, or whatever. Basically they just give pushback--”
[Interrupts] “I would never do that!”
“Great. Nice to hear it. Perhaps you’re in the latter group then. A small fraction of people at this point have a moment of clarity. They realize that this 25 times (or 4% number) means that they have an enormous responsibility to think clearly and carefully about what they spend their money on. They begin to realize, with genuine clarity, that they can adjust their expenses to a wide range of levels, and doing so has an enormous impact on the amount of retirement capital they will ultimately need.”
[Glancing around] “Mmm hmm.”
“They also start to see things differently. For example: monthly recurring expenses, like a car lease, a mortgage payment, or a big cable TV bill, when looked at through this 25 times/4% lens, suddenly start to look like gigantic wastes of money.”
“Wait, what do you mean?”
“Well, think about the amount of capital it takes to fund, say a $400 a month car lease--I mean, that’s $4,800 a year, so divided by 0.04 or times 25, that works out to $120,000 in required capital just to pay $400 a month. This car lease, which previously seemed like not that big a deal, suddenly becomes more clear: it lays a claim on all of the output of a hundred and twenty grand of capital.”
“Huh. I never thought about it that way.”
“Yeah, a $400 car lease and a $200 cable bill start to look a lot different all of a sudden, right? To say nothing of interest payments on credit card debt and other regular, recurring spending that doesn’t really satisfy any real, genuine needs. All of these things just seem a lot less worth it, particularly when they do nothing but lock you in to working for longer, perhaps many years longer.
[Glancing around again] “Mmmm. Right.”
“What this does is give people some serious clarity on differentiating between needs and wants, on actively choosing their spending level, and not letting it be set passively by their needs for social competition or identity construction. Basically it gives you a real shot at being empowered in this entire domain, on really having a mature conception of what’s really important when it comes to financially protecting your family over the long term.”
[Glancing around, this time more nervously] “Uh huh. Well! I see my friend over there. Thanks for all that! Really interesting.”
Read Next: Casual Kitchen's in-depth, chapter-by-chapter analysis of Your Money or Your Life
And: A Cup of Morning Death? How "Big Coffee" Puts Profits Before People
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
“So... how much money, really, does a person need to retire?”
“This is a heavy question, it’s complicated. Are you sure you want the answer?”
“Of course I want the answer! I wouldn’t have asked if I didn’t.”
“Okay. Basically there are three steps. First, you need to know how much you spend per year. And I don’t mean ‘know’ in the ‘I vaguely know, sort of’ sense. I mean knowing it with a great degree of precision.
“Sure. Okay.”
“In my experience, this question by itself stops about half of all people in their tracks, this alone is too much for them.”
“Well, right now I’m putting one of my kids through college and the other kid is about to start.”
“Great! You’ll still want to know exactly what your expenses are, and then you can simply normalize them for what they would be when you’re done putting your kids through school. Make sense?”
She nodded.
“Okay, the next step is to think about what quantity of capital will produce a sustainable level of income that covers your expenses. You do this by using what I call The Magic 4% Number.”
“Magic four percent? Sounds interesting.”
“Four percent is generally regarded as a safe annual withdrawal rate for a diversified investment portfolio such that you are almost guaranteed to never run out of capital. This just means that 4% is what you can take out of your investments each year to support your retirement and remain highly confident that you’ll never run out of money.”
“So I can take out 4% of my investments every year.”
“Basically yes. So if you think about it, you just have a simple math problem now. You know--or you should know--your expense line each year. You therefore simply calculate what amount of capital, times 0.04, produces that level of income. See? Or in other words, take your expense line, divide by 0.04, and that gives you the amount of capital you will need. Oh, wait: remember a moment ago when I said that about half of people check out the second they find out they need to know their expenses with a great degree of precision? This, here, is where everybody else checks out.”
“I’m not checking out, I really want to know this stuff.”
“Well, just giving you a friendly warning. So, another way to think about this ‘Magic 4% Number’ is this: It means you’ll need total investment capital equal to 25 times your annual expenses in order to have enough money to retire.
“Wait, what? Twenty-five times my annual expenses? Twenty-five times? How’s that work?”
“Yep. Four percent is one twenty-fifth of something. If you can spend four percent of your capital in any given year, your total capital has to be twenty five times your annual expenses.
[Pauses, blank stare] “Oh.”
“A lot of times it helps to use a simple example. So let’s say you have a million dollars in investments, say, in various diversified low fee index funds or whatever. You can therefore spend about 4% per year, or $40,000. Forty grand is one twenty-fifth of one million. By the way, this is where most people politely excuse themselves and go talk about something else, anything else, with anyone else. You’re still here! That’s a sign of courage.”
[Looking around] “Yeah, I guess.”
“Well, the rest of this just boils down to what numbers you choose, and the degree of psychological agency and personal power you’re willing to take. There are usually two types of responses people have here. Most people, once they’re confronted with the idea that they need to save, invest and amass capital that equals 25 times their annual expense line, suddenly start spinning their inner mental hamster wheel. They start disputing the numbers or the math, or they claim they don’t really want to be so preoccupied with money, or whatever. Basically they just give pushback--”
[Interrupts] “I would never do that!”
“Great. Nice to hear it. Perhaps you’re in the latter group then. A small fraction of people at this point have a moment of clarity. They realize that this 25 times (or 4% number) means that they have an enormous responsibility to think clearly and carefully about what they spend their money on. They begin to realize, with genuine clarity, that they can adjust their expenses to a wide range of levels, and doing so has an enormous impact on the amount of retirement capital they will ultimately need.”
[Glancing around] “Mmm hmm.”
“They also start to see things differently. For example: monthly recurring expenses, like a car lease, a mortgage payment, or a big cable TV bill, when looked at through this 25 times/4% lens, suddenly start to look like gigantic wastes of money.”
“Wait, what do you mean?”
“Well, think about the amount of capital it takes to fund, say a $400 a month car lease--I mean, that’s $4,800 a year, so divided by 0.04 or times 25, that works out to $120,000 in required capital just to pay $400 a month. This car lease, which previously seemed like not that big a deal, suddenly becomes more clear: it lays a claim on all of the output of a hundred and twenty grand of capital.”
“Huh. I never thought about it that way.”
“Yeah, a $400 car lease and a $200 cable bill start to look a lot different all of a sudden, right? To say nothing of interest payments on credit card debt and other regular, recurring spending that doesn’t really satisfy any real, genuine needs. All of these things just seem a lot less worth it, particularly when they do nothing but lock you in to working for longer, perhaps many years longer.
[Glancing around again] “Mmmm. Right.”
“What this does is give people some serious clarity on differentiating between needs and wants, on actively choosing their spending level, and not letting it be set passively by their needs for social competition or identity construction. Basically it gives you a real shot at being empowered in this entire domain, on really having a mature conception of what’s really important when it comes to financially protecting your family over the long term.”
[Glancing around, this time more nervously] “Uh huh. Well! I see my friend over there. Thanks for all that! Really interesting.”
Read Next: Casual Kitchen's in-depth, chapter-by-chapter analysis of Your Money or Your Life
And: A Cup of Morning Death? How "Big Coffee" Puts Profits Before People
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: A Few Brief Thoughts on Risk Tolerance
"Risk tolerance" is one of those financial euphemisms many people toss around without fully understanding. In almost every instance, people actually do not know their risk tolerance until it's too late.
Here's what's more typical: an investor thinks he knows his risk tolerance, and then has his investments cut in half during a 2008/2009-type stock market correction. Then and only then, he realizes that his risk tolerance was way, way lower than he thought it was. This is a classic setup for an overconfident investor who gets blasted out of stocks at market bottoms.
I don't care who you are: your risk tolerance is lower than you think it is. The time to realize this, however, is before a market correction.
Read Next: Money Sundays: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Here's what's more typical: an investor thinks he knows his risk tolerance, and then has his investments cut in half during a 2008/2009-type stock market correction. Then and only then, he realizes that his risk tolerance was way, way lower than he thought it was. This is a classic setup for an overconfident investor who gets blasted out of stocks at market bottoms.
I don't care who you are: your risk tolerance is lower than you think it is. The time to realize this, however, is before a market correction.
Read Next: Money Sundays: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: How To Invest During Stock Market Corrections
Readers, this is a post I wrote up for my Facebook feed during another heavy stock market selloff a few years ago. Given the recent stock market correction, I thought I'd share it here, edited and updated slightly.
*****************************
I've been asked by a few people how I invest personally during truly bad stock market environments--uh, for example, like the current one. I thought I'd put together a note to share my process with readers, particularly those readers looking to become more sophisticated investors. Thoughts, reactions and feedback are welcome!
Before we get started, please keep in mind these caveats:
a) Your mileage may vary.
b) I give bad advice sometimes.
c) Do not fixate on the specific dollar amounts discussed below, and do not compare your financial situation favorably or unfavorably to them. View the numbers as mere examples to illustrate a process, nothing more.
d) No yes-butting.
Okay--here's my process:
1) First, make sure you have--at a minimum--two years' worth of expenses saved somewhere in an emergency fund that is totally separate from money you intend to put into the market. If you are worried about your job, are retired, or you don't have any alternate income sources, make that FIVE years' worth of expenses. If you can't meet this test, forget about investing in stocks. You need to save more money first.
1a) You cannot be fully invested now. If you are, you've already screwed up. You need to have additional cash available beyond the money in your emergency fund and beyond the stocks you already own.
2) Create a "shopping list" of dividend-paying stocks that you would like to own, with an investment holding time frame of 5-15 years (yes, I'm serious. Five to fifteen years). Diversify across sectors, choose leading companies, look for dividend yields of 2.5% to 5.0% depending on the sector. Consider including one highly-regarded, dividend-paying bank and one highly-regarded, dividend paying industrial company. When heading into a market downturn, you always want to have a shopping list ready and waiting with buy ideas.
3) Next, choose stock market levels at which you will gradually put your money to work. For me, I choose arbitrary levels of the Dow Jones Industrial Average: 16,000, 15,000, 14,000, 13,000, etc. Allocate your non-emergency cash in fixed and smallish amounts at each level as the market breaches those levels. You can choose other market benchmarks if you prefer, or choose levels of the stock market of your own home country.
What works for me is to create six or seven stock market levels. As the first few levels are breached, I put 5-10% of my cash to work. At progressively lower levels, I invest larger and larger portions of that cash. Continue this process as the market continues to fall.
Let's go over an example: Let's say you have $50,000 in cash (again, this in addition to your emergency fund) that you would like to put to work in the stock market (edit: once again, don't get hung up on this specific dollar amount or compare your available cash amount favorably or unfavorably to it, just consider it as an example). Thus at the Dow 16,000 level (uh, like last Friday), put ~$2-3k to work by buying shares of one or two stocks on your list. At Dow 15,000 do the same: invest another ~$3k in a couple of other stocks from your shopping list. At Dow 14,000, put $5-6k to work into 2-3 stocks. At Dow 13,000 another $5-6k. At Dow 12,000, put $7-10k to work, at Dow 11,000 another $7-10k. And so on.
You can see how as the market gets lower and lower, this process forces you to gradually commit larger and larger sums of fresh capital. If we really head into a serious shitshow, and the Dow breaches, say 10,000 (this would represent an enormous correction of nearly 50%), you will have only put about $25,000-$30,000 of your $50,000 in capital to work. Yes, you will have bought all the way down, but you will still have substantial available money to continue buying at market levels that will probably be at or close to a bottom.
A few final notes: Using this process, you will be separated from your money, at first, during any really big market crash, but it will protect you from committing too much capital too soon. Further, if the market recovers, doesn't crash, and never breaches these lower levels, you'll have automatically put at least some of your capital to work at relatively attractive prices--certainly better prices than anything the market's been offering investors over the past several months.
A few words on fear and emotion. No one ever said this game was easy. Even when you do have excess cash available to put to work at very low market levels, the palpable fear you and other investors will feel still makes it very difficult to actually put that money to work. Be ready for this, and keep extra pairs of underwear handy at all times. Rely on the discipline of this process to help you overcome fear and panic, and you will make investments that--in several years--you'll be ecstatic you made.
Most investors are either too arrogant or too fearful. Some of us think we can nail the bottom, others panic and can't help but get in and out at at exactly the wrong times. This process is based on accepting, with fundamental humility, that you cannot know the future, nor can you know where or when the market will bottom. It may bottom much lower or much higher than you think. This process will help you put modest amounts of money to work on the way down, and yet you will hold back extra cash in case things are far worse than you expected.
Finally, this process is guaranteed to prevent you from making the standard retail investor mistake of getting sucked into stock markets at the peaks of bull markets and then getting shaken out at the bottom of bear markets. This method insures that you gradually step deeper and deeper into the market at juicier and juicier prices.
Make sure you are always liquid and in a position to deal from strength as the market declines. Nobody ever made a dime panicking, and you can't make good investment decisions if you are already fully invested in a falling stock market.
Read Next: Recommended Investing Books and Becoming a Knowledgeable and Sophisticated Investor: Six Tips
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
*****************************
I've been asked by a few people how I invest personally during truly bad stock market environments--uh, for example, like the current one. I thought I'd put together a note to share my process with readers, particularly those readers looking to become more sophisticated investors. Thoughts, reactions and feedback are welcome!
Before we get started, please keep in mind these caveats:
a) Your mileage may vary.
b) I give bad advice sometimes.
c) Do not fixate on the specific dollar amounts discussed below, and do not compare your financial situation favorably or unfavorably to them. View the numbers as mere examples to illustrate a process, nothing more.
d) No yes-butting.
Okay--here's my process:
1) First, make sure you have--at a minimum--two years' worth of expenses saved somewhere in an emergency fund that is totally separate from money you intend to put into the market. If you are worried about your job, are retired, or you don't have any alternate income sources, make that FIVE years' worth of expenses. If you can't meet this test, forget about investing in stocks. You need to save more money first.
1a) You cannot be fully invested now. If you are, you've already screwed up. You need to have additional cash available beyond the money in your emergency fund and beyond the stocks you already own.
2) Create a "shopping list" of dividend-paying stocks that you would like to own, with an investment holding time frame of 5-15 years (yes, I'm serious. Five to fifteen years). Diversify across sectors, choose leading companies, look for dividend yields of 2.5% to 5.0% depending on the sector. Consider including one highly-regarded, dividend-paying bank and one highly-regarded, dividend paying industrial company. When heading into a market downturn, you always want to have a shopping list ready and waiting with buy ideas.
3) Next, choose stock market levels at which you will gradually put your money to work. For me, I choose arbitrary levels of the Dow Jones Industrial Average: 16,000, 15,000, 14,000, 13,000, etc. Allocate your non-emergency cash in fixed and smallish amounts at each level as the market breaches those levels. You can choose other market benchmarks if you prefer, or choose levels of the stock market of your own home country.
What works for me is to create six or seven stock market levels. As the first few levels are breached, I put 5-10% of my cash to work. At progressively lower levels, I invest larger and larger portions of that cash. Continue this process as the market continues to fall.
Let's go over an example: Let's say you have $50,000 in cash (again, this in addition to your emergency fund) that you would like to put to work in the stock market (edit: once again, don't get hung up on this specific dollar amount or compare your available cash amount favorably or unfavorably to it, just consider it as an example). Thus at the Dow 16,000 level (uh, like last Friday), put ~$2-3k to work by buying shares of one or two stocks on your list. At Dow 15,000 do the same: invest another ~$3k in a couple of other stocks from your shopping list. At Dow 14,000, put $5-6k to work into 2-3 stocks. At Dow 13,000 another $5-6k. At Dow 12,000, put $7-10k to work, at Dow 11,000 another $7-10k. And so on.
You can see how as the market gets lower and lower, this process forces you to gradually commit larger and larger sums of fresh capital. If we really head into a serious shitshow, and the Dow breaches, say 10,000 (this would represent an enormous correction of nearly 50%), you will have only put about $25,000-$30,000 of your $50,000 in capital to work. Yes, you will have bought all the way down, but you will still have substantial available money to continue buying at market levels that will probably be at or close to a bottom.
A few final notes: Using this process, you will be separated from your money, at first, during any really big market crash, but it will protect you from committing too much capital too soon. Further, if the market recovers, doesn't crash, and never breaches these lower levels, you'll have automatically put at least some of your capital to work at relatively attractive prices--certainly better prices than anything the market's been offering investors over the past several months.
A few words on fear and emotion. No one ever said this game was easy. Even when you do have excess cash available to put to work at very low market levels, the palpable fear you and other investors will feel still makes it very difficult to actually put that money to work. Be ready for this, and keep extra pairs of underwear handy at all times. Rely on the discipline of this process to help you overcome fear and panic, and you will make investments that--in several years--you'll be ecstatic you made.
Most investors are either too arrogant or too fearful. Some of us think we can nail the bottom, others panic and can't help but get in and out at at exactly the wrong times. This process is based on accepting, with fundamental humility, that you cannot know the future, nor can you know where or when the market will bottom. It may bottom much lower or much higher than you think. This process will help you put modest amounts of money to work on the way down, and yet you will hold back extra cash in case things are far worse than you expected.
Finally, this process is guaranteed to prevent you from making the standard retail investor mistake of getting sucked into stock markets at the peaks of bull markets and then getting shaken out at the bottom of bear markets. This method insures that you gradually step deeper and deeper into the market at juicier and juicier prices.
Make sure you are always liquid and in a position to deal from strength as the market declines. Nobody ever made a dime panicking, and you can't make good investment decisions if you are already fully invested in a falling stock market.
Read Next: Recommended Investing Books and Becoming a Knowledgeable and Sophisticated Investor: Six Tips
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: In Investing, Be Able to Argue Both Sides
Readers, take a look at the following quote from Decisive
by Chip and Dan Heath:
Imagine walking into a courtroom where the trial consists of a prosecutor presenting PowerPoint slides. In 20 pretty compelling charts, he demonstrates why the defendant is guilty. The judge then challenges some of the facts of the presentation, but the prosecutor has a good answer to every objection. So the judge decides, and the accused man is sentenced.
That wouldn’t be due process, right? So if you would find this process shocking in a courtroom, why is it acceptable when you make an investment decision?
This courtroom analogy for investing is incredibly helpful, and it offers us a couple of useful insights.
First, it’s a window into how most people invest. They more or less form a decision first, then amass facts to support it, and then--if they’re lucky--they might challenge a few minor facts, mainly to satisfy their ego’s need to be viewed as a judicious decision-maker. Not unlike the pseudo-judiciousness in the “20 pretty compelling charts” example above.[1]
Second, this quote indirectly teaches one of the key secrets to investing, and it’s this: you must be able to argue both sides of any decision such that the arguments are equally compelling. You simply must. You want to buy XYZ stock? Make a list of the reasons why, record them in your investing journal, and then make an even longer list of reasons why not to buy XYZ stock.
And if you can’t come up with that many reasons, you’re not trying hard enough.
Use this exercise at every stage of your investment decision-making. Which sector of the stock market (dividend-paying consumer products stocks, technology stocks, industrial stocks, etc.) would I like to invest in? Should I invest in individual stocks or low-fee index funds? Or, more foundationally: should I invest in the stock market at all? Make a list of reasons why, and a longer list of reasons why not.
Why does this technique work? Two reasons. First, when good reasons to own a stock are known, those reasons are generally already accounted for in the price. And second, when it seems like a bad time to invest in stocks, it usually isn’t.[2]
Which brings us to another important insight. There’s never an all-clear sign for any specific stock market decision. The coast is never clear.
Wait, I take that back! I can think of two examples when the coast was clear.
The coast was “clear” for owning tech stocks back in late 1999/early 2000. And the coast was “clear” for owning single family homes and residential real estate in 2006/2007. Both of those investment themes worked out great, didn’t they?
Didn’t they?
Money coming out of the wazoo
Once again, it’s not just that investments tend to work out badly when the coast seems clear. It’s also that investments work out well when the reasons against them are both known and properly feared. When everybody’s a fan of, say, tech stocks, everybody will already be invested in them. When everyone’s already in these stocks, who’s left to buy? Likewise: if everybody hates tech stocks (say in mid-2002 when revulsion against the sector was at all-time highs and prices were at lows) only a few brave contrary thinkers were invested in the sector.
Who do you think's going to have good investment results here?
All of this tells you something extraordinarily valuable about investing. If you don't want the stock market to separate you from your money, you have to talk to people. You have to get a sense of what people are doing, where their thinking is. Readers of a certain age should be able to remember the craziness of the waning days of the late 90s when there were constant discount brokerage ads on TV featuring characters like tow-truck drivers so wealthy from daytrading that they could buy their own islands. Back then, when nearly everybody was talking about the tech stocks they owned, ads with slogans like “he’s got money coming out of the wazoo” were widely seen as funny. Or worse, true.
Today, they are cringe-worthy. Horrendous.
When your barber and tow-truck driver and most of your friends and neighbors are daytrading their accounts and they can’t shut up about it, that’s a warning. A big one.
Interestingly, right now, not all that many people are talking all that much about stock market investing.
Who’s on the other side of your trade?
Let’s tie all this back to our concept of arguing both sides of an investment decision. If you are so brilliant to arrive at a decision to buy a stock, and if that decision to buy is so airtight and ego-satisfying (think back on those 20 pretty compelling charts), why would anybody sell it to you? Obviously, somebody has to sell to you or there’d be no stock for sale in the first place.
So what about that guy, the one taking the other side of your trade? What's he thinking?
Roll this idea over in your mind for a moment. Do you really think you’re smarter than that guy?[3] Stroll down this avenue of inquiry even for just a few minutes and it quickly makes you very, very humble about being right. Even if you have a stack of PowerPoint slides justifying your position.
I’ll close with one final thought. Think of the universe as containing two taxonomies of information:
1) Facts that support your opinion
2) Facts that do not support your opinion
Cultivate the ability to seek the second of these two items and you will go very far as an investor.
Footnotes:
[1] Many of you reading probably think you don't do this. And you certainly wouldn't be the kind of person who gets played by your ego into settling for "pseudo-judiciousness." Except you do. We all do. And professional investors do this too--in fact they’re often the worst offenders precisely because they think they’re above doing it. There’s a huge insight right there about why investors must cultivate humility to be successful.
[2] Hence the stock market expression “the market climbs a wall of worry.”
[3] Warren Buffett had an even better expression for this: “If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.”
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
by Chip and Dan Heath:Imagine walking into a courtroom where the trial consists of a prosecutor presenting PowerPoint slides. In 20 pretty compelling charts, he demonstrates why the defendant is guilty. The judge then challenges some of the facts of the presentation, but the prosecutor has a good answer to every objection. So the judge decides, and the accused man is sentenced.
That wouldn’t be due process, right? So if you would find this process shocking in a courtroom, why is it acceptable when you make an investment decision?
This courtroom analogy for investing is incredibly helpful, and it offers us a couple of useful insights.
First, it’s a window into how most people invest. They more or less form a decision first, then amass facts to support it, and then--if they’re lucky--they might challenge a few minor facts, mainly to satisfy their ego’s need to be viewed as a judicious decision-maker. Not unlike the pseudo-judiciousness in the “20 pretty compelling charts” example above.[1]
Second, this quote indirectly teaches one of the key secrets to investing, and it’s this: you must be able to argue both sides of any decision such that the arguments are equally compelling. You simply must. You want to buy XYZ stock? Make a list of the reasons why, record them in your investing journal, and then make an even longer list of reasons why not to buy XYZ stock.
And if you can’t come up with that many reasons, you’re not trying hard enough.
Use this exercise at every stage of your investment decision-making. Which sector of the stock market (dividend-paying consumer products stocks, technology stocks, industrial stocks, etc.) would I like to invest in? Should I invest in individual stocks or low-fee index funds? Or, more foundationally: should I invest in the stock market at all? Make a list of reasons why, and a longer list of reasons why not.
Why does this technique work? Two reasons. First, when good reasons to own a stock are known, those reasons are generally already accounted for in the price. And second, when it seems like a bad time to invest in stocks, it usually isn’t.[2]
Which brings us to another important insight. There’s never an all-clear sign for any specific stock market decision. The coast is never clear.
Wait, I take that back! I can think of two examples when the coast was clear.
The coast was “clear” for owning tech stocks back in late 1999/early 2000. And the coast was “clear” for owning single family homes and residential real estate in 2006/2007. Both of those investment themes worked out great, didn’t they?
Didn’t they?
Money coming out of the wazoo
Once again, it’s not just that investments tend to work out badly when the coast seems clear. It’s also that investments work out well when the reasons against them are both known and properly feared. When everybody’s a fan of, say, tech stocks, everybody will already be invested in them. When everyone’s already in these stocks, who’s left to buy? Likewise: if everybody hates tech stocks (say in mid-2002 when revulsion against the sector was at all-time highs and prices were at lows) only a few brave contrary thinkers were invested in the sector.
Who do you think's going to have good investment results here?
All of this tells you something extraordinarily valuable about investing. If you don't want the stock market to separate you from your money, you have to talk to people. You have to get a sense of what people are doing, where their thinking is. Readers of a certain age should be able to remember the craziness of the waning days of the late 90s when there were constant discount brokerage ads on TV featuring characters like tow-truck drivers so wealthy from daytrading that they could buy their own islands. Back then, when nearly everybody was talking about the tech stocks they owned, ads with slogans like “he’s got money coming out of the wazoo” were widely seen as funny. Or worse, true.
Today, they are cringe-worthy. Horrendous.
When your barber and tow-truck driver and most of your friends and neighbors are daytrading their accounts and they can’t shut up about it, that’s a warning. A big one.
Interestingly, right now, not all that many people are talking all that much about stock market investing.
Who’s on the other side of your trade?
Let’s tie all this back to our concept of arguing both sides of an investment decision. If you are so brilliant to arrive at a decision to buy a stock, and if that decision to buy is so airtight and ego-satisfying (think back on those 20 pretty compelling charts), why would anybody sell it to you? Obviously, somebody has to sell to you or there’d be no stock for sale in the first place.
So what about that guy, the one taking the other side of your trade? What's he thinking?
Roll this idea over in your mind for a moment. Do you really think you’re smarter than that guy?[3] Stroll down this avenue of inquiry even for just a few minutes and it quickly makes you very, very humble about being right. Even if you have a stack of PowerPoint slides justifying your position.
I’ll close with one final thought. Think of the universe as containing two taxonomies of information:
1) Facts that support your opinion
2) Facts that do not support your opinion
Cultivate the ability to seek the second of these two items and you will go very far as an investor.
Footnotes:
[1] Many of you reading probably think you don't do this. And you certainly wouldn't be the kind of person who gets played by your ego into settling for "pseudo-judiciousness." Except you do. We all do. And professional investors do this too--in fact they’re often the worst offenders precisely because they think they’re above doing it. There’s a huge insight right there about why investors must cultivate humility to be successful.
[2] Hence the stock market expression “the market climbs a wall of worry.”
[3] Warren Buffett had an even better expression for this: “If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.”
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: Lessons from the Stock Market Crash
Readers, this is a post I wrote way back in late 2008 for a now-defunct website called Helium.com. Ironically (and not due to any brilliance on my part), the lessons and insights here are probably more valuable now than they were when I wrote it. I hope you find it useful.
***************************
With most global stock markets down 30-50% year to date, and many individual investment accounts down even more than that, now is a particularly good time to see if there are any lessons we can learn from a period that, quite frankly, has been an awful experience for almost all investors. Here are seven lessons to take away from the recent stock market crash:
1) Always be liquid
No matter how good things may seem in the market, and no matter how confident you are in your future, always keep a healthy amount of liquid assets available at all times. These assets can be in the form of cash, short-term CDs or money market funds. Ideally, this money should be in addition to a fully funded 6-12 month emergency fund. You never know when you might need extra capital for an attractive investment opportunity, to fund a large unplanned liability, or to support your family during an unexpected period of unemployment. And most importantly, you never want to be in a position where you are forced to sell your long-term investment assets during a severe market correction.
How much liquidity is the right amount? A good rule of thumb is to keep 20-30% of your investment capital in risk-free, shorter-term interest bearing investments. I also suggest people keep up to two years of expenses in readily available, liquid form.
2) Avoid catastrophic losses at all costs
If you happen to suffer losses of 50% in a mutual fund or in your retirement account (something not uncommon to many investors in 2008), a curious thing happens: in order to get back to even, you will need to double your money. And assuming an average annual return of 7% (which is looking more and more like an optimistic assumption for stock market returns going forward), doubling your money will take you roughly ten years of compounding time.
Recognize that it can take many years to claw back to break even after heavy losses. When you decide what percent of your investment dollars to allocate to stocks, particularly when you are nearing retirement age, keep this concept in the very front of your mind. During certain periods of an investor's life, stocks can be far riskier than you might think.
3) Any stock can go to zero (or close)
Before the crisis, it would have seemed laughable that a company like AIG, trading at above $70 a share with all of its enormous competitive and economic advantages, could have close brush with annihilation and have its stock nearly wiped out. And yet that is exactly what happened: the stock is down 97% from its all time high and the company's prospects are permanently impaired.
Unfortunately, this isn't as unusual an occurrence as it may seem, especially during severe bear markets. So far in 2008 alone, several airlines, a number of retailers (including Circuit City and Linens'N' Things) and more than 20 financial companies (including major names like Lehman Brothers, Bear Stearns and WaMu Bank) fell into bankruptcy. And in each of these cases, stockholders were left either with nothing or very close to nothing. As a stockholder, you are the first to be wiped out if a serious event occurs to a company in which you hold stock. Respect this fundamental risk inherent in owning stocks.
4) However, don’t let this scare you away from stocks
Are you wondering how I can talk about stocks going to zero in one breath and then encourage you to own them in the next? The reason is that you will never earn large investment gains over the long term by investing in bonds or bank CDs. Just be sure to recognize the risks involved in stock investing, especially during severe bear markets, and allocate your money to this asset class accordingly. And always remember one of the most important and ironic truths of investing: asset classes that are hated by investors now typically outperform in future periods. [Edit: note also the converse of this statement: asset classes loved by investors now typically underperform in future periods.]
5) Don’t limit yourself to “long only”
Most people invest in the stock market by owning mutual funds or holding shares in individual stocks. There's a fundamental problem with this: "long-only" investment vehicles like these only enrich investors during rising markets. I encourage you to add other investing tools to your investment toolbox so you can profit during all kinds of markets. Read up and learn how to short stocks. Learn how stock options work. Start small and gradually develop experience with these other types of investments, and you will become an all-weather investor.
6) Stay humble. Respect the unpredictable nature of the market
The sectors, markets and companies that may seem like great investment opportunities today quite often end up being grave disappointments to investors who follow the herd. Remember tech stocks in 1999? Or real estate in 2006? [Edit: Or oil stocks in 2013?] They seemed like great sectors at the time.
Markets can be highly counterintuitive, and risks are often only visible after the fact. Try to avoid consensus investment thinking, and don't fixate on the risks that are obvious to investors today. Instead, train yourself to anticipate what risks investors are likely to think about in the future.
7) Save more
I apologize for closing this essay with such an unpalatable final piece of advice, but the easiest way to make up for investment losses is to increase your personal savings. Most investors will need a combination of investment returns and aggressive savings to reach their financial goals, whether those goals are early retirement, a certain level of net worth, or a college fund for a young child. When your investment returns have been below your expectations, you can make up the difference by spending less of your income and allocating the extra savings to these longer-term goals.
We may live in a society that collectively saves and invests very little of its discretionary money, but if you save aggressively, take prudent risks, and remain mindful of the various strengths and weaknesses of stocks as an asset class, you will achieve your financial goals. Good luck!
Read Next: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
***************************
With most global stock markets down 30-50% year to date, and many individual investment accounts down even more than that, now is a particularly good time to see if there are any lessons we can learn from a period that, quite frankly, has been an awful experience for almost all investors. Here are seven lessons to take away from the recent stock market crash:
1) Always be liquid
No matter how good things may seem in the market, and no matter how confident you are in your future, always keep a healthy amount of liquid assets available at all times. These assets can be in the form of cash, short-term CDs or money market funds. Ideally, this money should be in addition to a fully funded 6-12 month emergency fund. You never know when you might need extra capital for an attractive investment opportunity, to fund a large unplanned liability, or to support your family during an unexpected period of unemployment. And most importantly, you never want to be in a position where you are forced to sell your long-term investment assets during a severe market correction.
How much liquidity is the right amount? A good rule of thumb is to keep 20-30% of your investment capital in risk-free, shorter-term interest bearing investments. I also suggest people keep up to two years of expenses in readily available, liquid form.
2) Avoid catastrophic losses at all costs
If you happen to suffer losses of 50% in a mutual fund or in your retirement account (something not uncommon to many investors in 2008), a curious thing happens: in order to get back to even, you will need to double your money. And assuming an average annual return of 7% (which is looking more and more like an optimistic assumption for stock market returns going forward), doubling your money will take you roughly ten years of compounding time.
Recognize that it can take many years to claw back to break even after heavy losses. When you decide what percent of your investment dollars to allocate to stocks, particularly when you are nearing retirement age, keep this concept in the very front of your mind. During certain periods of an investor's life, stocks can be far riskier than you might think.
3) Any stock can go to zero (or close)
Before the crisis, it would have seemed laughable that a company like AIG, trading at above $70 a share with all of its enormous competitive and economic advantages, could have close brush with annihilation and have its stock nearly wiped out. And yet that is exactly what happened: the stock is down 97% from its all time high and the company's prospects are permanently impaired.
Unfortunately, this isn't as unusual an occurrence as it may seem, especially during severe bear markets. So far in 2008 alone, several airlines, a number of retailers (including Circuit City and Linens'N' Things) and more than 20 financial companies (including major names like Lehman Brothers, Bear Stearns and WaMu Bank) fell into bankruptcy. And in each of these cases, stockholders were left either with nothing or very close to nothing. As a stockholder, you are the first to be wiped out if a serious event occurs to a company in which you hold stock. Respect this fundamental risk inherent in owning stocks.
4) However, don’t let this scare you away from stocks
Are you wondering how I can talk about stocks going to zero in one breath and then encourage you to own them in the next? The reason is that you will never earn large investment gains over the long term by investing in bonds or bank CDs. Just be sure to recognize the risks involved in stock investing, especially during severe bear markets, and allocate your money to this asset class accordingly. And always remember one of the most important and ironic truths of investing: asset classes that are hated by investors now typically outperform in future periods. [Edit: note also the converse of this statement: asset classes loved by investors now typically underperform in future periods.]
5) Don’t limit yourself to “long only”
Most people invest in the stock market by owning mutual funds or holding shares in individual stocks. There's a fundamental problem with this: "long-only" investment vehicles like these only enrich investors during rising markets. I encourage you to add other investing tools to your investment toolbox so you can profit during all kinds of markets. Read up and learn how to short stocks. Learn how stock options work. Start small and gradually develop experience with these other types of investments, and you will become an all-weather investor.
6) Stay humble. Respect the unpredictable nature of the market
The sectors, markets and companies that may seem like great investment opportunities today quite often end up being grave disappointments to investors who follow the herd. Remember tech stocks in 1999? Or real estate in 2006? [Edit: Or oil stocks in 2013?] They seemed like great sectors at the time.
Markets can be highly counterintuitive, and risks are often only visible after the fact. Try to avoid consensus investment thinking, and don't fixate on the risks that are obvious to investors today. Instead, train yourself to anticipate what risks investors are likely to think about in the future.
7) Save more
I apologize for closing this essay with such an unpalatable final piece of advice, but the easiest way to make up for investment losses is to increase your personal savings. Most investors will need a combination of investment returns and aggressive savings to reach their financial goals, whether those goals are early retirement, a certain level of net worth, or a college fund for a young child. When your investment returns have been below your expectations, you can make up the difference by spending less of your income and allocating the extra savings to these longer-term goals.
We may live in a society that collectively saves and invests very little of its discretionary money, but if you save aggressively, take prudent risks, and remain mindful of the various strengths and weaknesses of stocks as an asset class, you will achieve your financial goals. Good luck!
Read Next: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Money Sundays: On Making Overconfident Predictions
In some domains, there's a clear and direct relationship between a prediction's accuracy and the evidence supporting it. Example: You want to know if Hillary's going to win the 2016 election. You look at polls, and if they show a high likelihood that she'll win, you can thus have high confidence that she will indeed win.
Or: You want to see if the latest iThing is a good product or not. You read many reviews, and all of them are positive. This leads you to believe--again, with high confidence--that the product is a good one.
In those kinds of domains, a prediction, as long as it's backed by a lot of evidence, can actually be "confident." And it's likely to be right.
However, in other domains, there is much less of a relationship between a prediction, the evidence and your confidence. As an example, take investment markets. You think XYZ stock is a great stock. You look at all the evidence: it has amazing profitability metrics, a growing market share, a juicy dividend, rapid growth, whatever. You therefore predict that this stock is a good stock to own, that it will offer you very good returns. And because of all of this compelling evidence, you are highly confident in your prediction.
Except that here you are likely to be wrong with your prediction, and your wrongness will likely be proportional to your confidence.
Why is this? Because you are not acting alone in this domain. Others are looking at the same information you are and have likely acted accordingly, perhaps by buying the stock and driving it up to a price where all of this compelling evidence is already fully discounted in the stock price. In other words, information about the domain directly impacts the domain itself, because others are taking action alongside you based on that information.
The environment therefore becomes recursive and it leads to, at times, painfully counterintuitive outcomes. Information that makes a stock look attractive actually causes that stock to become unattractive, because too many other people already agree with you.
So, what are other examples of domains where we see this? We see it in bond markets, currency markets, commodity markets and in interest rates, which are essentially a market for the price of money. We also see it in many forms of economic forecasting.
In each of these domains you must be mindful of the second-order (and third-order, and nth-order) effects at play. What do I mean by this? Simply that you have to think about not just the information available, but also what other people think about that information. And what people think about people's thoughts about it. And so on.
This is not to say that evidence doesn't play a role in decision-making and prediction-making in domains like the stock market. It does. But you must also consider to what extent the opinions, information, evidence and predictions you hold are shared by or already acted upon by others. Admittedly, it can be difficult to know this part of the equation, but one general heuristic you can use in these domains is this: the widely-held obvious conclusion usually isn't the right one.
This is an important distinction between two different types of decision-making domains, and it's why it is dangerous to claim rock solid confidence with any prediction about interest rates, stock prices, inflation rates, bond prices/yields, etc.--particularly over the near- to medium-term. The perfect example here would be the widely- and confidently-held view from say, two years ago, that we were in a soon-to-pop stock market bubble and that terrible inflation and significantly increasing interest rates were right around the corner. So far, that "obvious conclusion" has been quite painfully wrong. The irony, of course, is that this conclusion will probably become likely only when people start to seriously doubt its obviousness.
To put it bluntly: No one is ever on rock solid ground making predictions in these domains. And your confidence in your prediction is much more likely to be a reverse indicator!
Read Next: Money Sundays: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Or: You want to see if the latest iThing is a good product or not. You read many reviews, and all of them are positive. This leads you to believe--again, with high confidence--that the product is a good one.
In those kinds of domains, a prediction, as long as it's backed by a lot of evidence, can actually be "confident." And it's likely to be right.
However, in other domains, there is much less of a relationship between a prediction, the evidence and your confidence. As an example, take investment markets. You think XYZ stock is a great stock. You look at all the evidence: it has amazing profitability metrics, a growing market share, a juicy dividend, rapid growth, whatever. You therefore predict that this stock is a good stock to own, that it will offer you very good returns. And because of all of this compelling evidence, you are highly confident in your prediction.
Except that here you are likely to be wrong with your prediction, and your wrongness will likely be proportional to your confidence.
Why is this? Because you are not acting alone in this domain. Others are looking at the same information you are and have likely acted accordingly, perhaps by buying the stock and driving it up to a price where all of this compelling evidence is already fully discounted in the stock price. In other words, information about the domain directly impacts the domain itself, because others are taking action alongside you based on that information.
The environment therefore becomes recursive and it leads to, at times, painfully counterintuitive outcomes. Information that makes a stock look attractive actually causes that stock to become unattractive, because too many other people already agree with you.
So, what are other examples of domains where we see this? We see it in bond markets, currency markets, commodity markets and in interest rates, which are essentially a market for the price of money. We also see it in many forms of economic forecasting.
In each of these domains you must be mindful of the second-order (and third-order, and nth-order) effects at play. What do I mean by this? Simply that you have to think about not just the information available, but also what other people think about that information. And what people think about people's thoughts about it. And so on.
This is not to say that evidence doesn't play a role in decision-making and prediction-making in domains like the stock market. It does. But you must also consider to what extent the opinions, information, evidence and predictions you hold are shared by or already acted upon by others. Admittedly, it can be difficult to know this part of the equation, but one general heuristic you can use in these domains is this: the widely-held obvious conclusion usually isn't the right one.
This is an important distinction between two different types of decision-making domains, and it's why it is dangerous to claim rock solid confidence with any prediction about interest rates, stock prices, inflation rates, bond prices/yields, etc.--particularly over the near- to medium-term. The perfect example here would be the widely- and confidently-held view from say, two years ago, that we were in a soon-to-pop stock market bubble and that terrible inflation and significantly increasing interest rates were right around the corner. So far, that "obvious conclusion" has been quite painfully wrong. The irony, of course, is that this conclusion will probably become likely only when people start to seriously doubt its obviousness.
To put it bluntly: No one is ever on rock solid ground making predictions in these domains. And your confidence in your prediction is much more likely to be a reverse indicator!
Read Next: Money Sundays: How To Get Balanced, Consistently Useful Expert Advice
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com
via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Things Are Important Before They're Important
When does something become important?
Consider the life domain of exercise and fitness. For some of my friends and acquaintances, back in our twenties, "being fit" simply wasn't a priority. It just wasn't all that important at that point in life. However, now that they're in their forties and fifties, not being fit is a having a significant negative impact in their lives. Perhaps they've developed high blood pressure, high cholesterol, or maybe they're just not all that happy with how they look in the mirror.
All of a sudden, fitness is important.
Except now they've got 40 and 50 year old bodies that struggle to handle the training required to get fit. Many struggle with obesity--ironically, a stealth product of years of "training" in the habit of not exercising. Many will earnestly begin an exercise program, only to hit a wall of knee, ankle or other joint problems.
Not making fitness a priority turned out to have a cumulative impact. It compounded over the years. Each year it got harder to build a habit of regular exercise and harder to train without injury. Which made it harder still to build a habit of regular exercise.
So, when did fitness really become important?
Apparently, it became important well before you thought it did.
Consider another major life domain: retirement. I'm sure all readers here at Casual Kitchen have friends or acquaintances who didn't really begin thinking about retirement until they were in their forties or fifties--after many years of never really building a habit of saving money.
When someone never builds a habit of regular savings, that person, by definition, runs a high expense line relative to income (think of the exact opposite of my Extreme Savings post). Worse, many of these expenses are likely to be fixed expenses in the form of a large mortgage, car lease payments, other debts, etc. These are difficult-to-escape expenses, and they make adopting a serious savings habit still more difficult. Jacob Lund Fisker calls this "the lock-in" in his book Early Retirement Extreme.
Of course, the cumulative cost of postponing retirement savings is enormous. We've all seen those retirement compounding charts showing how much less a younger person needs to save per month compared to an older person in order to reach a certain money goal. A 25 year old saving $1,000 a month at, say, a 6% average annual return, will accumulate a million dollars by age 55. A 45 year old, however, needs to save $6,000 a month to get to a $1 million by age 55.
That 45-year-old needs to save six times as much every month, without having built any history of regular savings, and with a likely high and largely fixed expense line. A person considering retirement for the first time at age 45 faces a profound challenge--a far greater challenge than the 45-year-old considering exercise for the first time.
So, when did this life domain become important?
Once again, well before you thought it did.
Readers, share your thoughts!
Read Next: Tips vs. Strategy
How can I support Casual Kitchen?
Easy. Do all your shopping at Amazon.com via the links on this site! You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.
Consider the life domain of exercise and fitness. For some of my friends and acquaintances, back in our twenties, "being fit" simply wasn't a priority. It just wasn't all that important at that point in life. However, now that they're in their forties and fifties, not being fit is a having a significant negative impact in their lives. Perhaps they've developed high blood pressure, high cholesterol, or maybe they're just not all that happy with how they look in the mirror.
All of a sudden, fitness is important.
Except now they've got 40 and 50 year old bodies that struggle to handle the training required to get fit. Many struggle with obesity--ironically, a stealth product of years of "training" in the habit of not exercising. Many will earnestly begin an exercise program, only to hit a wall of knee, ankle or other joint problems.
Not making fitness a priority turned out to have a cumulative impact. It compounded over the years. Each year it got harder to build a habit of regular exercise and harder to train without injury. Which made it harder still to build a habit of regular exercise.
So, when did fitness really become important?
Apparently, it became important well before you thought it did.
Consider another major life domain: retirement. I'm sure all readers here at Casual Kitchen have friends or acquaintances who didn't really begin thinking about retirement until they were in their forties or fifties--after many years of never really building a habit of saving money.
When someone never builds a habit of regular savings, that person, by definition, runs a high expense line relative to income (think of the exact opposite of my Extreme Savings post). Worse, many of these expenses are likely to be fixed expenses in the form of a large mortgage, car lease payments, other debts, etc. These are difficult-to-escape expenses, and they make adopting a serious savings habit still more difficult. Jacob Lund Fisker calls this "the lock-in" in his book Early Retirement Extreme.
Of course, the cumulative cost of postponing retirement savings is enormous. We've all seen those retirement compounding charts showing how much less a younger person needs to save per month compared to an older person in order to reach a certain money goal. A 25 year old saving $1,000 a month at, say, a 6% average annual return, will accumulate a million dollars by age 55. A 45 year old, however, needs to save $6,000 a month to get to a $1 million by age 55.
That 45-year-old needs to save six times as much every month, without having built any history of regular savings, and with a likely high and largely fixed expense line. A person considering retirement for the first time at age 45 faces a profound challenge--a far greater challenge than the 45-year-old considering exercise for the first time.
So, when did this life domain become important?
Once again, well before you thought it did.
Readers, share your thoughts!
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