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Latticework Wealth Management, LLC

Monthly Archives: August 2013

Should you fear the Fed “taper”? How are the financial markets being affected by this discussion?

27 Tuesday Aug 2013

Posted by wmosconi in bonds, business, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

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bonds, business, Fed taper, Federal Reserve, finance, investing, investments, stocks, Syria

 As I have mentioned before, I dislike offering comments on current activity in the financial markets.  However, a number of readers of my blog have asked about this topic, and there appears to be quite a bit of disinformation and misunderstanding about what the Fed taper actually is.  Thus, I thought it would be valuable to take some time to discuss this subject.

Before I dive into my commentary on the Fed taper, I wanted to set the stage.  What exactly is the Fed taper?  Well, the Federal Reserve has a policy called quantitative easing (QE) which is now in its third form via QE3.  The Federal Reserve is trying to inject more dollars into the monetary base to keep interest rates at historically low levels in the US economy.  The most effective way to do this on a large scale is to buy US Treasuries and mortgage backed securities (MBS).  In fact, the Federal Reserve is buying $85 billion worth of these securities each month.  If this sounds kind of odd, it is in certain respects.  The Department of the Treasury issues US Treasury bills, notes, and the long bond, and then the Federal Reserve purchases some of those securities at auction.  Some estimates have been that the Federal Reserve purchases some 70% of the new supply.  Yes, it is a very interesting phenomenon.

If you have been watching the financial media or reading financial news publications, you are inundated with information of how the Fed taper will have dire consequences for the stock and bond markets.  The Fed taper is simply that the Fed will buy less than $85 billion worth of securities per month.  Now no one knows if that will happen next month or by how much the Fed will reduce its purchases.  The taper does NOT mean that the Fed will be raising interest rates.  Interest rates are going up on their own.  Market participants are figuring that there will not be enough demand to soak up the excess supply when the Fed reduces its purchases.  The target rate on the Federal Funds is still 0%, and the effective rate for Federal Funds is still around 0.10-0.15%.

The more interesting thing is that the S&P 500 has not gone down since interest rates on the US 10-year Treasury have started on its “meteoric” rise.  The 10-year bottomed out at a closing yield of 1.62% on May 2, 2013.  The S&P 500 closed slightly above 1,597 on that same day.  Even with today’s (August 27, 2013 to 1630.48) selloff in the stock market, the S&P 500 remains above that level.  Therefore, when you hear guests on financial media shows talk about the taper destroying stock values, you need to take that with a grain of salt.  What will happen in the future?  That is the real question.

The US economy has been operating with negative real interest rates for the past five years.  What are negative real interest rates?  Negative real interest rates occur anytime the nominal (actual) interest rate on a security is less that the rate of CPI (inflation).  You are receiving interest, but the purchasing power of your dollars is less.  Even though interest rates are going up now, financial pundits are forgetting that this is not a typical increase in interest rates.  An increase in interest rates, when real rates are positive, tends to slow down the economy.  We have not seen an environment where real rates were negative and now they will be flat or positive.  You should want real interest rates to be positive.  It is the sign of a growing and healthy economy.  When I used to work structuring bond deals, the head of our trading desk would always comment on economic data.  If GDP growth was higher than expected, interest rates went up.  If more jobs were added, interest rates went up.  Why?  Good news about the economy meant that there would be more demand from businesses for borrowing.  Now this was happening over six years ago; however, economic data normally affects the bond market in this manner.

Here is what you need to worry about?  If the Federal Reserve decides that it is time to raise the target rate for Federal Funds that is actual tightening of monetary policy.  The real “black swan” is the Fed’s balance sheet.  After buying all kinds of securities over the course of QE and during the 2008 financial crisis, the Fed’s balance sheet has ballooned.  The Federal Reserve now holds over $4 trillion in securities.  If the Fed ever decides to shrink its balance sheet, they will have to flood the bond market with supply.   Offloading hundreds of billions of dollars or more of bonds will certainly wreak havoc on the financial markets as a whole.  Until the Federal Reserve actually raises interest rates and/or reduces its balance sheet, there is no reason to panic and sell all your stocks.  It just does not make much sense.  The Fed taper will lead to a rise in interest rates.  It is normal.

Halting of the NASDAQ: No Worries for Readers of this Blog

22 Thursday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, NASDAQ, stocks, Warren Buffett

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bonds, business, education, finance, investing, investments, NASDAQ, retirement, stock market, stocks, trading

There was an outage at the NASDAQ around 12:15pm EST.  At the time of this writing, the NASDAQ is still down.  You will see the financial media and various news outlets making a big deal about this story.  While it is a big deal to traders and speculators, a long-term investor really does not need to worry.  In fact, the focus will go back to the meeting at Jackson Hole, Wyoming tomorrow.  Remember that this makes for good TV only.  If your time horizon is 5+ years, you have nothing to worry about.

My suggestion would be to read The Intelligent Investor written by Benjamin Graham.  The edition I would recommend would be the one with commentary by Jason Zweig.  You will learn about Graham’s discussion of the distinction between investing and speculation.  Wall Street was unaware of this over fifty years ago.  The financial media is still unaware of this dichotomy.  The book also will introduce you to the famed, Mr. Market as well.  It is a good way to start learning about behavioral finance.  Irrationality can prevail during times such as these.  A link to the book is as follows:  http://www.amazon.com/The-Intelligent-Investor-Definitive-Investing/dp/0060555661/ref=sr_1_1?ie=UTF8&qid=1377192202&sr=8-1&keywords=The+Intelligent+Investor.

I look forward to sharing more information with you in the future.  Note that I will rarely talk about current events.  As I have previously mentioned, you need to ask yourself if you will remember this story in ten years.  If not, you can just watch the news coverage for entertainment value.

Quick and Effective Way to Learn about Investing in Stocks and Bonds

21 Wednesday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks, Warren Buffett

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bonds, business, economics, education, finance, interest rates, investing, investments, retirement, stocks, Warren Buffett

With the advent of the Internet and a plethora of financial news publications and television networks, there is an amazing amount of information available on investing and investments.  With that being said and obvious, why would you even read this?  Well, as I have said before, knowledge is power!  Now take a look at that cliché again but more closely.  Could you substitute the word information for knowledge?  Would it mean the same thing?  I am hoping you say that the answer is a resounding No.  Having access to information and having a lot of facts can be a detriment in some respects actually.  Is that how it feels with individual investing from your perspective?  You could spend months searching terms on the web, going to mutual fund websites, reading academic studies, keeping up with the current market moving news, and researching individual companies.  Would that really help you?  If you are waiting for someone to divine some wisdom for you in terms of when to invest and what to invest in, you will be waiting for many, many years.  Knowledge is taking information and constructing a framework that is actionable.

My recommendation to you is to read the following information in pieces.  Pick one or two items off the list to read per day. You can feel free to skip certain numbers if you are familiar with the concept already.  Let’s begin our discussion.

1)      How the Current News Affects Your Investments:

 

Learning how to invest in the financial markets can feel very overwhelming. Especially when you are retired or going to retire soon.  If you need to live on your “nest egg” and do not want to work again, where do you even begin?  I suggest that you never make rash decisions and adjust your entire portfolio based upon one day’s news.  For more information about that concept, please refer to this link:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.

 

2)      Do I Even Have Enough Money to Make Investing Worthwhile?:

 

The short answer is YES.  The funny thing is that if you leave these decisions in the hands of a financial professional you will be spending hundreds of thousands of dollars.  If you have a 401(k) or 403(b) retirement plan, this matters to you as well.  For information on how investment advisory and asset management fees add up, please refer to the following link:  https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/.

 

3)      Learning About How to Create a Simple Model Investment Portfolio:

 

How should you allocate your investments?  Which asset classes or sectors are the best to choose from?  Before you can tackle that issue, you should look at more general portfolio construction concepts.  You can find the link here:  https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/.

 

4)      You Need to Properly Assess Your Risk Tolerance:

 

 If the stock market goes down 10% and you are so nervous that you sell, you probably should not invest in stocks at all.  You have a very low risk tolerance and will not sleep well.  The most important thing to learn here is that gain and losses are not proportional.  In fact, if you view the financial markets in that way, you probably should NEVER have more than 50% of your portfolio in stocks.  If you are worried about a bear market occurring (bear market is defined as a 20% or more drop), you probably should either not have any stocks or invest NO more than 20% of your money in the stock market.  For more information about how stock market fluctuations affect your investment portfolio, please go to this link:  https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.

 

5)      Differences Between Active and Passive Investing:

 

Once you understand how different annual returns affect the value of your portfolio, you can start learning about how well you are doing and how to set a realistic target return for your portfolio.  The first thing to do is to learn about the difference between active and passive investing.  There is a third, emerging category which too many say is passive investing.  It is called enhanced indexing.  For a longer discussion of the difference between active and passive investing, you can refer to the following:  https://latticeworkwealth.com/2013/07/05/difference-between-active-and-passive-investing/.

 

6)      Measuring How Well Your Investment Portfolio is Performing:

 

I would never assert that active or passive investing is better. However, I will say that you need to ensure that your chosen investing approach is working.  If you are choosing an active approach, your investment portfolio should be beating the market over the long run.  If it does not, why would you spend all the time searching for ways to beat the market? Refer to this link to understand more about how to properly measure the investment performance of your portfolio:  https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/.

 

7)      Investing in Individual Stocks and Bonds Should Be Left to Professionals:

 

If investing is starting to sound boring, it can be in a certain sense.  If you are looking to make 100% per year by buying stocks, you are going to be sorely disappointed.  It can seem so easy when you watch TV shows.  You also can lose a lot of money though.  The real pros spend hours upon hours learning about a particular company prior to buying the stock.  How much time?  Probably more than you would imagine.  Refer to this article:  https://latticeworkwealth.com/2013/08/09/you-purchased-a-stock-now-what/.

 

8)      Does Hiring a Financial Professional Make Sense:

 

After reading all this information, it may seem like it is better to let a financial professional manage your money.  If you are going to a financial professional to seek advice, you should know why you are going.  What can’t you do yourself?  Here is a unique way to think about this topic:  https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/.

 

9)      List of Questions to Ask Any Financial Professional:

 

If you still think that going to a financial professional is the best option for you, I will not fault you for that.  What types of questions should you ask?  Here is a suggested list of questions:  https://latticeworkwealth.com/2013/08/12/important-list-of-questions-to-ask-when-selecting-a-financial-advisor/.

 

10)   Learn How a Financial Professionals Start in Investing Field Can Bias Them:

 

You will find that most financial professionals are biased based upon the time when they first started the profession.  Therefore, their advice might be “stuck in time” so to speak and not apply to your situation.  For a more detail explanation of this idea, you can refer to this post:  https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/.

 

 

11)   Understanding Why You Have Some Advantages over Institutional Investors:

 

You have different experiences and expertise in everyday life.  You can be more objective when it comes to investing and how the financial markets work.  Want to learn more:  https://latticeworkwealth.com/2013/08/11/why-did-i-choose-to-include-latticework-in-my-investment-firms-name-well-because-of-charlie-munger-of-course/.

 

12)   Learn That You Can Survive as an Individual Investor as Interest Rates Rise:

 

Do you keep hearing that higher interest rates are going to wreak havoc on the financial markets now and for years to come?  Should you not start investing until interest rates stabilize?  What if interest rates are going to continue to rise?  These are important questions, and I try to answer this question in the following post:  https://latticeworkwealth.com/2013/08/14/what-can-investors-do-in-a-rising-interest-rate-environment/.

You have finally reached the end of the list.  Do you feel smarter?  I sure hope you do.  My goal was to provide you with a framework to start your quest.  If you would like to learn more, I have a recommended reading list.  It will most likely take you 20 hours or so to read these books.  However, if you can save hundreds of thousands of dollars, would you say it is worth it?  Remember you are likely to live for over 20 years during your retirement years.  Here is the list:  https://latticeworkwealth.com/2013/07/23/spend-20-hours-learning-about-investments-to-prepare-20-years-of-retirement-2/.

Please feel free to send me your comments or other questions at latticeworkwealth@gmail.com.  You can post them directly on my blog as well.

Do you want to learn about investing in stocks and bonds but don’t know where to start? Here’s a roadmap.

20 Tuesday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks, Warren Buffett

≈ 3 Comments

Tags

bonds, business, economics, education, finance, investing, investments, retirement, stocks, Warren Buffett

With the advent of the Internet and a plethora of financial news publications and television networks, there is an amazing amount of information available on investing and investments.  With that being said and obvious, why would you even read this?  Well, as I have said before, knowledge is power!  Now take a look at that cliché again but more closely.  Could you substitute the word information for knowledge?  Would it mean the same thing?  I am hoping you say that the answer is a resounding No.  Having access to information and having a lot of facts can be a detriment in some respects actually.  Is that how it feels with individual investing from your perspective?  You could spend months searching terms on the web, going to mutual fund websites, reading academic studies, keeping up with the current market moving news, and researching individual companies.  Would that really help you?  On any given day, you can find financial market professionals telling you that the stock market is poised for a huge correction, a lot of upside, or will trade sideways for the foreseeable future.  If you are waiting for someone to divine some wisdom for you in terms of when to invest and what to invest in, you will be waiting for many, many years.  Knowledge is taking information and constructing a framework that is actionable.  For those of you who have been reading my posts regularly, you may still want to read on because I will try to provide some structure around my past commentary.

My recommendation to you is to read the following information in pieces.  Pick one or two items off the list to read per day.  It will take you a week or so to digest all the material.  I encourage you to go back to a number if it does not make sense at first.  You can feel free to skip certain numbers if you are familiar with the concept already.  Let’s begin our discussion.

1)      Learning how to invest in the financial markets can feel very overwhelming.  I used to work on Wall Street, and I felt that same way and I lived it every day.  When you are just starting out, I cannot imagine how it must feel.  Especially when you are retired or going to retire soon.  I started in 1987, so it is hard to think back that far and truly remember.  If you need to live on your “nest egg” and do not want to work again, where do you even begin?  Remember I mentioned that finding information about the financial markets, different investments, ideas about portfolio construction, investing strategies, withdrawing funds during retirement, or accumulating wealth is quite easy using your PC or smartphone.  The problem is that, since we live in a 24/7 news-driven society and investment world, the advice provided on any given day will change.  That is why I suggest that you never make rash decisions and adjust your entire portfolio based upon one day’s news.  For more information about that concept, please refer to this link:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.

 

2)      Since investing in the stock market seems so intimidating and can feel like gambling, why would you even consider learning about the financial markets?  The funny thing is that if you leave these decisions in the hands of a financial professional you will be spending hundreds of thousands of dollars.  Well, you might say that I do not have millions of dollars, so that does not apply to me.  The financial services industry sure makes it seem that way.  However, are you making $40,000 a year and saving 5% of your paycheck in a 401(k) or 403(b) retirement plan?  That equates to investing $2,000 per year.  If your answer to that question is yes, then the hundreds of thousands of dollars applies to your as well.  For information on how investment advisory and asset management fees add up, please refer to the following link:  https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/.

 

3)      Once you start to think about the money you stand to earn from investing in the financial markets and by avoiding excessive fees, I am hopeful that you will be motivated to learn more.  The next thing to consider is what types of investments you would like to purchase.  Essentially the question is how to build an investment portfolio.  How should you allocate your investments?  Which asset classes or sectors are the best to choose from?  Before you can tackle that issue, you should look at more general portfolio construction concepts.  You can find the link here:  https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/.

 

4)      Before you go any further, you need to learn how to assess your risk tolerance.  Your risk tolerance is just a fancy way to characterize your willingness to experience financial losses.  The stock and bond markets are volatile.  If the financial markets only went up, there really would not be too much of a story to write here.  In order to earn higher returns, you generally need to be able to accept higher risks.  The most important thing to learn here is that gain and losses are not proportional.  The proper term is symmetrical.  What do I mean by this?  If your stocks go down 50%, they need to go up 100% for you to break even.  It works for smaller amounts as well.  So if your stocks go down 10%, they need to go up 11.1% before you have the same amount of money.  If you are listening to the commentary on the financial news stations or reading “dire” predictions in the newspapers about a 10% drop in the stock market being very possible and probably, what will you do?  If you want to avoid that drop and could not bear to not sell before that decline, you have a very low risk tolerance.  In fact, if you view the financial markets in that way, you probably should NEVER have more than 50% of your portfolio in stocks.  If you are worried about a bear market occurring (bear market is defined as a 20% or more drop), you probably should either not have any stocks or invest no more than 20% of your money in the stock market.

 

Have you ever heard that from your financial professional?  Probably not.  The reason you need to set a realistic risk tolerance is that it will save you a lot of money down the road.  Now it is not simply that you will be taking the chance of losing nearly 40% as in 2008.  The problem is that investing is much too emotional the lower your risk tolerance.  For example, many individual investors sold all of their stocks toward the end of 2008 and beginning of 2009.  In fact, many wealthy investors still have 30-40% of their portfolio in cash today.  The S&P 500 bottomed at 666 in March 2009 and now trades around 1650 as of August 20, 2013.  If you get back in today and sold then, you missed out on over 100% of gains, and you are setting yourself up to sell again if the market goes down more than you are comfortable.   Most people know that you should “buy low and sell high” intellectually. However, the average investor will “buy high and sell low” in practice because emotions take over during periods of market volatility.  For more information about how stock market fluctuations affect your investment portfolio, please go to this link:  https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.

 

5)      Once you understand how different annual returns affect the value of your portfolio, you can start learning about how well you are doing and how to set a realistic target return for your portfolio.  The first thing to do is to learn about the difference between active and passive investing.  Active investing is selecting individual stocks and bonds that are likely to do better than the market.  Passive investing is selecting different types of stocks and bonds in different categories and then building a portfolio.  There is a third, emerging category which too many say is passive investing.  It is called enhanced indexing.  Enhanced indexing is really a hybrid approach.  You select certain stocks or bonds within an index based upon certain qualitative analysis.  Enhanced indexing is not passive and is not active.  The most common mistake is to confuse it with passive investing.  Once you start selecting specific securities, you are essentially being an active investor.  For a longer discussion of the difference between active and passive investing, you can refer to the following:  https://latticeworkwealth.com/2013/07/05/difference-between-active-and-passive-investing/.

 

6)      I would never assert that active or passive investing is better.  You have to learn more about investing in order to make that determination.  However, I will say that you need to ensure that your chosen investing approach is working.  If you are choosing an active approach, your investment portfolio should be beating the market over the long run.  If it does not, why would you spend all the time searching for ways to beat the market?  You could just throw your hands up and simply choose to invest your money in all the stocks or bonds in the various indexes.  So how do you measure your investment performance?  It is not as simple as comparing the performance of your stocks to the S&P 500 index and bonds to the Barclays Aggregate Bond index.  That might have been the way to do so twenty years ago, but the “smart” money does not do that anymore.  Think of it in this manner:  will an Olympic sprinter beat the faster runner in your neighborhood?  Probably.  Will the fastest runner in your neighborhood beat the fastest person in my neighborhood if they run the same distance?  Now that is a much harder question to answer.  Refer to this link to understand more about how to properly measure the investment performance of your portfolio:  https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/.

 

7)      If investing is starting to sound boring, it can be in a certain sense.  If you are looking to make 100% per year by buying stocks, you are going to be sorely disappointed.  It can seem so easy when you watch TV shows.  Why didn’t I buy NetFlix (NFLX) or Best Buy (BBY) a couple of months ago?  I could have doubled my money and then some.  You also can lose a lot of money.  I used to own Best Buy five years ago.  I purchased the stock at an average cost over $40.  The stock is up around 180% in 2013, but it is down more than 20% from where I bought the stock over five years ago.  If I had not sold my stock in Best Buy, I would still be losing money.  So even with the winners of today, you can lose money in the future.  Additionally, it is not as easy as it seems to pick individual stocks.  The real pros spend hours upon hours learning about a particular company prior to buying the stock.  How much time?  You can take a sneak peek, but I will warn you that you will most likely be asleep long before you reach the end of this article:  https://latticeworkwealth.com/2013/08/09/you-purchased-a-stock-now-what/.

 

8)      After reading all this information, it may seem like it is better to let a financial professional manage your money.  I mean you have many other things to do with your limited leisure time.  With that being said, you need to understand what you are really paying for.  If you are going to a financial professional to seek advice, you should know why you are going.  What can’t you do yourself?  Here is a unique way to think about this topic:  https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/.

 

9)      If you still think that going to a financial professional is the best option for you, I will not fault you for that.  No matter how much time you spend learning about investing, there will always be uncertainty and more questions.  However, you need to have a plan of attack when interviewing any Financial Advisor.  What types of questions should you ask?  Here is a suggested list of questions:  https://latticeworkwealth.com/2013/08/12/important-list-of-questions-to-ask-when-selecting-a-financial-advisor/.

 

10)   Another important thing to keep in mind once you start to feel comfortable with a financial professional is that you should get to know their background.  I am not referring to the number of years they have been investing or their educational credentials or professional designations.  You will find that most financial professionals are biased based upon the time when they first started the profession.  Therefore, their advice might be “stuck in time” so to speak and not apply to your situation.  For a more detail explanation of this idea, you can refer to this post:  https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/.

 

 

11)   The other thing to remember, and sometimes the most important, is that you have an advantage over most financial professionals.  You do not follow the markets daily.  Plus, you have different experiences and expertise in everyday life.  You can be more objective when it comes to investing and how the financial markets work.  You can choose to be like Warren Buffett’s trusted advisor, Charlie Munger.  Want to learn more:  https://latticeworkwealth.com/2013/08/11/why-did-i-choose-to-include-latticework-in-my-investment-firms-name-well-because-of-charlie-munger-of-course/.

 

12)   Do you keep hearing that higher interest rates are going to wreak havoc on the financial markets now and for years to come?  It is a common topic, especially since most asset managers believe that interest rates have bottomed earlier this year and are headed higher over time.  We had 30+ years of interest rates going lower.  It was bound to happen that interest rates would inevitably go up at some point.  Should you not start investing until interest rates stabilize?  What if interest rates are going to continue to rise?  These are important questions, and I try to answer this question in the following post:  https://latticeworkwealth.com/2013/08/14/what-can-investors-do-in-a-rising-interest-rate-environment/.

You have finally reached the end of the list.  Do you feel smarter?  I sure hope you do.  My goal was to provide you with a framework to start your quest.  If you would like to learn more, I have a recommended reading list.  It will most likely take you 20 hours or so to read these books.  However, if you can save hundreds of thousands of dollars, would you say it is worth it?  Here is the list:  https://latticeworkwealth.com/2013/07/23/spend-20-hours-learning-about-investments-to-prepare-20-years-of-retirement-2/.

Please feel free to send me your comments or other questions at latticeworkwealth@gmail.com.  You can post them directly on my blog as well.  If there are questions beyond the scope of this discussion, I will certainly address them in a future post.  I encourage you to take a look at some of my prior posts as well which are not included in this discussion of how to begin your “career” as an individual investor.

Before You Take Any Investment Advice Consider the Source

18 Sunday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

≈ 3 Comments

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bonds, business, education, finance, investing, investments, retirement, stocks

When I am talking about considering the source, I am not referring to the person’s qualifications (such as having a CFA, CFP, or CMT).  I am referring to the person’s investing paradigm.  For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry.  The first couple of years have a big impact on their recommendations throughout the rest of their careers.  I will give you an example in life, and then I will talk about Warren Buffett and even myself.

There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music.  For example, there are many people in their early 40’s that love 80’s rock.  They would prefer to listen to that over any type of new music.  My parents are in their sixties now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, and lots of one-hit wonders from the 50’s and 60’s.  Think about your own taste in music.  Does this ring a bell?  Most people fall into this category, and it is almost subconscious.  You like a certain genre of music best, and it sticks with you.  Did you have a family member that was really into music and had a collection of records?  Sometimes you get introduced to music at an even younger age, and you are drawn to it.  You listened to it during your formative years.  The same goes for investing in a similar way.

If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously.  Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics.  The themes in the book seemed to resonate with him.  I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them.  The rest of the classmates just sat back and enjoyed the “show”.  Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher.  Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits.  “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing.  This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.  Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style.  Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.

I did not pick Warren Buffett because of his long-term track record of stellar performance.  I only picked him because many individuals are familiar with Warren Buffett.  Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951.  If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929.  The baby boom was in full swing, and the US economy was on overdrive.  The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle.  There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent.  Well, there were still scams, but they were harder to pull off.  (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago).  Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could.  In fact, Buffett used to read entire books on every single public company.  During that time period, information was so disjointed and hard to get.  However, it was now available to the public and professional investors who could do much thorough analysis.  The financial markets had far more inefficiencies back then.  This time period was before the dawn of Modern Portfolio Theory, the Capital Asset Pricing Model, and the Efficient Market Hypothesis.  Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.

Buffett started his own investment partnership in the mid 50’s.  It was essentially a hedge fund in most respects.  Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969.  The stock market at this time seemed to be overpriced, so Buffett disbanded the partnership.  He referred his partners to Bill Ruane of the famed Sequoia Fund.  Bill was a former classmate of Warren, and he amassed quite a record himself.

So if we look at Buffett’s beginning career, he saw how doing your homework really paid off.  In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy.  After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on.  Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment.  Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing.  These formative years are still with Buffett.  Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well.  What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period.  This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.

Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987.  What got me so interested in the stock market?  Obviously Black Monday on October 19, 1987 really caught my attention.  It was not really the crash that really piqued my interest though.  My father told me that the market drop of 508 point on that day was an overreaction.  I did not know much about stocks, but it seemed to me like the world was ending.  At least that was how the nightly news portrayed things.  My father said watch the market over the next several days.  To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions.  Wow!  This turn of events was really weird to me.  How could stocks move around in value so greatly?  I thought that all the big money investors in the stock market really knew what they were doing.  However, most everyone was caught by surprise by Black Monday.  The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA.  If you want to get your friends’ attention, you can ask them what the return of the DJIA was for 1987 and 1988.  Most people will get it wrong.

Well, these events left a mark on me.  When I learned more about investing and was exposed to Modern Portfolio Theory and the Efficient Market Hypothesis, I really did not think it was true given my start in investing back in the later portion of 1987.  Now the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door.  Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market.  For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market.  I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems.  I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros.  Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam.  The CFA is now the standard designation for all portfolio managers of stocks and bonds.  I tried studying for it, but a lot of it made little sense to me.  I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.

Most of the financial professionals you meet will range in age from twenties to sixties.  You should always ask them when they started investing or their career as a Financial Advisor.  Here are the major events that will cover those individuals:

1)      The 1973-1974 severe bear market;

2)      The Death of Equities article from Time magazine in 1982;

3)      Black Monday in October 1987;

4)      The Bond Bubble Bursting in 1994;

5)      The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;

6)      The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;

7)      The Bursting of the Internet Bubble in April 2001;

8)      The Financial Crisis of 2008;

9)      The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.

These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation.  In fact, I met a Financial Advisor that tells his clients that they can expect to earn 10% annually from stocks over the long term.  He uses this return for modeling how much clients need to invest for retirement.  He was introduced to investing around 1996 which is when the stock market went gangbusters.  I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks.  He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement.  He started advising clients in 2007, and he lost a great many clients in 2008.  Therefore, he wants to have limited downside risk for two reasons.  First, he has seen how much the stock market can drop in one year.  Second, this gentleman wants to ensure that his clients to not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.

As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly.  I am not saying that any of this advice is “wrong” per se.  My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with.  Thus, you can refer to the aforementioned list of nine major events in the history of the financial markets.  These events really shape the investment paradigm of all of us.  I will admit that I am no different.  With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals’ first few years with the financial markets.  Some financial professionals are more bullish than others.  Others focus on downside risk and limiting volatility in investment portfolios.  Therefore, you need to understand your risk tolerance and financial goals.  You have your own personal experience with the market.  If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful.  History does repeat itself, but the repeating events will be caused by much different factors in most cases.  Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a host of other things.  You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.

Important List of Questions to Ask When Selecting a Financial Advisor in Brief

17 Saturday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

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I realize that, despite what I write about, the vast majority of you will decide to choose a financial professional to assist you with your investment portfolio and reaching your long-term financial goals.  Going to see a Financial Advisor can be an intimidating experience.  You are coming in with limited knowledge of the financial markets, and you hear from the financial media and read in financial publications that the market is poised to go up, dive with a correction, or consolidate (i.e. unchanged).  The “noise” causes confusion.  Not to mention that the jargon utilized in the investment world is difficult to get up to speed quickly.  Your Financial Advisor should be able to explain his/her approach in layman’s terms, explain available services, and discuss the fee schedule of the firm.  Luckily for you, I have prepared a list which you can prepare for that meeting in 45-60 minutes and be armed with better questions and a foundation in the workings of the financial markets and some of the terminology.  Just so you know, I would say that if you perform this exercise, you will most likely be in the 90th-95th percentile of retail investor knowledge.  Here is the list of questions with links to past posts on the blog:

List of Questions

1)       How do you approach tactical versus strategic strategies for reallocating ones investment portfolio?

 

Refer to this post for more information:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.

 

2)      How do you go about constructing an investment portfolio for me?

For more information regarding the construction of an investment portfolio can be found here:  https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/.

3)      How do you calculate the fees that I will pay in both percentage terms and absolute dollars?

 

Here is a link to a further explanation of this concept:  https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/.  Fees lead to an opportunity cost because you could have invested those fees in the stock market yourself.

 

4)      Will you provide me with a blended benchmark to track my investment performance?  Will you highlight both absolute returns and relative returns in regard to my selected target annual rate of return on my investment portfolio?

 

For more information on blended benchmarks, please refer to this post:  https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/.

 

5)      How do I calculate the value you provide from recommending a given asset allocation for my investment portfolio?

 

Please refer to the following post for additional information: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/.

 

6)      How do you arrive at expected returns for my investment portfolio?  Do you tend to use arithmetic averages or geometric averages?

 

  For more information on this concept, please refer to this post: https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.

 

7)      If I have a long-relationship with you to manage my money?  How will fees add up over time?  Am I making a “bet” that you will beat the financial markets?

 

This topic is always the hardest to discuss.  When you choose a financial professional, the ideal relationship is for the rest of your lifetime.  If you are retiring soon or just retired, you are likely to be dealing with the Financial Advisor you select for 20+ years.  It is a big decision because you will be paying AUM fees for the rest of the relationship.  You need to know what you are getting into and feel comfortable with that Financial Advisor because they are helping you live your golden years in the way you always envisioned.  How do you go about determining the value that the prospective Financial Advisor will provide over your retirement years?

 

You need to use the economic concept of opportunity cost.  If you have a retirement portfolio worth $1 million at the start of your retirement and your Financial Advisor charges you a 1% AUM fee, you will pay $200,000 ($10,000 * 20 years) over the course of the relationship.  Well, think about that.  If you managed your own investments, you would not need to pay that AUM fee.  You could take that $10,000 and invest that money in an ETF or index mutual fund tied to the S&P 500 and earn the long-term historical average of that index which is roughly 7%.  Now if you did that, you would have roughly $425,570 at the end of 20 years.  As you might imagine, dollars 20 years from now will not be worth as much as they are now.  So how do you relate your opportunity cost into present day dollars?  You do a process called discounting.  If you assume inflation will equal 3.25% over the course of those 20 years, you would have $224,475 in today’s dollars.

 

Now let’s reference your beginning portfolio balance.  You can think about this in two ways.  First, that is the cost of you not managing your own investments which is a decision that only you can make.  You need to measure the utility of your leisure and your risk tolerance (emotional about money and acting rashly at times).  Second, you are making a $224,475 “bet” that the prospective Financial Advisor can beat the market.  Remember you could just choose an asset allocation yourself.  You will earn the index averages minus the expense ratio of those investments.  Most expense ratios on passive options are 0.20% or less.  You will never beat the market averages, but you avoid the chance that your Financial Advisor recommends a poor choice for your asset allocation that significantly underperforms its proper benchmark.

 

Now if you do not have $1 million or the AUM fee is not 1%, you can easily calculate how much your present value is.  Simply take the ratio of your investment portfolio divided by $1 million and multiply by the AUM fee as a number.  Here is an example:  let’s say you have $250,000 now and your AUM fee is still 1%.  Your present value would be $56,370 (($250,000/$1,000,000) * 1.  If you compare that to your entire portfolio, the amount is approximately 22.5% ($56,370/$250,000) of your portfolio value.

 

There is no reason why you cannot work with a Financial Advisor for a couple of years and then take the reins once you learn from him/her and get comfortable with the volatility and workings of the financial markets.  You can seek out a financial planner or an independent Registered Investment Advisor (RIA) who charges an hourly fee.  You could go to see that financial professional and pay may $200-$250 per hour.  You might spend two hours at year-end and maybe see him/her once during the year when current events make you want to sell all your stocks, bonds, and other assets.  That financial professional can probably “talk you off the ledge” in one hour.  If we look at that in totality, you would pay that type of financial professional $600-$750 over the course of the year.  Looking back at our hypothetical portfolio of $1 million with a 1% AUM fee, you would be paying $10,000 to the Financial Advisor.  This option would save you over $9,000 in fees.  Try to remember that the choice is not manage your own investments or turn it over to a Financial Advisor.  There is a “gray” area where you use a trusted financial professional to bounce ideas off of.  Therefore, there is a spectrum of choices when you are looking at how to ensure that your investment portfolio will allow you to reach your financial goals successfully.

 

As you can see, you should be quite comfortable and more confident going to speak with a prospective Financial Advisor.  Keep a few things in mind though.  You spent about 60 minutes doing a crash course in learning the fundamentals of portfolio construction and fees.  The Financial Advisor has years of experience and deals with clients every single day.  So if the Financial Advisor does not understand the questions, does not know the answers, thinks the questions are not relevant, or tries to steer you away from looking at fees and relative returns, I would seriously consider looking for another Financial Advisor.  These types of questions are what a high net worth client would ask.  You may not have $5 million+ to invest, but there is no reason why you cannot ask similar questions.  It is your hard-earned money, and you deserve exceptional service no matter whatever the amount in your investment portfolio.

For your free eBook, please send me an email with your name and email address. I will send you the expanded version of this list of questions. My email address is latticeworkwealth@gmail.com. Please feel free to ask any questions or provide feedback as well. Thank you.

What Can Investors Do in a Rising Interest Rate Environment?

14 Wednesday Aug 2013

Posted by wmosconi in bonds, business, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

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bonds, business, finance, interest rates, investing, investments, retirement, rising interest rates, stocks

I probably get this question asked of me more than any other these days, especially by retirees.  Investors were once able to place money into bank certificate of deposits (CDs) or into money market funds and easily earn more interest than the rate of inflation.  Unfortunately, the financial crisis of 2008 changed all that in a major way.  While the events surrounding the dark days of the close of Lehman Brothers, the bailout of AIG, and the nearly $800 TARP program, were not the sole cause of this phenomenon, they certainly did not help.  The Federal Reserve (Fed) led by the chairman, Ben Bernanke, had to lower interest rates to avoid the credit and liquidity crisis of that time period.  The Fed brilliantly avoided a meltdown and depression.  The side effect is that financial market participants have gotten used to low interest rates.  You will hear the term “taper” thrown about now.  The Fed is not going to raise interest rates yet; rather, they are going to slow their purchase of Treasury instruments and mortgages on the open market.  They are not raising the Fed Funds rate (do not worry about what that is exactly), but, since they were buying approximately 70% of all US Treasuries issued, bond market investors are worried that this demand/supply imbalance will naturally cause interest rates to rise (interest rates have already gone up).  Well, if interest rates will be higher, shouldn’t that be better for bond investors?

The short answer is no.  Before we can answer that question and look at some investment strategies and potential purchases, we need to review how a bond works.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit risk.  Credit risk is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser know is interest rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest rate risk relates to the fact that interest rates may rise, while you hold the bonds.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.

How do bonds work in terms of prices?  Most bonds are issued at a price of 100 which is referred to as par.  Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000.  The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own.  Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100).  Bonds can be bought and sold after that issue date though.  If interest rates rise or fall after issuance, how does the price of a bond adjust?  If interest rates go up, bond prices will go down.  If interest rates go down, bond prices will go up.  Why?  It is referred to as an inverse relationship.  Think about it this way.  If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors?  The answer is no if you decide to hold firm to a price of 100.  Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%?  The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full).  Luckily for you, the process works in reverse as well though.  If interest rates go down to 4%, you have the advantage.  If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment.  How much more?  Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity.  Why is this important to you as an investor today?

Let’s take a quick look at history.  Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s.  In the early 1980s, interest rates on bonds were incredibly high compared to today.  The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”.  How high were interest rates?  The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after.  For more information on the interest rates of this time period, please refer to this link:  http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from  the University of Chicago.  Friedman was really the start of monetarism.  Monetarism is simply the effect of the money supply in any economy on interest rates.  In general, as more money in the economy is available, interest rates will go down.  As less money is available, interest rates will go up.  Why?  Think about it in this manner.  If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals.  So the Fed of that time period began buying all types of bonds on the open market.  The hope was that, as the money supply grew, interest rates would fall.  As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards.  Needless to say, the policy eventually worked.  It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond.  First, you earn money from the coupon paid over the life of the bond.  Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price.  Therefore, you can earn money from interest and capital gains.  In a rising interest rate environment, you can only earn money from the coupon.  What individual investors, and some money managers even, fail to realize is this simple fact of finance.  The yield on a 3-month US Treasury bill today is roughly 0.06%.  No, that is not a misprint!  The yield on these bills has gone down over 16% over the past 30 years or so.  The bond market has never seen such an extended period of falling interest rates.  Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now.  That anomalous occurrence is coming (has come) to an end.  What can individual investors do then?

There are a number of things you can do to deal with the specter of rising interest rates.  I do not recommend any specific securities to purchase.  However, these investment strategies are something to consider.  They are as follows:

1)       Purchase an ETF that invests in floating rate fixed income securities

Investors are accustomed to bonds issued with a fixed coupon.  Yes, that is the most common.  However, there are other bonds that have an interest rate which is variable over the life of that bond.  Why would a company want to consider this?  There are two reasons why.  The first reason is that some companies need to borrow money from financial market participants constantly and for short periods of time.  The second reason is that certain companies that have liabilities which float over time.  Why?  They may have revenues that float over time as well.  It is much more complicated than that, but I do not want to get too bogged down into the details.  The most commonplace is a financial instrument known as commercial paper (CP) which is an example of the first reason.  CP is any financial instrument with a maturity of up to 270 days.  Firms, such as General Electric or Goldman Sachs, will sell CP to institutional investors for purposes of raising working capital.  It might be to pay short-term bills, or it might be to fund operations until money comes from previous sales at a later date.  Whenever CP is issued, the current interest rate prevails.  There are ETFs out there (only a few right now though, such as the iShares Floating Rate Note ETF – Ticker Symbol:  FLOT) that invest in CPs or other variations thereof.  The ETF will hold these fixed income securities with very short maturities.

2)      Purchase a target maturity bond ETF

 

When you purchase a bond mutual fund, you are pooling your money with other investors.  You do NOT own the bonds that the mutual fund invests in.  The mutual fund firm will calculate the value of their bond holdings each day and divide it by the number of shares outstanding to arrive at the net asset value (NAV) of the mutual fund.  The mutual fund will allow mutual fund investors to buy additional shares at that price or sell shares at that price.  Isn’t that just semantics and really is the same thing?  Absolutely not!  When you own a bond mutual fund, the holdings of the mutual fund are constantly changing.  You will see an SEC yield quoted and a weighted average maturity (WAM) of the bond mutual fund show in years.  If interest rates rise and you need to sell, the NAV of the bond mutual fund will go down.  Since the bond mutual fund needs to earn as much interest for its bond investors as possible, they will constantly take new inflows from investors, interest payments, and principal payments to invest in bonds issued today.  Therefore, the NAV of the bond mutual fund has to go down.  Since you are never holding the actual bonds to maturity, in a rising rate interest environment, you will receive interest payments from the bond mutual fund, but the value of the bonds held by the bond mutual fund will fall gradually, ceteris paribus.  Since interest rates have been falling for so long, most individual investors do not know this.  How do you combat that?  Well, BlackRock and other ETF providers have developed a new type of ETF which is based upon a target maturity.  How do they work?  You can purchase an ETF that might be in existence for five years, for example.  The ETF will invest in bonds with five years to maturity and then disband the ETF after five years.  Thus, as a bond investor, you are only subject to default risk.  As you will recall, default risk is the risk that an entity will not pay back the principal and interest on the bond.

 

3)      Purchase a floating rate instrument directly with a credit enhancement

There are fixed income securities sold which have interest rates that are set very frequently.  One of these instruments is known as a put bond or floater.  Put bonds or floaters are fixed income securities that are sold with an interest rate that is “reset” (i.e. adjusted to reflect current interest rates) on a periodic basis.  For example, they might be reset daily, weekly, or monthly.  Therefore, if you own a floater and interest rates go up, you will earn that new interest rate.  If interest rates go down, you will earn that interest rate.  You do not lose your original principal.  The interest rate is always chosen such that the floaters will sell at par.  Now owning a floater that is tied directly to a company, non-profit, charter school, municipality or other entity is a risky proposition.  You are subject to the credit risk of that entity, and they might default.  However, you can get around being exposed to the credit risk of that entity.  It is possible to purchase floaters (most are actually issued this way) which have a credit enhancement.  A credit enhancement is something that the obligor (i.e. the entity that issues the bonds and needs the money) purchases.  The types of credit enhancements are not that important; the concept is more significant for individual investors.  A floater with a credit enhancement means that, if the obligor defaults, the entity providing the credit enhancement will pay the principal and interest then.  Banks and bond insurers offer credit enhancements.  Therefore, when you purchase a floater with a credit enhancement, you are essentially exposed to the credit risk of the entity providing the credit enhancement and not the issuer (i.e. obligor).  Yes, you still have credit risk.  With that being said, there are floaters out there which have a credit enhancement from Bank of America, JP Morgan, US Bank, Wells Fargo, or Assured Guaranty.  The interest rate will be lower than the interest rate that the company itself would be able to get by accessing the bond market directly.  However, it will save you the time of trying to do a credit analysis of a small manufacturing firm with $50 million in annual revenues.  You can contact a middle-market or larger full service brokerage firm to see if they offer put bonds or floaters for sale.  If they say no, but they offer Auction Rate Securities (ARS), it is not the same thing at all.  ARS have very different characteristics which rear their ugly head during liquidity crises like the financial crisis of 2008.

4)      Purchase mortgage back securities (MBS)

 

MBS may have a bad name from the financial crisis of 2008.  I am not referring to MBS that invest in subprime loans.  Subprime loans are speculative in nature.  I am talking about mortgages issued to individuals with good credit scores.  You can purchase an MBS issued by GNMA (Ginnie Mae), FNMA (Fannie Mae), or the FHLB (Freddie Mac).  The GNMA is a government sponsored enterprise (GSE), and FNMA and FHLB are sometimes referred to as “quasi” in nature.  These MBS essentially purchase thousands of mortgages that meet certain requirements in terms of size of the loan and credit of the borrower.  The mortgages are pooled together and sold to investors.  These securities are essentially pass through instruments.  Pass through instruments mean that the principal and interest payments flow through to the owners of the MBS.  Why might you want to own these?  In a rising interest rate environment, people with mortgages will not refinance their mortgages.  Why would you get rid of your 4% 30-year fixed rate mortgage and change to a 5% 30-year fixed rate mortgage?  As interest have been falling over the past several decades, it has been advantageous to refinance ones mortgage to a lower rate.  There are bond mutual funds that invest in MBS.  However, they fall subject to the same phenomenon that I mentioned above.  You are investing in a pool and do not own the MBS directly.  If interest rates go up and you need to sell that bond mutual fund, the NAV on the bond mutual fund will go down.  You can inquire at your local brokerage firm about MBS.  Now if your broker or Financial Advisor talks to you about collateralized mortgage obligations (CMOs) being the same thing basically, that is not the case.  CMOs do offer different characteristics which may be attractive, but they are much harder to analyze.

 

5)      Consider purchasing bonds issued by international firms or different countries

 

International firms and different countries have bonds that sell at different interest rates.  The nice thing about these bonds is that they are affected by different factors or the economy may be in a different stage than the US.  It is akin to the multiverse concept of Mohammed El-Erian of PIMCO.  El-Erian tells investors that the global economy is not simply something that is changing in one direction or in one way.  Rather, he states that different countries or regions can be moving in the same or opposite directions at any given time.  Furthermore, bonds issued outside of the US provide diversification to your investment portfolio.  It is the concept of not “having all your eggs in one basket”.  It is one other option for you.  There are countries which are in the process of lowering interest rates, so you can benefit from the interest rate payment and capital gains then.

 

One other thing you can do is to just reduce your duration.  Duration is simply the time it takes for your bonds to mature.  Under normal market conditions, bonds with shorter maturities have lower interest rates than bonds will longer maturities.  Believe it or not, that is not always the case though.  When short-term interest rates are lower than long-term interest rates, bonds with shorter maturities are less sensitive in terms of price movement than longer maturities.  I do not consider this an investment strategy really.  It is just a way of lowering risk.  Now when you hear financial professionals speak about searching for yield in other ways like investing in dividend stocks or MLPs (master limited partnerships) that is not investing in fixed income securities.  Given your risk tolerance, you should have a set allocation to fixed income securities.  You might decide to replace some of that allocation with a higher level of other stocks or other instruments.  However, that is a choice, and you are normally increasing the risk of your portfolio.  I am not saying that is good or bad.  I am simply saying that implementing this strategy comes with tradeoffs.

 

If any of you have comments on investing in a rising interest rate environment or more questions, please feel free to add them to this post.  You also may feel free to send me an email at latticeworkwealth@gmail.com.

Important List of Questions to Ask When Selecting a Financial Advisor

12 Monday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

≈ 4 Comments

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bonds, business, education, finance, investing, investments, retirements, stocks

I realize that, despite what I write about, the vast majority of you will decide to choose a financial professional to assist you with your investment portfolio and reaching your long-term financial goals.  Going to see a Financial Advisor can be an intimidating experience.  You are coming in with limited knowledge of the financial markets, and you hear from the financial media and read in financial publications that the market is poised to go up, dive with a correction, or consolidate (i.e. unchanged).  The “noise” causes confusion.  Not to mention that the jargon utilized in the investment world is difficult to get up to speed quickly.  Your Financial Advisor should be able to explain his/her approach in layman’s terms, explain available services, and discuss the fee schedule of the firm.  Luckily for you, I have prepared a list which you can prepare for that meeting in 45-60 minutes and be armed with better questions and a foundation in the workings of the financial markets and some of the terminology.  Just so you know, I would say that if you perform this exercise, you will most likely be in the 90th-95th percentile of retail investor knowledge.  Here is the list of questions with links to past posts on the blog:

List of Questions

1)       How do you approach tactical versus strategic strategies for reallocating ones investment portfolio?

 

You should start with this question for one reason only.  There are a great deal of Financial Advisors that recommend that you invest for the long-term and not worry about temporary bumps in the financial markets.  However, they make changes to your portfolio each quarter.  If you have 20+ years to retirement, you really should not be making changes so often.  The world is always going to be uncertain.  You need to build a portfolio with the intention to make some tactical changes annually (make sure you are at your target allocations to each asset class).  Strategic changes should really only occur if a major life event happens or the market reaches an inflection point.  It seems like over time, there are really major market moving events every 5-7 years.  Think about the financial crisis in 2008, the bursting of the Internet Bubble in 2001, the Asian Contagion and Long Term Capital Management in 1997-1998, and the recession of 1991.  These events really moved the markets and necessitate a close look at your investment strategy.  Most of the current events are really “noise”.  They are only temporary influences on the financial markets.  Refer to this post for more information:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.

 

2)      How do you go about constructing an investment portfolio for me?

Nowadays there are many different options for investors that are “set it and forget it”.  One example is the life stage funds offered by various mutual fund families.  The ETF providers also have model portfolios based upon passive investing strategies.  Your Financial Advisor should be able to explain why your risk tolerance and financial goals require a different investment portfolio.  Are those changes to common models marginal or are they going to provide value for you?  For more information regarding the construction of an investment portfolio can be found here:  https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/.

3)      How do you calculate the fees that I will pay in both percentage terms and absolute dollars?

 

I have spoken at length about how fees can really lower long-term performance of your investment portfolio.  Most financial services firms will provide you with an AUM fee in percentage terms.  You always want to convert that percentage into the actual dollars you will pay.  Therefore, if you have a $750,000 portfolio and your AUM fee is 1%, you would pay $7,500 per year for the advice of the Financial Advisor.  Here is a link to a further explanation of this concept:  https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/.  Fees lead to an opportunity cost because you could have invested those fees in the stock market yourself.

 

4)      Will you provide me with a blended benchmark to track my investment performance?  Will you highlight both absolute returns and relative returns in regard to my selected target annual rate of return on my investment portfolio?

 

Most Financial Advisors will speak with you during quarterly meetings in what I refer to as a vacuum.  What I mean by this is they only talk about your absolute returns.  What are absolute returns?  Absolute returns are nothing more than what your portfolio earned during the year.  The Financial Advisor will let you know how that compares to reaching your selected target annual return to meet your financial goals.

 

Well, there also is the concept of relative returns.  Remember that whatever asset allocation your Financial Advisor recommends, you could just buy an ETF or index mutual fund that invests in all the members of that asset class.  For example, if your Financial Advisor wants you to invest a piece of your portfolio in small cap stocks, your other option is to simply invest in an ETF or index mutual fund tied to the Russell 2000 or S&P 600 indexes.  If the actively managed mutual fund or separate account that your Financial Advisor recommends does not achieve the performance return of one of those indexes, you “lost” money on a relative basis.  Yes, you did not actually “lose” money if that actively managed fund component goes up.  However, that asset manager should be able to beat the index.  That is the only reason you would select actively managed mutual funds.  Unless they can beat the market over the long-term, there is no reason to choose that option.  You can do a “no-brainer” and invest in the whole index.  The importance of blended benchmarks is that it shows how well your Financial Advisor is doing in terms of helping you reach your target annual return.  Last year the S&P 500 was up 16%.  Thus, if you owned a large cap mutual fund that did not achieve that return, your relative performance is lagging the index.  For more information on blended benchmarks, please refer to this post:  https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/.

 

5)      How do I calculate the value you provide from recommending a given asset allocation for my investment portfolio?

 

If we take a concept from economics, you have probably heard that there is no such thing as a “free lunch”.  While this is true in most cases, when it comes to investing, the closest thing to a free lunch is investing in US Treasury bills, notes, and bonds.  When you are finally hitting retirement, you could simply buy 10-year US Treasury notes and live off the interest.  Most individual investors are not satisfied with this investment return.  With that being said, US Treasuries are backed by the full faith and credit of the federal government.  They are among the safest investment on the globe.

 

When you go to a Financial Advisor, you are paying him/her to earn what I refer to as an incremental return.  For example, if you are retired and your target investment return is 5.50% net of fees; your Financial Advisor will set up a portfolio to help you earn that return.  Let’s say you reach the 5.50% hurdle in your first year with your Financial Advisor.  How much money did your portfolio earn?  It turns out that this is a trick question.  You really only earned the incremental return which is 2.92% (5.50% – 2.58%).  The yield on the 10-year US Treasury note closed at 2.58% on August 9, 2013.  Therefore, if your Financial Advisor charges you an AUM fee of 1%, you are paying him/her 1% in fees to earn an extra 2.92%.  If you look at things in this manner, you will not that your fees are quite high when you do not compare the AUM fee to the investment portfolio solely. Remember that you already have the money, so it is really a moot point and irrelevant for purposes of calculating the value provided by the Financial Advisor.  Please refer to the following post for additional information: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/.

 

6)      How do you arrive at expected returns for my investment portfolio?  Do you tend to use arithmetic averages or geometric averages?

 

The calculation of your target expected return is of paramount importance.  It determines whether or not you have enough money to comfortably reach your financial goals.  Arithmetic and geometric averages may sound like complicated concepts, but they are really quite simple.  An arithmetic average is simply adding up the returns for each year and dividing that number by the total number of years used.  Arithmetic returns are fine for trying to arrive at an expected return for any given year.  However, once you introduce a negative return into that series, the arithmetic average is of no use.  Geometric averages measure what is referred to as terminal values.  Now terminal values is a fancy way to say what return you earned over time that equals how much money your investment portfolio is worth at the end of the period.  I will give you an example to make this more concrete.  Let’s say you invest $10,000 into the stock market, and the stock market goes down 10% in the first year and then goes up 10% in the second year.  How much money do you have at the end of year two?  You have $10,000, right?  No.  Do not worry; most people get that question wrong.  Take a look at the math.  If your $10,000 portfolio goes down 10% in the first year, you have $9,000 ($10,000 * (100%-10%)) at the end of the year.  If your investment portfolio goes up 10% in the second year, you have $9,900 ($10,000 * (100%+10%)).  You actually lost 1% over that period.  It is easier to think of in more extreme returns.  What if you owned a stock that went down 50%?  How much does the stock need to go up to get back to even?  Well, you have half as much money, so you need to double that amount.  It works out that you need a 100% return to have the same amount of money in your brokerage account.  Why is this important?  Many Financial Advisors will tell you that you can earn 8-9% if you invest in stocks.  Well, the long-run historical average return of stocks is somewhere around 7%.  It depends on what stocks you include in the index.  Now the recent past has been great for most every stock.  With that being said, there is always the chance that the market will drop significantly in any single year.  When the S&P 500 went down almost 40%, you would have needed to earn 66.6% just to get back to even.  Now remember that your Financial Advisor told you that you can expect to earn 8% or 9% as a target return over the long-term.  The stock market rarely goes up that high.  It usually will take 4-5 years to earn that 66.6% return.  For each year it takes to get back to even, you are missing out on the assumed compounding over the period.  Thus, you will be behind your long-term plan to reach your financial goals because you are only trying to get back to even.  For more information on this concept, please refer to this post: https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.

 

7)      If I have a long-relationship with you to manage my money?  How will fees add up over time?  Am I making a “bet” that you will beat the financial markets?

 

This topic is always the hardest to discuss.  When you choose a financial professional, the ideal relationship is for the rest of your lifetime.  If you are retiring soon or just retired, you are likely to be dealing with the Financial Advisor you select for 20+ years.  It is a big decision because you will be paying AUM fees for the rest of the relationship.  You need to know what you are getting into and feel comfortable with that Financial Advisor because they are helping you live your golden years in the way you always envisioned.  How do you go about determining the value that the prospective Financial Advisor will provide over your retirement years?

 

You need to use the economic concept of opportunity cost.  If you have a retirement portfolio worth $1 million at the start of your retirement and your Financial Advisor charges you a 1% AUM fee, you will pay $200,000 ($10,000 * 20 years) over the course of the relationship.  Well, think about that.  If you managed your own investments, you would not need to pay that AUM fee.  You could take that $10,000 and invest that money in an ETF or index mutual fund tied to the S&P 500 and earn the long-term historical average of that index which is roughly 7%.  Now if you did that, you would have roughly $425,570 at the end of 20 years.  As you might imagine, dollars 20 years from now will not be worth as much as they are now.  So how do you relate your opportunity cost into present day dollars?  You do a process called discounting.  If you assume inflation will equal 3.25% over the course of those 20 years, you would have $224,475 in today’s dollars.

 

Now let’s reference your beginning portfolio balance.  You can think about this in two ways.  First, that is the cost of you not managing your own investments which is a decision that only you can make.  You need to measure the utility of your leisure and your risk tolerance (emotional about money and acting rashly at times).  Second, you are making a $224,475 “bet” that the prospective Financial Advisor can beat the market.  Remember you could just choose an asset allocation yourself.  You will earn the index averages minus the expense ratio of those investments.  Most expense ratios on passive options are 0.20% or less.  You will never beat the market averages, but you avoid the chance that your Financial Advisor recommends a poor choice for your asset allocation that significantly underperforms its proper benchmark.

 

Now if you do not have $1 million or the AUM fee is not 1%, you can easily calculate how much your present value is.  Simply take the ratio of your investment portfolio divided by $1 million and multiply by the AUM fee as a number.  Here is an example:  let’s say you have $250,000 now and your AUM fee is still 1%.  Your present value would be $56,370 (($250,000/$1,000,000) * 1.  If you compare that to your entire portfolio, the amount is approximately 22.5% ($56,370/$250,000) of your portfolio value.

 

There is no reason why you cannot work with a Financial Advisor for a couple of years and then take the reins once you learn from him/her and get comfortable with the volatility and workings of the financial markets.  You can seek out a financial planner or an independent Registered Investment Advisor (RIA) who charges an hourly fee.  You could go to see that financial professional and pay may $200-$250 per hour.  You might spend two hours at year-end and maybe see him/her once during the year when current events make you want to sell all your stocks, bonds, and other assets.  That financial professional can probably “talk you off the ledge” in one hour.  If we look at that in totality, you would pay that type of financial professional $600-$750 over the course of the year.  Looking back at our hypothetical portfolio of $1 million with a 1% AUM fee, you would be paying $10,000 to the Financial Advisor.  This option would save you over $9,000 in fees.  Try to remember that the choice is not manage your own investments or turn it over to a Financial Advisor.  There is a “gray” area where you use a trusted financial professional to bounce ideas off of.  Therefore, there is a spectrum of choices when you are looking at how to ensure that your investment portfolio will allow you to reach your financial goals successfully.

 

As you can see, you should be quite comfortable and more confident going to speak with a prospective Financial Advisor.  Keep a few things in mind though.  You spent about 60 minutes doing a crash course in learning the fundamentals of portfolio construction and fees.  The Financial Advisor has years of experience and deals with clients every single day.  So if the Financial Advisor does not understand the questions, does not know the answers, thinks the questions are not relevant, or tries to steer you away from looking at fees and relative returns, I would seriously consider looking for another Financial Advisor.  These types of questions are what a high net worth client would ask.  You may not have $5 million+ to invest, but there is no reason why you cannot ask similar questions.  It is your hard-earned money, and you deserve exceptional service no matter whatever the amount in your investment portfolio.

 

I leave you with this link to lighten the mood and make yourself proud:  https://latticeworkwealth.com/2013/08/06/when-it-comes-to-your-investments-are-you-smarter-than-a-14-year-old/.  You spent roughly 60 minutes reading and can count yourself as knowing more about investments and fees than 90 or 95 people out of 100.  As an aside, if your Financial Advisor uses financial jargon that you do not understand, you must ask for an explanation.  Do not pretend to know everything.  Asking questions is a sign of intelligence.  You will have the foundation after reading this to know you are asking intelligent questions.  Best of luck to you when you depart to meet with a prospective Financial Advisor!  By all means, you can feel free to take this list of questions with you to help you learn more about the Financial Advisor and the services that his/her firm offers.

Why Did I Choose to Include Latticework in my Investment Firm’s Name? Well because of Charlie Munger, of Course.

11 Sunday Aug 2013

Posted by wmosconi in bonds, business, Charlie Munger, Education, Fed Tapering, Federal Reserve, finance, financial planning, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, personal finance, portfolio, statistics, stock prices, stocks, Warren Buffett

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bonds, business, Charlie Munger, education, finance, investing, investments, markets, stocks, Warren Buffett

I affectionately refer to Charlie Munger as Warren Buffett’s sidekick at Berkshire Hathaway. Buffett and Munger have been friends for decades and business partners as well. Charlie Munger serves as the Vice Chairman of Berkshire Hathaway and is 89 years old. He reminds me a bit of Andy Rooney. Some might classify him as eccentric and a bit of a curmudgeon. However, I heard once that Howard Buffett, Warren’s son, tells people that Charlie is the only person he knows that is smarter than his father. When I read that, it really caught my attention and piqued my interest. Smarter than the great Oracle of Omaha? Wow!

Mr. Munger is a fascinating man. You might think of him as a modern day Benjamin Franklin. The man is well-versed in most every subject imaginable. The most interesting thing about him is his “latticework of mental models”. You see Charlie views the world of investments and financial markets differently than most. In fact, he sees the entire world quite uniquely. The “latticework of mental models” is essentially using the “big” ideas and concepts from other disciplines to improve your understanding of market participants and investing in general. For example, Charlie talks a lot about the behavior of investors from a biological standpoint. One of the big concepts in biology has to do with complex adaptive systems in ecosystems. If you think about the rain forests of Brazil, there is so much diversity in life forms and interactions there. Many new species are discovered there every year. However, pollution and burning of the rain forest has caused the ecosystem to change in unexpected ways. Now Munger believes that financial markets operate in the same way. Each investor or institution is constantly trying out new investment strategies and trying to anticipate what other market participants will do and how the global economy will grow in the future. There is essentially an ever-changing disequilibrium within the financial markets which is always searching for an equilibrium. My actions in the financial markets will affect how others will react now and act in the future. It is very much akin to game theory developed by the Nobel Prize Winning economist, John Nash. This example demonstrates just one of Charlie’s insights.

I strongly suggest that you get to know Charlie Munger better. Once you listen to him, you can’t help wanting to learn more about him and the latticework. If you would like to learn more about this man, I would point you in the direction of this book: http://www.amazon.com/Damn-Right-Berkshire-Hathaway-Billionaire/dp/0471446912/ref=sr_1_1?ie=UTF8&qid=1376246794&sr=8-1&keywords=Damn+Right. The book, Damn Right, is a fabulous discussion of the man that sits beside Warren Buffett. In fact, Charlie is a lawyer, but his investment partnership had incredible returns as well. If you want to learn more about his “latticework of mental models”, here is a link that describes it briefly: http://www.psyfitec.com/2011/09/mental-models-arrayed-on-charlie.html. Now let’s move to the man that has codified Charlie Munger’s ideas into a book which focuses on investments.

There is a book out there by Robert Hagstrom. Here is the link: http://www.amazon.com/Latticework-Investing-Robert-G-Hagstrom/dp/1587990008/ref=sr_1_sc_1?ie=UTF8&qid=1376247028&sr=8-1-spell&keywords=latticwork+the+new+investing. The book is called Latticework: The New Investing. You may know Robert Hagstrom from Legg Mason fame with Bill Miller who beat the S&P 500 for over a decade straight. Mr. Hagstrom also has written extensively on Warren Buffett. In fact, I consider them the best practical books on investing like Warren Buffett. The books are The Warren Buffet Way, The Warren Buffett Portfolio, and The Essential Buffett. Since he covered Warren Buffett, he couldn’t help but notice Charlie Munger. Thus, he decided to write a book about him.

I will now try to bring this concept back down to earth and not so abstract. Have you ever met a “random” person and found out that you know the same person or grew up a few blocks away from each other? Even though you do not know the person, you have something in common. It makes the discussion easier. I will give you an example from my personal life. My best friend is an African American. We couldn’t come from more different backgrounds, level of education, family structure, and life experience. I met this gentleman at work in the financial services industry. Now we talked about finance of course, but, I cannot actually recall how it happened back then and we first really connected. Well, my friend happened to be a DJ who knows everything there is to know about hip hop music, and he is a very talented musician as well. I listened to a lot of hip hop growing up and playing basketball at the inner city parks in Milwaukee. We started to talk about music. There was an instant connection there, and I felt like I knew him forever. The odd thing is that he happens to be the smartest person I know. Why? He does not have a college degree, but he views the world very interestingly. You can have a conversation with him about Federal Reserve policy, deontological concepts from Immanuel Kant, black holes, conspiracy theories, and if Queensbridge has the best rappers from the origins of hip hop. Very diverse knowledge base to say the least. I count myself extremely fortunate to have this friend. He sees the world differently than most. He sees connections where others see silos of academic subject matters. Now if you saw us on the street, you would probably never guess that we were such good friends. Well, Charlie Munger sees the world in such a way as well.

Hagstrom’s book goes into depth about the subjects that Munger reads and learns about. He talks about physics, biology, psychology, history, literature, and other matters. It is interesting how many of the concepts and theories of these disparate topics can be used to look at financial markets and economic activity in the world. For example, you might be most familiar with the fields of behavioral finance and behavioral economics. All these fields are “simply” applying psychological concepts to the real world of investing. Are people really rationale? Do we have cognitive biases that blind us in making everyday decisions? Now psychology is easier to relate to investing. However, the equilibrium and disequilibrium theories of physics can be applied as well. I will not go into any further depth. As you can tell from my blog in general and this post, brevity and being succinct are not really my strong suits. With that being said, I would point you to a website that will “blow your mind” and really make the “latticework of mental models” come alive: http://www.santafe.edu/. The Santa Fe Institute has a group of academicians and others who look for connections between different subjects. Now I will warn you that a lot of the material is quite complex and it is not specifically about investing. However, you will learn quite a bit from looking at a few of the papers published.

Well, how do you go about building your “latticework of mental models”? Have you ever wanted to learn more about astrophysics, history, or science? There is one free way to do it. The Massachusetts Institute of Technology (MIT) has a website that provides actual information taught in the classroom and a lot of video lectures. When you hear MIT, you might automatically associate it with technology, engineering, and computer science. However, it is a great higher learning institute and has renowned professors in business, math, history, and literature. Here is the link: http://ocw.mit.edu/index.htm. The OpenCourseWare system is incredibly unique and valuable. Try it out with a topic you have heard of, but you do not know about in any detail. There are video lectures that are 20-30 minutes long. Additionally, you will have access to lecture notes and the books/articles read. So you can go to your local library and research more. You can link to one of the best schools in the world and learn from them. It is an exceptional opportunity.

I hope this explains the Latticework in my company’s name and why I use the concept in my investing and personal life as well. Once you learn about the “latticework of mental models”, it will definitely challenge how you view the financial markets. If nothing else, it might satisfy your intellectual curiosity.

You Purchased a Stock: Now What?

09 Friday Aug 2013

Posted by wmosconi in bonds, business, finance, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

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bonds, Buffett, business, finance, investing, investments, stocks

One of the questions that I have been asked is about individual stocks, and, more specifically, how to monitor developments after the purchase. Now I have mentioned before that I strongly recommend that you do not start off trying to buy individual stocks. ETFs and index mutual funds are a better way to start off investing and will generally garner you higher returns in the long-run. Why? Well, please continue reading, and you will see how I approach the decision to purchase a stock and when I decide to sell. Now my method is strictly my own, but you will see it closely mirrors Warren Buffett’s style of investing. There are many other market participants that use a variation of the Buffett and Graham paradigm. Moreover, there are literally tens of thousands of portfolio managers, hedge fund investors, research analysts, and others that value stocks every second of every day in response to company, economic, and geopolitical news. Once you see how much work it takes, I am hopeful that you do NOT try it to begin with.

Before delving into the process of following a stock after your purchase, I will go through the steps I take prior to a purchase. I strive for a turnover of 15-20%. Turnover measures how long an investor holds a particular stock. A turnover of 100% means that an investor holds a stock for one year. Thus, my turnover equates to a holding period of 5.0 to 7.5 years. So if I am willing to hold a stock for that long, I better make sure I am confident that it is a good investment. How do I start? I have a list of stocks that I am interested in purchasing. If I decide to possibly invest, I go through a lengthy process. Now I am not recommending any security. However, I want to put some meat surrounding the discussion. Therefore, I will talk about my process in terms of my decision to purchase Western Union (WU). Western Union is now my top holding. Should you buy WU? Maybe so. Maybe not. You must do your own homework and not take my word for it. As a show of good faith, I encourage you to look at my Twitter account: @NelsonThought. I have been posting information about WU for several months, so I am not “cherry-picking” to make me look good. Let’s begin.

Regardless of where I get my ideas of stocks to analyze, I start off my analysis by learning everything I can possibly get my hands on. You would be amazed at how much information is out there. Prior to deciding to even value WU, I took a number of steps. First, I read the last three annual reports for WU. What do I focus on? The most important part of any annual report is a section called Management Discussion & Analysis (MD&A). MD&A is indispensable because management has a chance to be open and honest with investors. Now when you purchase a stock, you should view yourself as a fractional owner in the actual company. You do not own a piece of paper that says you have x number of shares. You own a claim to the future cash flows and dividends of that firm. Contained within the MD&A is management’s discussion is a review of the most recent financial developments, their strategy, and what management thinks is the future direction of the company. WU’s management team talks a great deal about emerging markets. WU relies upon the wiring of money between individuals. The most important, growing income stream comes from immigrants sending money back home to their families. For example, did you know that 30% of the Gross Domestic Product of El Salvador comes in the form of these remittances? Wow! That fact always gets to me. Obviously you can see that the emerging markets are a great way for WU to grow earnings. Additionally, WU has a huge market share in the correctional system. If family members or loved ones of prison inmates need money to purchase items behind bars, they can use WU to transfer money into their accounts to buy food, hygiene products, and even other items like TVs and radios. WU’s management speaks at length about these opportunities, and they also focus on growing their network of facilities that provide their services. There is a “network effect” for WU. The more money transfer centers there are, the more people in general will use their services. For instance, if a local WU outlet is right near your house, and you need to wire some money to an individual or business, you are more likely to use it. Well, if you need to wire money to a friend, and the nearest WU outlet is 50 miles from that person, WU is probably not a good option for you. Therefore, it makes sense for WU to provide good incentives to build up their network.

Now I really focus on MD&A going back in time because management is telling you what they intend to do in the future. Think about it in these terms. Have you ever had a friend who tells you that they are going to quit working and start a business? I know that I have. More often than not, when I see that person in several years, they tell me that they are still working but they are starting the business soon or they found a better business to start. It is great to have ideas, but, unless you act upon them and do it, there really is no point. Well, the same scenario happens very often with a business. Management might describe great plans to grow the business back in 2010. If they never speak about it again, or they have new and better ideas when you read the 2012 annual report, that should be a red flag for you. Now changing strategy is sometimes warranted, but management should be transparent with you. If a strategy is no longer relevant, or it did not work out, they should explain why. It is only fair. You own the stock; you own part of the company. Always take the time to compare prior MD&A with current MD&A. This technique can save you a lot of time. Why value a stock if management does not seem to know what they are doing?

After you feel comfortable with management and still have strong beliefs that the business is well-positioned, you can look at the financial statements of the company. Every publicly traded company is required to file financial statements with the Securities and Exchange Commission (SEC). The reports are called 10-Ks on an annual basis and 10-Qs on a quarterly basis. The SEC even has a website that you can go to when you look for them. It is called the EDGAR system can be found here: http://www.sec.gov/edgar.shtml. The financial statements will include the income statement, balance sheet, and statement of cash flows. Which part is most important to me? Well, that is a trick question. I go to the back of the financial statements and look at the notes to the financial statements. Do not feel bad if you got the question wrong. When I pose the question to undergraduate students during presentations that I give, I have never had a finance student give the correct answer.

Why do I say the notes? For one, I have an accounting undergraduate degree, so I am interested in them. You can always get financial statement ratios and earnings expectations online, but they rarely incorporate information from the notes. Now the notes to the financial statements tend to be boilerplate to begin with. The accounting firm that audits the financial statements of a firm will explain that the company used generally accepted accounting principles (GAAP) and disclose the accounting methodology utilized when GAAP allows different choices. After all these disclosures, you will find lesser known items. The second reason why I look at the notes to the financial statements is to see if there is something I do not understand. What do I mean by this? You may remember the downfall of Enron. The downfall of Enron was right in plain sight all along. Enron had a disclosure “buried” in the notes that talked about Special Purpose Vehicles (SPVs). What is a SPV? I still really have a vague understanding, but here are the basics without getting too technical. A SPV is a separate legal entity that is set up to own assets and incur liabilities. It is really like a subsidiary of a company but, since it is a separate entity, the assets and liabilities of the SPV are not required to be reported on the company’s balance sheet. What? This phenomenon is called off-balance sheet reporting. Essentially it is a way to not disclose liabilities. Think about it in terms of the federal government. The federal government does not consider future Social Security and Medicare benefits to be necessary to be reported in the current budget. Thus, the $50+ billion of future payments of benefits is not reported; only think tanks talk about it periodically. Now I do not want this to be a political discussion. That is not my intent. I simply bring it to your attention as a more familiar example of this topic. Thus, Enron had liabilities that it had to repay in the future, but, if you only examined the financial statements, the future payments were not on the balance sheet. The auditors did not look too closely. Why? I liken it to this. No one wanted to raise his/her hand and say what is this SPV thing. In general and in business, people do not want to look uninformed or “dumb”. If you see something in the notes to the financial statements that you do not understand, I would suggest that you pass on the purchase of that stock. When I look at the notes for WU, there is nothing that bothers me in particular.

After I look at the notes, I focus on the statement of cash flows, balance sheet, and then the income statement. I look at them in that exact order. Now I do not prepare a model at this point to value the company. Rather, I do some calculations in my head. Is the company actually generating cash from the operations of the business? Does the company have enough assets to invest in the business? Are earnings coming from sources that will either never occur again or have nothing to do with its core business? These are very vital questions to ponder. Why do you not value the company at this point? Now I really have a number in mind for what the stock is worth, you still need to compare that to the sub-industry and industry that the company operates within.

As one reader commented, he was probably going to use this discussion to cure his insomnia ailment. Hopefully you made it this far. Are we having fun yet? I promise we will get to the discussion of how to follow a stock after making a purchase, but I need to lay the foundation to ensure that my method makes sense. Not that it is right, but the logic of the paradigm is plausible. As it relates to the sub-industry and industry, I perform what is referred to as a SWOT analysis. SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. Now I already know the S and W part from my review of MD&A and the review of the financial statements issued by the company. The O and the T refer to the industry and competitors. The main competitors in this space to WU are MoneyGram International and Euronet Worldwide. How does WU match up against these two? These two companies are smaller than WU, but bigger is not always better. These two firms are constantly innovating and trying to make inroads into the niche of WU. They are referred to as firms within the sub-industry. The industry as a whole is the financial services industry. Now WU is able to grow significantly in the emerging markets because the banking industry is not very developed in these countries. It is easier at this point to simply pick up a wire transfer at a Western Union outlet than to open a checking accounting. I can assure you that banks have noticed taking note. Banks are trying to come up with ways to make it easier to open an account and simply have the money deposited there. That is the most common way to look at the industry. Now sometimes it is easier to ignore other developments, but I try to take everything into account. Did you know that you can make wire transfers at most Wal-Mart stores now? That development might be a game-changer. Think about it this way. Why should you go to WU when you can simply do your normal shopping at Wal-Mart and then send your wire transfer? Remember that there are a plethora of Wal-Mart stores, so they already have a built in “network effect”. They are a definite competitor even though they are technically in the retail industry.

After my entire analysis, I was confident that the purchase of WU would be a good investment. How do I go about valuing any stock? As I mentioned previously, I use a method that Warren Buffett has perfected over the years. Trust me, I am no Warren Buffett. If I were as good as Warren Buffett, I would not be writing this blog. However, his method (coupled with Phil Fisher, David Dodd, Charlie Munger, Bill Ruane, and a few others) makes sense to me. Think about stocks like bonds. Bonds are much easier to value. Why? They are a promise to pay back money loaned to them. The only return from a bond held to maturity comes from the coupon. The coupon is simply the interest rate. As an aside, you will hear coupon over and over again. Where does the term come from? Back in the older days, when you would purchase a bond, the company would give you a certificate that actually had coupons. When a payment was due from the company, you would take the coupon to your local bank and get your money. The bank would collect all the coupons and present them directly to the company. This was prior to the introduction of computer systems to monitor who owned which bond. That is why you will hear the term coupon. Anyway, the interest rate of the bond does not vary over time. A bond is worth a set amount that you will receive upon maturity and the periodic interest payments, but you need to remember that the payment is fixed. What if interest rates fall? If you purchased a bond that had a 6% coupon and the prevailing interest rate for the same type of bond rises to 8%, how are you able to sell the bond? Why would I buy your bond if I can simply buy one with an 8% coupon? You can sell me that bond by lowering the price. A corporate bond is usually issued in $1,000 increments, so, if interest rates rise, you can simply lower the price to make its return equivalent to owning an 8% percent bond. This is what is referred to as an inverse relationship. It works the same way in reverse if interest rates fall. If prevailing interest rates fall to 4%, you can afford to charge what is referred to as a premium because buyers in the marketplace cannot find a better opportunity with your 6% coupon. Therefore, you can charge more than $1,000. How does this relate to stocks? Stocks are nothing more than bonds with variable cash flows. Now if you ignore the fact that owning a bond makes you a creditor and holding a stock makes you an owner of the firm, you really need to value it in the same way. However, it is infinitely more difficult. Why? You do not know how the company will fare in the long-term. Will the strategies work out, will they be executed properly, will another competitor overtake the company, or will a new technology displace the service provided by the company? I have already talked about the competitors of WU, banks knocking at the door, and the “invasion” of Wal-Mart into the space. All of these elements cause the future earnings of WU to be unknown and variable. I am still confident with the prospects of WU, so I move to valuing the company and approach it in the same manner as I would a bond.

To me (and many others), a stock is only worth what a company can earn in the future. If you have a friend that has a business idea but you can see that it is unlikely to work, would you invest in the firm? Probably not. When I look at WU, I see that it is likely to earn money far into the future. What are earnings? You will hear many different terms because there are many different types of market participants and other stakeholders. I focus on a concept called owner earnings. Owner earnings are a combination of Free Cash Flow (FCF) and changes in Plant, Property, and Equipment (PP&E) and working capital. FCF is simply the cash that comes from ongoing operations of the firm. However, you need to remember that the firm needs to make future investments in technology and other items. Thus, when you look at depreciation of PP&E which is only an accounting convention, the company may need to make more or less investments into the business in order to keep competing. Additionally, the company needs cash to simply pay current bills that come due which relates to working capital. If you calculate FCF and adjust for PP&E additions and working capital, you come up with owner earnings. Once you calculate owner earnings, you know that the firm will be able to grow owner earnings over time. If they cannot grow owner earners in the future, you probably would not be at this point in the analysis right now. Well, you also need to remember that these earning will occur in the future. Why is this important? Think about loaning $100 to a friend for a year. If he/she tells you that they will pay you the $100 back sometime next year, you will most likely want more than $100. For one, you automatically know that under normal economic conditions, it will cost more than $100 to buy the same amount of products or services next year. Additionally, you could have bought something else with the $100 and enjoyed it right away. This is the concept of utility. For example, you could have purchased 5 or 6 Blu-Ray discs and enjoyed watching these movies. You are forgoing that consumption because you loaned out the money. In order to make it worth your while, you might tell your friend that you will loan him/her $100, but you want them to pay you $110 next year. This will compensate you for inflation and delaying your consumption. The same economic principle applies to the purchase of stocks. You could spend your money, or you could invest in another stock. Therefore, you will only purchase a stock if the price will increase satisfactorily in the future such that you can make money. You need to discount these future owner earnings.

How do you discount the owner earnings? I come up with my financial model at this point. I determine how much WU will earn over the next five years, the five years after that, and then for the rest of its existence. Once you have calculated the next five years, you need to remember something. If a certain company is earning what is referred to as “excess profits”, other firms will come into the market and try to do the same thing because it is lucrative. Additionally, there might be other technological advances which make the wire transfer business of WU less attractive or obsolete, which is even worse. Thus, I assume that WU will grow at a certain rate for five years, a lower rate for the next five years, and then a growth rate similar to the general economy forever. The last part is somewhat of a plug figure. Most stock analysts will say that WU (or any other company) cannot keep growing at high rates forever, it will eventually grow owner earnings very similar to GDP growth in perpetuity. Now I use an assumed growth rate of 3.5% which is higher than the domestic economy because WU has a significant presence in the emerging markets which are growing at a faster clip. Now that I have a stream of owner earnings, I need to discount them to the present. The discount rate is a subject of much debate. I use a rate of 7% or the equivalent of the yield on the 10-year US Treasury. Other investors will use a higher rate. I won’t get into a debate about the proper discount rate to use. I simply follow the advice of Warren Buffett. Here is a link to see his rationale: http://www.sherlockinvesting.com/help/faq.htm. If I discount that owner income stream back to the present at that discount rate, I come up with what is referred to as an intrinsic value. Intrinsic value is a concept that was coined and explained at length by the father of value investing, Benjamin Graham. The intrinsic value is what I think WU is worth right now given the current business environment and likely future prospect. Now since I am fallible and the future is uncertain, I use the margin of safety concept also introduced by Benjamin Graham. I take the intrinsic value figure and reduce it by a certain amount. For WU, since it is in a somewhat stable industry and finance is my background, I use a margin of safety of 20%. Therefore, I multiply my intrinsic value figure by 80% (100%-20%). If the current stock price of WU is lower than my calculation, I am inclined to buy. The intrinsic value I get for WU is significantly above the current stock price. I purchased WU at $14.24 average cost, and it now trades at $18.36 as of August 9, 2013. I still hold the largest portion of my portfolio in WU because I see the intrinsic value of WU as being higher than that presently.

As you might imagine, this entire process took me roughly 55-60 hours. Surprisingly, there are many stock analysts that may say that I was not thorough enough. An example would be the famed hedge fund investor Bill Ackman. I am willing to bet that I spent more time prior to the purchase of WU than you will spend on financial planning over the course of your lifetime. I do not mean this in a condescending manner. I only point this out to simply show why the purchase of an individual stock is not right for everyone. I tend to refer to myself as a “dork”. I am passionate about investing, and I love to perform this type of analysis and calculations. If you are not willing to put in that type of time to do your homework, I would stop at this point. I will repeat again that ETFs and index mutual funds are much better choices for individual investors. If you would like the chance to beat the index averages, I would rather see you invest in actively managed mutual funds or separate accounts than try your hand at selecting individual securities. With that being said, I will now turn to what I promised to in the beginning. Please forgive me for what might seem to be a circuitous route.

I intend to hold WU for a long time. I have a set intrinsic value, and I am willing to stick to holding the stock through all the “visiccitudes and vagaries” of the stock market. My emotional intelligence is higher than most investors. I view investing as an intellectual exercise. The money is secondary. As soon as you start focusing on the money, you may be tempted to sell your stock if it falls in price significantly for what might seem like no apparent reason. If I need to wait for 5-10 years for WU to reach its intrinsic value, I am willing to do so. Does this sound like fun? Well, it is to me. Unfortunately, this has really nothing to do with what you read in most financial news publications or see on financial media. However, you need to remember that I am an investor in the company and not trading pieces of paper. I can confidently say that the way investing is portrayed in the financial media is much more akin to speculation. My suggestion is to go to the casino if you want to try to double your money. You will have more fun. Investing in stocks to gain significant riches immediately is a fool’s game in my opinion.

What do I focus on after the purchase? The first thing I do is to read all the earnings transcripts of the firm. After each quarter, the company will file a 10-Q with the SEC and announce financial results to the public. Management will then talk to analysts on an earnings call to recap the quarter and then answer questions from a selected group of research analysts. I try to see if the earnings results match up with MD&A and if management uses any “excuses”. An example of a typical excuse is the weather. If a retail outlet has depressed earnings, they tend to use bad weather as an excuse at times. It may be likely, but, more often than not, it is a way to hide poor execution by management. Any particular quarter should not affect your intrinsic value calculation much. In the short-term, there can be developments that affect earnings for a temporary time. I do not worry about quarterly earnings, but I am interested in how the company is doing.

The second thing I do is to keep up with general economic conditions. I visit the Bureau of Labor Statistics (BLS) website on a periodic basis. The link is as follows: http://www.bls.gov/. The BLS is the agency of the government that monitors and releases economic statistics like GDP growth, new housing starts, the trade deficit, and a lengthy amount of others. I focus on leading indicators, but I also am interested in the so-called lagging and coincident indicators released by the BLS. Why do I pay attention to this? I do so for one primary reason. I am very confident in my calculations of future owner earnings for WU. However, I usually extend that to include a three-part probability exercise. For example, the likely path of owner earnings for WU is definitely affected by the current/future state of the economy. I have a percentage for normal, boom, and bust scenarios. The normal part gets the highest weight, and I then attribute different percentages to the other two. Now I will admit that these are very subjective, but they are imperative. How does the calculation work? Well, I assume that WU will earn more money if the economy does better than expected or less money if the economy enters a recession. Therefore, I multiply these scenarios by three different percentages. For example, I currently weight my estimates of future owner earnings by 80% normal, 15% boom, and 5% bust. Therefore, if the state of the economy changes or its future trajectory, I alter the percentages. Since WU relies so much on remittances across borders, if global growth slows significantly, I need to weight the stream that assumes a recession much higher. Using this approach, I do not have to recalculate owner earnings for WU again. I simply use the three different scenarios and weight them differently. Trust me, it saves a lot of time.

The next thing I do is to follow the developments of competitors. I read the earnings transcripts of these firms, do a cursory review of financial statements, and look at how the industry is possibly changing (for better or for worse in terms of WU’s positioning). It is extremely valuable to be constantly testing your investment thesis. You need to be ready to admit that you made a mistake. You can lose a lot of money otherwise. I can attest to that via Best Buy (BBY) and Citigroup (C) stock holdings in the past. With that being said though, you need to do that without referencing the case laid out by speculators. If someone tells me that WU will have a bad third quarter, I really do not care. I am willing to ride out stock price volatility because I know that WU is worth more than the current market price. The advice from speculators relates to traders of stocks (owning pieces of paper) and not investors.

I also follow market developments. Although I do read the Wall Street Journal and Financial Times, I try not to get too hung up on the current news of the day. You can get in trouble that way by feeling itchy and pulling the proverbial trigger and selling in a panic. I commented on this in more detail in a previous blog as it relates to the entire stock market. The link is as follows: https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/. I tend to put more weight in The Economist, Barron’s, Bloomberg Businessweek, and trade journals. I even read a few publications that seem unrelated but can make all the difference. One great source is the Harvard Business Review. This magazine is technical and “heavy duty”, but it can be a great way to identify mistakes that WU management is making or how they are behind the curve when it relates to business strategy. This information helps me to determine whether or not my calculation of future owner earnings is correct and will come to fruition.

My next technique is a little odd to some. I have found that I can learn a great deal about investing from other disciplines. In fact, I will devote an entire post to the name of my firm. I use what Charlie Munger, whom I lovingly refer to as Warren Buffett’s sidekick, calls the latticework of mental models. This approach is to acknowledge that ideas from other disciplines are germane and pertain to investing. A perfect example is psychology. There has been an explosion of ideas in the disciplines of behavioral finance and behavioral economics. These fields do not assume that market participants are rationale. Humans have innate biases and make consistent mistakes. As an investor, you can use this to your advantage. The one adage along these lines comes from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful”. If everyone is telling me that WU is going to the moon, I start to question my investment thesis. Now as a contrarian investor, if everyone is selling WU for reasons that are temporary or are related to general market selling, I perk up and even look to add to my position. You can read more about the latticework of mental models in an excellent book by Robert Hagstrom called Latticework: The New Investing. I use the concept of complex adaptive systems from biology, and the concept of nature searching for equilibrium from physics all the time. In fact, there is an entire website that you can learn a great deal from. It is called the Santa Fe Institute. This think tank is not devoted to investing at all, but they are looking for common themes among different disciplines. Take a look; I promise you will not be disappointed: http://www.santafe.edu/. I now will turn to the little talked about decision to sell a stock.

I think about WU in these terms. If I come across another investment opportunity that is better than WU, I will sell WU. If management or the state of the economy changes, I will sell WU. If you are in a tax-deferred account (401(k), 403(b), Roth IRA, etc), you do not need to worry about taxes. However, my individual stocks are in a taxable account. While taxes should not guide your sell decision, you must take them into account when deciding if another opportunity is truly better. Why? You should only care about terminal values. If you sell WU and buy another stock, that purchase should increase the value of your portfolio in the future. That makes sense intuitively. However, your mind can play tricks on you. What if I am expecting to earn 9% a year from WU and another stock comes along that I can earn 13%? Should I sell WU and earn the 13%? The answer is that it depends. Here is a typical scenario. Let’s say I now own $20,000 of WU and purchased WU with an original investment of $10,000. Thus, I have a $10,000 capital gain that is now subject to a 20% capital gains tax. If I decide to sell WU and receive $20,000, I have to pay $2,000 ($10,000 * 20%) to the federal government come tax time. Let’s look at the scenario in terms of expected yearly results. If I sell WU to earn 13% in another stock, I am really only investing $18,000. If I decide to keep WU, I still earn the 9% and avoid a capital gains tax. What happens at the end of the year? If my scenario holds true, I will have $21,800 ($20,000 + $20,000 * 9%) in my brokerage account at the end of a year if I earn 9% from owning WU. If I decide to sell WU and buy the other stock, I will have $ 20,340 ($18,000 + $18,000 * 9%). Yes, I earned 13% on my new stock, but I have a lower amount in my brokerage account. Why is this a common phenomenon? Well, most people file their taxes and pay any capital gains tax from their checking account. The money does not come out of the brokerage account directly. Your net worth goes down overall, but your brokerage account “misleads” you into thinking you made a great selection because you earned an extra 4% by owning this other stock. In fact, you would need to earn 21.1% in order to have $21,800 in my brokerage account by being able to pay the capital gains tax and then have the same terminal value as I would by simply holding WU and earning 9%. If you ever wondered why Warren Buffett holds onto Coca-Cola (KO) and American Express (AXP), taxes factor in greatly.

Now for all of you readers that are not asleep, I appreciate you bearing with me. As I mentioned before, investing is not meant to be fun or exciting. It is only fun and exciting if you like the intellectual challenge. For all of us “dorks”, we go through this analysis because it is truly fun to us. For most people, they would much rather not spend 60 hours finding a stock to buy and then 20-25 hours per year following your stock after the purchase. Luckily, you can own an ETF or index mutual fund and likely match my investment return in WU or even beat it over the long term. For more information on the style of Warren Buffett, I refer you to the following series of books by Larry Hagstrom (mentioned him before):

1) The Warren Buffett Way

2) The Warren Buffett Portfolio

3) The Essential Buffett

4) Security Analysis by Benjamin Graham the sixth edition

You will note that my investing style is similar to Warren Buffett, but I have incorporated elements from other famous investors and from other disciplines. I will never be another Warren Buffett. However, I can strive to use a similar investing paradigm. Hopefully this discussion was helpful in thinking about one possible way to monitor your stock purchases. Yes, it is a great deal of work and time consuming. You will have much better investment results though, if you know as much as you can about your stock.

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