Originally published October 3, 2013
While the old adage "don't eat the seed corn" warns
against consuming the permanent assets (principal)
that produce earnings, a common misunderstanding
can make this safe policy rather risky.
Some investors consider securities to be principal and
all dividends or interest to be spendable income. They
believe only income can be spent and selling securities
to create cash flow is "spending principal."
Focus instead on "total return," which is income plus appreciation. Appreciation, particularly the amount in excess of inflation, can be spent without diminishing productive capital.
Income securities, including high-dividend stocks, have little growth potential. Overweighting these raises risk, and spending all the income can shrink the inflation-adjusted value of a portfolio - the same result as spending principal.
Chasing high yields can be worse. Some products artificially increase income and pay out principal.
Appreciation is unreliable, so projected "spendable" appreciation must be averaged. A reserve fund (or "bucket") should hold three to five years' worth of income so securities are not sold in a depressed market.
Even with these drawbacks, spending the total return (after inflation) of a diversified portfolio is wiser than overweighting bonds and only spending income.
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WHAT ARE PREFERRED STOCKS, AND SHOULD I INVEST IN THEM?
Originally published August 20, 2013
Preferred stock is a hybrid – a cross between common
stock and bonds. While considered equity (ownership),
preferreds act more like bonds, paying a fixed dividend
and callable (redeemable) at the company’s option.
It is labeled “preferred” because it stands ahead of
common stock (although behind bonds) when it comes to
payment of dividends or in liquidation.
READ: What is the best way to learn about investing?
While this might make preferred stock slightly safer than the common, preferreds also carry the same risks as bonds but with less protection.
The fixed dividend exposes preferreds to bond risks such as duration/interest rate risk (prices fall when rates rise), inflation risk, credit/default risk, and call risk. With no maturity date, preferreds act like the longest maturity, most junior (lowest quality) bond of the same company.
If interest rates fall sufficiently, preferred stock can be called which means shareholders must reinvest proceeds at prevailing (lower) rates. So investors should not buy preferreds trading much above their call price.
If interest rates rise because of inflation, preferred shareholders lose in two ways: through falling share prices and through the dividend’s decreased purchasing power.
But companies can increase a common share’s dividends making it possible to maintain the common stock’s purchasing power during inflationary periods.
So although preferred stocks initially pay bigger dividends, if the company regularly raises the common dividend (and shares are held long enough) the common payout could eventually surpass that of the preferred.
Compared to bonds, exchange-traded preferreds are more liquid, have greater price visibility and can be purchased in smaller amounts. They also have higher yields than bonds but this reflects the greater risk they carry.
READ: What should I take into consideration before investing?
So, to answer your question: You should invest in preferreds if you want more income (although with higher risk than investment-grade bonds), if this will be a small portion of a reasonably well-diversified portfolio, and if you are careful not to pay a huge premium to the call price (be sure you know all call provisions).
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BONDS ARE LESSON IN LEARNING TO STOMACH THE WAITING GAME
By Janet Kidd Stewart, August 17,2013
Feeling nervous about the bonds in your retirement portfolio as
interest rates rise?
You might try adapting the film noir classic to "Dr. Strangelove or:
How I Learned to Stop Worrying and Love the Bond."
After all, it's retirees living on fixed incomes who have paid the price for historically low interest rates around the world for years. Despite the short-term pain in bond mutual funds since rates spiked higher this summer, eventually a more normal yield environment for retirees could be in the offing. This is good news, right?
Or will it end badly, like the satirical film?
Just because higher rates are inevitable doesn't mean they're imminent, so it's important for investors to stay nimble and informed, said Kent Grealish, an investment adviser and partner with Quacera LLC in San Bruno, Calif.
"Be in bonds, but be nervous," Grealish said he is telling clients, about half of whom are retired. "You have to be prepared for anything to happen and not bet on one thing."
In short, Grealish and other advisers said, diversification is your friend. Short-term bonds are great for providing income you'll need right away, but blend in some intermediate-term issues for your longer horizon, they say.
For money you'll be living on in the next few years, he said, consider if certificates of deposit, U.S. Treasurys or state general obligation bonds are right for you.
You can check out CD rates at bankrate.com. Recently, the highest rates on a 1-year CD were just over 1 percent.
As you are CD shopping, pay attention to terms as well as rates, said Leslie Trowbridge Corcoran, founder and president of Family First Financial Planning in Stuart, Fla.
Particularly if you're considering longer-term CDs, she said, look for banks that charge only a couple of months' interest penalties for bailing. That will make it more palatable to shift course if rates start to take off, she said.
Despite the specter of higher rates, Corcoran believes investors, particularly retirees, will begin to gravitate back into bond funds, avoiding catastrophic meltdowns because of redemptions.
Of course, there are no guarantees. Remember not so long ago when we used to rest easy in the knowledge that home prices had historically only gone up?
In fact, a fundamental change is occurring in bond markets, said Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Investments.
In a recent client webcast, he advocated for a new way of looking at how bond portfolios are allocated, emphasizing credit risk over interest rate risk.
Because credit remains relatively easy to obtain, he said, companies can continue to borrow even if their debt levels climb substantially.
That argues for taking on high-yield, or junk bond, issues he said, though that strategy won't work for everyone and it could be short-lived.
Junk bonds are more volatile and behave more like stocks than bonds, experts noted, which just can't be tolerated in many retirement portfolios.
And when the proverbial punch bowl is pulled and marginal borrowers can't continue to refinance their debt, defaults will shoot higher.
For those who can take the volatility, however, Rosenberg says floating-rate debt and the high yield category could help keep investors from falling into a lost decade for bonds.
The only way to really learn about investing is to commit a
meaningful amount of your own money to the market.
Investing "on paper” doesn’t produce the same amount of
concentration and attentiveness (not to mention, anxiety)
necessary to effectively learn the fundamentals of finance
and investor behavior. You have to have skin in the game.
But first, you need to develop a personal, common sense investment plan (and then, of course, you have to actually follow the plan).
The plan should be customized to your particular investment objectives and your own unique tolerance for risk (which really means your tolerance for loss). It should follow a logical investment strategy that is easy for you to understand, implement and monitor and you should use broadly diversified, low cost (and no-load) mutual funds or ETFs. Asset allocation should be an important part of the strategy to produce a balanced portfolio that will better withstand stock market volatility.
There are a number of good books that can help you get started and provide you with a sound strategy and some well-diversified, low-cost fund recommendations to help you construct your portfolio. I highly recommend reading John Bogle's The Little Book of Common Sense Investing or Rick Ferri's All About Index Funds.
One final bit of advice: Once you have your investments in place, leave them alone. Resist the temptation to buy and sell based on what you think the market is going to do. Monitor how you are doing but no more than once a month.
The first lesson we all have to learn is: You can’t beat the market! So don’t try.
Experience is a very effective teacher, but that education seldom comes cheap. We learn our most valuable lessons through expensive mistakes. But if you can stick to the basics and follow sound investment advice, you can learn the fundamentals and develop your investing skills without losing your shirt.
Originally published in Dimespring.com July 18, 2013
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People are funny about risk. We over-worry about unlikely
disasters (plane crashes) but not enough about more likely
threats (automobile crashes). Sometimes this is attributable
to a recent event that is fresh in our minds – the classic
being when people watch Shark Week on TV and suddenly
become afraid of swimming in the ocean.
The opposite can also be true. After enough time has passed without a stark reminder about the consequences of taking risk, it is easy to become complacent, undervalue safety and underestimate threats.
This is particularly true in the stock market.
The body forgets pain over time. In much the same way, we can forget how disoriented and upset we became when the stock market dropped in half five years ago. That huge decline is now a dim memory as is the intense anxiety and regret we experienced.
It is easier to remember that the market has been rising steadily for 18 months while producing above average returns.
So ask yourself these questions:
1. How much risk are you exposed to right now and is that the right amount?
2. Could you withstand a market decline of 20% – or more?
3. If that happened, what would you do next?
Better to ask these questions now and be ready rather than face making an important decision under duress.
Follow the Boy Scouts’ motto: Be Prepared!
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The first rule of investing is “Buy Low, Sell High.” But how
can you tell if the market is high or low?
The stock market has more than doubled since 2009 yet
some will claim that the market is cheap even while others
call it expensive. Which one is it? Like much in life, it all
depends on your perspective.
Traditional rules of thumb like the Price-Earnings Ratio (P/E) only add to the confusion. The P/E Ratio is the market price divided by earnings (profits). Normally these are company profits reported over the past twelve months. This measure currently suggests that the market is overvalued by about 20%.
But that’s history. Investors looking to the future like to use security analysts’ forecasts of operating earnings (earnings before charge-offs) for the coming year. On that basis, the market looks slightly undervalued.
But purists argue that earnings can be extraordinarily volatile, rising dramatically in a robust economy and even turning into losses during recessions. In 2009 earnings plunged and the P/E ratio soared even as the stock market fell by half.
Economist Robert Shiller advises using the Cyclically Adjusted Price Earnings (CAPE) Ratio which averages ten years’ worth of earnings. That ratio is now nearly 50% above the average.
To further confuse things, the Fed Model method compares “earnings yield” (the inverse of the P/E) to the US Treasury 10-Year bond yield. With bond yields near historical lows, this makes the market look cheap.
So you could say the market is cheap, slightly undervalued, somewhat overvalued or very expensive. It all depends on your valuation method.
Like beauty, market valuation is in the eye of the beholder and there is no single reliable indicator to tell you whether the market is cheap or dear. So don’t base your investment decisions solely on the P/E Ratio. And when someone tells you that the market is incredibly cheap or outrageously expensive, ask him what yardstick he’s using.
Originally published in MOAA Financial Frontlines® May 30, 2013. Check out Kent’s other MOAA articles here
A few years ago I came across a humor book called
Momilies, a collection of funny advice and admonitions from
mothers to their children.
The classic was, "If you fall out of that tree and break your
leg, don't come running to me."
I was reminded of the book while thinking that some of the best advice about investing (and life as well) can be derived from the proverbs learned at your mother's knee. This opinion relies upon the sometimes radical notion that there is a direct correlation between successful investing and common sense.
You don't get something for nothing. One of the most valuable pieces of advice that we must perennially relearn, this warning is as difficult to follow in adulthood as it was when we were kids. Ignorance of this basic truth is what makes us believe that we can invest in something with an impressive rate of return without risking a good portion our capital.
Look both ways before crossing the street (also see act in haste, repent at leisure) is the basis for "investigate before you invest." Over the years I could have saved a lot of money by checking out those hot tips and last-minute opportunities that fortune (both good and bad) dropped into my lap.
Don't be selfish, share is good investment advice, particularly when your stock price has appreciated far in excess of what you could reasonably expect. Maybe it's time to sell the stock to someone else and allow them to share in future profit (and risks).
Education is important (better known as Do your homework!). In investing, as in life, what you don't know is far more likely to hurt you than what you do know. You can't be successful over the long run just by buying stocks recommended in financial magazines and on television shows. You have to learn the basics about securities and securities markets.
How many hours a week do you spend really studying investments and markets (and not just looking up prices or reading Alan Abelson)? At what price is your stock a buy and at what price is it a sell? And just how did you calculate those prices?
There are many others: If it seems too good to be true ... A stitch in time ... (i.e., cut your losses), Save for a rainy day ..., Life is not fair ... (e.g., bad things can happen to good stocks), not to mention the one which all professionals use to describe the virtues of diversification: Don't put all your eggs in one basket.
And anyone who has had a poor investment experience dealing with someone they didn't check out beforehand can appreciate: Don't talk to strangers.
But my favorite expression should be the motto of all contrarian investors - particularly now, when everyone is certain that this stock market is different and that trees can grow to the sky.
This is the cliché which every parent has, at one time or another, sworn never to use but, when pushed to the wall by exasperation and emotion, will use nevertheless: If all of your friends wanted to jump off the Golden Gate Bridge, would you want to do it too?
Unfortunately, as far as investing goes, our response today is likely to be the same one we defiantly threw back at our parents so many years ago.
[Originally published in the San Mateo Times on January 17, 1994 as COMMON SENSE BEST ADVICE WHEN IT COMES TO INVESTING]
Allan Roth in his regular column for CBS MoneyWatch recently wrote how some advisors rationalize their behavior, convincing themselves that they are meeting their fiduciary duty to their clients when, in fact, they are only benefiting themselves. Allan is a very talented advisor, not to mention a friend, and I normally agree with virtually everything he writes. This time, though, I totally disagreed with his assertion that he “…could only exercise true fiduciary duty of putting my client's interests ahead of mine by lowering my hourly fee to zero.” I feel strongly about this because I know Allan to be scrupulous to a fault and someone who is far more likely to undercharge his clients for his very valuable services.
A fiduciary obligation does not mean you cannot be fairly compensated for your work nor is a fiduciary required to take a Vow of Poverty. “Fiduciary,” as defined by the CFP Board, means “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.” Being a fiduciary is all about acting ethically and the acid test is how you resolve the inevitable conflicts of interest.
Compensation is the most common and, arguably, the most serious conflict of interest but getting paid for your work does not disqualify you as a “true fiduciary.” Private fiduciaries serving as conservators are not expected to work for free. Certainly their fees are subject to court scrutiny and there is always the chance of abuse, but no one would begrudge the conservator fair compensation for his or her labor.
The same holds true for the investment fiduciary. It is not the absence of compensation that proves that the advisor is meeting his fiduciary duty but whether the advisor is working in the best interests of the client. Clients should receive financial benefits that are significantly greater than the fee which must be reasonable, proportional to the advisor’s labor and expertise, and completely transparent to the client. In addition, the advisor must take pains not to waste client money by using the most cost-effective strategy and investment products even if an unnecessary cost does not directly benefit the advisor.
Allan knows that exercising a fiduciary duty is hardly a lucrative business model to begin with. If that were not the case the financial services industry wouldn’t be fighting tooth and nail to avoid a strict universal fiduciary standard. So while I appreciate Allan’s sentiment and altruism, I think his clients would agree with me that he can be both fairly compensated and a true fiduciary.