Category Archives: Investing

Staying Invested in the Stock Market

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“The stock market is the only market where the goods go on sale and everyone becomes too afraid to buy.”  Nerd Wallet

When the market dips even a few percent, as it often does, many retail investors become fearful and sell in a panic, according to Nerd Wallet. Yet when stock prices rise, investors beomce greedy and plunge in headlong which is the perfect definition for “buying high and selling low.”

Here are the three popular fairytales investors tell themselves regarding investing:

  1. Wait until the stock market is safe to invest – This excuse is used by investors after stocks have declined, when they’re too afraid to buy into the market. But when investors say they’re waiting for it to be safe, they mean they’re waiting for prices to climb. So waiting for (the perception of) safety is just a way to end up paying higher prices, and indeed it is often merely a perception of safety that investors are paying for. Fear drives the behavior and psychologists call this behavior “myopic loss aversion.” That is, investors would rather avoid a short-term loss at any cost than achieve a longer-term gain.
  2. Buy back in next week when the stock market is lower – This excuse is used by would-be buyers as they wait for the stock to drop. But as the data shows, investors never know which way stocks will move on any given day, especially in the short term. Both fear and greed drive this behavior. The fearful investor may worry the stock is going to fall and waits, while the greedy investor expects a fall but wants to try to get a much better price.
  3. Bored with this stock, so I’m selling – This excuse is used by investors who need excitement from their investments. But smart successful investing is actually boring. The best investors sit on their stocks for years and years, letting them compound gains. All the gains come while you wait, not while you’re trading in and out of the market. Investor’s desire for excitement drives this behavior.

The key to long term investment success is creating a plan, sticking to the plan and remaining in the stock market through “thick and thin”. Your length of “time in the market” is the best predictor of your investing performance. Unfortunately, investors often move in and out of the stock market at the worst possible times, missing out on performance and annual return.

“The secret to making money in stocks? Staying invested long-term, through good times and bad.”  Nerd Wallet

In a nutshell, more time in the stock market equals more opportunity for your investments to increase in value. The best companies tend to increase their revenue and profits over time, and investors reward these greater earnings with a higher stock price. That higher price translates into a higher total return for patient and disciplined investors who own the stock.

References:

  1. https://www.nerdwallet.com/article/investing/make-money-in-stocks

Small-Cap Stocks

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“Growth is greatest in the early stages of a company’s development.” Cabot Wealth

There is a common perception among investors that over the long term, small-cap stocks outperform large-cap stocks. In exchange for more risk, you get more reward.

As it turns out, this is mostly untrue, according to Seeking Alpha. The best small-cap stocks offer more explosive upside potential, but as a group they don’t really outperform large-cap stocks, subject to a few caveats.

The best possible investing scenario is to identify a top small-cap stock that will go on to become a large-cap stock over the coming years, and go up in value by 10x or 100x.

Unfortunately, for every massive winner that does that, there are multiple losers. Both Russell and Wilshire data show that small-cap stocks don’t really outperform as a group. They’re not bad, but over four decades they don’t really stand out either. Mid-cap stocks are a potential sweet spot, that investors can benefit from either by directly investing mid-cap fund or investing into an equal weight large-cap fund which tends to have a lot of overlap with the mid-cap space.

A 2017 study by Hendrik Bessembinder that analyzed virtually all U.S. public stocks over the past 90 years found that small-cap stocks have much higher performance variance. A smaller percentage of small-cap stocks provide positive long-term returns compared to the percentage of large-cap stocks that provide positive long-term returns. As a consequence, small stocks more frequently deliver returns that fail to match benchmarks.

Conversely, while the absolute best-performing small caps outperform the best-performing large caps over a given period, small caps as a group also have much higher rates of catastrophic loss.

Anytime you buy shares of a small, lessor-known company, there are a plethora of unknowns. Thus, it’s impossible to take the risk completely out of small-cap investing. But there are ways to minimize those risks without sacrificing potential profits.

The defining characteristics of small-cap stocks are that many are young, attractive investments and tend to be highly volatile. This volatility can be absolutely maddening for those who are new to small-cap investing (and even to those who aren’t).

Don’t let this volatility drive you away from small-cap stocks if you’re inclined to invest in them. Volatility comes and goes, and over the long-term small caps tend to beat the market.

FIVE SIMPLE RULES FOR SUCCESS WITH SMALL-CAP STOCKS

It’s important to set up a clearly established set of rules ahead of time, and stick to them. The simple rules that can increase your odds of success, especially during uncertain markets, are:

Rule #1: Commit To The Long Term: One of the more frequently quoted Warren Buffett quips is, “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”

You don’t need to own every small-cap stock you buy for the next decade. But you do need to look out at least a year or two if you expect to have significant success.

There are select examples of investors making money trading in and out of small caps in the short term. But very few can do it week in and week out, year after year. All the studies say the same thing; your odds of making money go up the longer you stick with small-cap stocks.

A study from Ibbotson, a financial research firm owned by Morningstar, found that investors have a 70% chance of making money with small-cap stocks if they stay invested for one year. That probability goes up to 82% after three years, 86% after five years and 98% after 10 years. The percentages aren’t all that different for large caps.

Rule #2: Dollar Cost Average Your Cost Basis: Small-cap stocks can be irrational in the short term. That’s why you never do anything too drastic. Don’t go all in on an individual stock on a big pullback, or a big breakout. Instead, average into a position by buying shares at different prices and on different days. The strategy helps to reduce the risk of buying a full position in a stock at an unlucky time, which is bound to happen occasionally.

The period over which you average in should be dictated by your holding time horizon. If you’re investing for just a year or two, you’ll probably average in over a week or two, maybe a month. If you’re in it for three or more years, you can average in over a year, or more.

Rule #3: Take Partial Profits: If averaging in makes sense, then averaging out should too. Consider selling a quarter or a half position on the way up, and especially if a gain has surpassed 100%. This doesn’t have to mean giving up on the stock. It’s simply a risk-mitigation strategy. The original capital can be allocated to a lower-risk investment.

Also, it’s fine to average back into a position even if you sold shares at an earlier date. Sometimes, especially during corrections, investors are forced to dump some shares to protect their gains. Months later, the stock might be doing just fine. If the growth story is intact and the market is trending up there’s no reason you can’t build up your position again.

Rule #4: Use a Stop Loss: For small cap stocks, many advisors advocate a 15% to 30% stop loss for large caps. The reason is that you often see quality small caps drop 20% or so during market corrections. Often, these are the times to average down if and when the stock has stabilized, assuming the stock’s growth story is intact,.

That said, it can also be a time to sell a partial, or full, position to protect gains, or help avoid catastrophic losses. How close you are to your desired position size will usually determine if you’re averaging in, or out. The underlying reason for using stop losses is that the bigger the loss, the bigger the return you need to get back to break even (see table below). Don’t go below the red line!

Rule #5: If You’re Not Sure What To Do, Do Nothing: Just because the market is open doesn’t mean you need to participate in it. If you’ve had a streak of losses, or things just don’t feel right, take a break. Focus your attention on a few stocks you’d like to own eventually and read up on those so you’re ready to go when the stock’s margin of safety improves, and your confidence returns.

As Warren Buffett said, “I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”

Investing in small-cap stocks is a good way to earn huge returns. Consequently, there are two major ways to outperform the market.

  • You can take advantage of short-term price dislocation versus a company’s intrinsic value, or
  • Use long-term compounding to achieve market outperformance.

References:

  1. https://seekingalpha.com/article/4287533-small-cap-performance-gap-doesnt-exist-why
  2. https://cabotwealth.com/category/daily/small-cap-stocks
  3. https://cabotwealth.com/daily/small-cap-stocks/small-cap-stock-warren-buffett/

The Biggest Mistakes Individual Investors Make

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“The public’s careful when they buy a house, when they buy a refrigerator, when they buy a car. They’ll work hours to save a hundred dollars on a roundtrip air ticket. They’ll put $5,000 or $10,000 on some zany idea they heard on the bus. That’s gambling. That’s not investing. That’s not research. That’s just total speculation.” Peter Lynch

For the 13 years, Peter Lynch ran Fidelity’s Magellan® Fund (1977–1990). During his tenure, he earned a reputation as a top performer, increasing assets under management from $18 million to $14 billion. He beat the S&P 500 in all but two of those years. He averaged annual returns of 29% which means that $1 grew to more than $27.

Additionally, Lynch has authored several top-selling books on investing, including One Up on Wall Street and Beating the Street. He has a plain-spoken manner and offers wisdom on investing that can help you become a better investor.

To become a successful investor, you really need to “have faith that 10 years, 20 years, 30 years from now common stocks are the place to be”, according to Lynch. “If you believe in that, you should have some money in equity funds.”

Yet, “there will still be declines”, Lynch says. “It might be tomorrow. It might be a year from now. Who knows when it’s going to happen? The question is: Are you ready—do you have the stomach for this?”

Long term, the stock market has been a very good place for investors to employ their money and capital. But whether the market will be 30% higher or lower in 2 years from now…nobody knows. “But more people have lost money waiting for corrections and anticipating corrections than in the actual corrections”, according to Lynch. “I mean, trying to predict market highs and lows is not productive.”

“In the stock market, the most important organ is the stomach. It’s not the brain.” Peter Lynch

Theoretically, in Lynch’s opinion, the individual investor has an edge versus the professional in finding winning companies (“10-baggers”) that will go up 4- or 10- or 20-fold. They have the opportunity to see breakthroughs, company’s fundamentals get better, and analyze companies way ahead of most people. That’s an edge and you need an edge on something to find the hidden gems.

“The problem with most individual investors is people have so many biases. They won’t look at a railroad, an oil company, a steel company. They’re only going to look at companies growing 40% a year. They won’t look at turnarounds. Or companies with unions.” Thus, individual investors miss great opportunities in overlooked industries or unjustly beaten down companies to chase hot growth stocks.

“But my system for over 30 years has been this: When stocks are attractive, you buy them. Sure, they can go lower. I’ve bought stocks at $12 that went to $2, but then they later went to $30.” Peter Lynch

“You have to really be agnostic” to pick winners and to invest in a company poised for a rebound, according to Lynch.

“Stocks aren’t lottery tickets. Behind every stock is a company. If the company does well, over time the stocks do well.” Peter Lynch

Peter Lynch’s eight simple investing principles for long term investors are:

  1. Know what you own – Few individual investors actually do their research. And, almost every investor is guilty of jumping into a stock they know very little about.
  2. It’s futile to predict the economy and interest rates (so don’t waste time trying) – The U.S. economy is an extraordinarily complex system. Trying to time the market is futile. Set up a financial plan that allocates your assets based on your risk tolerance, so that you can sleep at night.
  3. You have plenty of time to identify and recognize exceptional companies – You don’t need to immediately jump into the hot stock. There’s plenty of time to do your research first.
  4. Avoid long shots – Lynch states that he was 0-for-25 in investing in companies that had no revenue but a great story. Make sure the risk-reward trade-off on an unproven company is worth it.
  5. Good management is very important; good businesses matter more – “Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it.”
  6. Be flexible and humble, and learn from mistakes – “In this business, if you’re good, you’re right six times out of 10. You’re never going to be right nine times out of 10.” You’re going to be wrong. Diversification and the ability to honestly analyze your mistakes are your best tools to minimize the damage.
  7. Before you make a purchase, you should be able to explain why you’re buying – You should be able to explain your thesis in three sentences or less. And in terms an 11-year-old could understand. Once this simply stated thesis starts breaking down, it’s time to sell.
  8. There’s always something to worry about. – There are plenty of world events for investors to fear, but past investors have survived a Great Depression, 911 terrorist attack, two world wars, an oil crisis, 2007 financial crisis, and double-digit inflation. Always remember, if your worst fears come true, there’ll be a heck of a lot more to worry about than some stock market losses.

Finally, in the words of Peter Lynch…”You can lose money in the short term, but you need the long term to make money.”

References:

  1. https://investinganswers.com/articles/51-peter-lynch-quotes-empower-your-investing
  2. https://www.fidelity.com/viewpoints/investing-ideas/peter-lynch-investment-strategy
  3. https://www.fool.com/investing/general/2010/05/21/how-peter-lynch-destroyed-the-market.aspx
  4. https://www.fidelity.com/viewpoints/investing-ideas/peter-lynch-investment-strategy

The Psychology Behind Your Worst Investment Decisions | Kiplinger Magazine

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“When it comes to investing, we have met the enemy, and it’s us.” Kiplinger Magazine

Excited by profit and terrified of loss, we let our emotions and minds trick us into making terrible investing decisions, writes Katherine Reynolds Lewis of Kiplinger Magazine.

Most individual investors allow their emotions to dictate their investment decisions. Effectively, there are two types of emotional reactions the average investor can experience:

Fear of Missing Out (FOMO). These investors will chase stocks that appear to be doing well, for fear of missing out on making money. This leads to speculation without regard for the underlying investment strategy. Investors can’t afford to get caught up in the “next big craze,” or they might be left holding valueless stocks when the craze subsides.

  • Fear of Missing Out (FOMO) can lead to speculative decision-making in emerging areas that are not yet established.
  • Fear of Losing Everything (FOLE) is a more powerful emotion that comes from the fear that they will lose all of their investment.

Acording to a 2021 Dalbar study of investor behavior, Dalbar found that individual fund investors consistently underperformed the market over the 20 years ending Dec. 31, 2020, generating a 5.96% average annualized return compared with 7.43% for the S&P 500 and 8.29% for the Global Equity Index 100.

“As humans, we’re wired to act opposite to our interests,” says Sunit Bhalla, a certified financial planner in Fort Collins, Colo. “We should be selling high and buying low, but our mind is telling us to buy when things are high and sell when they’re going down. It’s the classic fear-versus- greed fight we have in our brains.”

Avoiding these seven “emotional and behaviorial” investing traps will allow you to make rational investments.

  1. Fear of Missing Out – Like sheep, investors often take their cues from other investors and sometimes follow one another right over a market cliff. This herd mentality stems from a fear of missing out.  The remedy: By the time you invest in whatever is trending, it’s too late because professional investors trade the instant that news breaks. Individual investors should buy and sell based on the fundamentals of an investment, not the hype.
  2. Overconfidence – Some investors tend to overestimate their abilities. They believe they know better than everyone else about what the market is going to do next, says Aradhana Kejriwal, chartered financial analyst and founder of Practical Investment Consulting in Atlanta. “We want to believe we know the future. Our brains crave certainty.” The remedy: To combat overconfidence, build in a delay before you buy or sell an investment so that the decision is made rationally.
  3. Living in an Echo Chamber – Overconfidence sometimes goes hand in hand with confirmation bias, which is the tendency to seek out only information that confirms our beliefs. If we think an asset holds promise for riches, news about people making money sticks in our minds more than negative news, which we tend to dismiss. The remedy: To counteract this bias, actively seek out information that contradicts your thesis.
  4. Loss Aversion – Our brains feel pain more strongly than they experience pleasure. As a result, we tend to act more irrationally to avoid losses than we do to pursue gains. The remedy: Stock market losses, however, are inevitable.If seeing the losses pile up in a down market is too hard for you, simply don’t look. Have faith in your long-term investing strategy, and check your portfolio less often.
  5. No Patience for Sitting Idly By – As humans, we’re wired for action. That compulsion to act is known as action bias, and it’s one reason individual investors can’t outperform the market — we tend to trade too often. Doing so not only incurs trading fees and commissions, which eat into returns, but more often than not, we realize losses and miss out on potential gains. The remedy: Investors need to play the long game. Resist trading just for the sake of making a decision, and just buy and hold instead.
  6. Gambler’s Fallacy – “This is the tendency to overweight the probability of an event because it hasn’t recently occurred,” says Vicki Bogan, associate professor at Cornell University. Over time, the probability of equities having an up year or a down year is about the same, regardless of the previous year’s performance. That’s true for individual stocks as well. The remedy: When stocks go down, don’t just assume they’ll come back up. “You should be doing some analysis to see what’s going on,” Bogan says.
  7. Recency Bias – Past performance is no guarantee of future results. Yet, our minds tell us something different. “Most people think what has happened recently will continue to happen,” Bhalla says. It’s why investors will plow more money into a soaring stock market, when in fact they should be selling at least some of those appreciated shares. And if markets plummet, our brains tell us to run for the exits instead of buying when share prices are down.The remedy: You can combat this impulse by creating a solid, balanced portfolio and rebalancing it every six  months. That way, you sell the assets that have climbed and buy the ones that have fallen. “It forces us to act opposite to what our minds are telling us,” he says.

It is wise to always keep in mind that the market is volatile as a result of investors’ emotions and behaviors, and thus does not move logically.

References:

  1. https://www.kiplinger.com/investing/603153/the-psychology-behind-your-worst-investment-decisions

by: Katherine Reynolds Lewis – July 22, 2021

Price Line vs. Earnings Line

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“A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.” Peter Lynch

As the former head of Fidelity’s flagship Magellan Fund, Peter Lynch produced an annualized rate of return of 29.2% over his 13-year stint at the helm. This track record has arguably placed him as the best mutual fund manager of all time.

In his best-selling book, “One Up On Wall Street,” Lynch revealed a powerful charting tool, called the “Peter Lynch chart,” that greatly simplified his investment decisions. This simple graph plots the stock price against its “earnings line,” a theoretical price equal to 15 times the earnings per share.

When a stock trades well below its earnings line, you should buy, according to Lynch’s theory. When it rises above its earnings line, you should sell. For example, the Wal-Mart Stores (ticker: WMT ) share-price line fell below the Lynch line at about $55 in March 2010. It didn’t climb back over the Lynch line until June 2012, when shares were $67.50. Had you bought the first crossover and sold the second, you would have gained $12.50 a share, or about 23%.

The idea behind this technique is simple. Lynch believe that mature, stable companies are worth roughly 15 times their annual earnings. And over the last 135 years, this has proven to be the mean valuation of the S&P 500 index.

This is known as a the P/E ratio. It is merely the price of the stock divided by its earnings per share. The resulting multiple represents how many times you are paying for last year’s earnings at today’s stock price.

All things being equal, the lower the number the better. Low P/E ratios mean that you are getting more earnings for your investment dollar. And since most large cap stocks eventually trade for at least 15 times earnings, you are more likely to see your shares appreciate as they return to the 15 P/E level.

This simple idea was the basis of Lynch’s investment approach and the reason he created the chart whichconsists of only two lines. The first is the stock price. The second is the hypothetical stock price if it were to trade at a P/E of 15 (the earnings line).

It is a well-known fact among experienced investors that a stock’s price follows its earnings. Over multi-year periods, stock prices move in sync with changing company earnings.

But over the short term, stock prices are unpredictable. This is what creates valuable opportunities for savvy and patience investors.

Furthermore, a good rule of thumb is that the P/E ratio of any fairly valued company will equal its earnings growth rate. A company with a P/E ratio that is half its growth rate is very positive. A company with a P/E ratio that is twice its growth rate is deemed negative.

Thirteen attributes you should investigate for in a stock with the potential for 10x growth, according to Peter Lynch:

  1. The company name is dull or ridiculous.
  2. The company does something dull and boring
  3. The company does something disagreeable or disgusting.
  4. The company is a spin-off like the Baby Bells.
  5. Institutions don’t own it and analysts don’t follow it.
  6. There are negative rumors about it, like Waste Management.
  7. There is something depressing about it such as SRB, which provides burial services.
  8. That it is a company in a no growth industry, since it’s in a non competitive business.
  9. It has a niche such as drug companies.
  10. People have to keep buying the products such as drugs, food and cigarettes.
  11. The company is the user of technology such as Domino’s.
  12. The company insiders are buyers of the stock.
  13. The company is buying back its shares.

Best stocks to avoid is the hottest stock in the hottest industry. Negative growth industries do not attract competitors. Additionally, avoid companies with excessive debt on its balance sheet and invest in companies that have little or no debt.

The debt must always be lower than the equity. If the company has a debt lower than 50% of the equity, it is considered to be in a good financial position. If it is lower than 25%, it’s excellent. When the debt is above 75% of the equity, it is recommended to avoid that company.

References:

  1. https://finance.yahoo.com/news/peter-lynch-earned-29-13-231636799.html
  2. https://tofinancialfreedom.co/en/one-up-on-wall-street-summary-book/
  3. https://www.forbes.com/sites/investor/2021/04/16/lynchs-one-up-on-wall-street-inspired-screening-strategy/

Investing Truths by Peter Lynch

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“Wisdom acquisition is a moral duty. It’s not something you do just to advance in life. Wisdom acquisition is a moral duty. As a corollary to that proposition which is very important, it means that you are hooked for lifetime learning. And without lifetime learning, you are not going to do very well.”  Charlie Munger

Peter Lynch stressed the importance of looking at the underlying business enterprise strength, which he believed eventually shows up in the company’s long-term stock price performance. Also, pay a reasonable price relative to the company’s market value.

Here are important investing truths from Peter Lynch:

  1. Know what you own and be able to explain why you own it.  Only buy what you understand. ” Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.”
  2. Compounding of capital and principal takes time. Be patient, because most great wealth from the stock market is built over decades. “Often, there is no correlation between success of a company’s operations and the success of its stock over a few months or even years. In the long term, there is 100% correlation between the success of the company and the success of the stock. This disparity is the key to making money; it pays to be patient and to own successful companies.”
  3. Simple is usually better than complex and smart. “If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.”
  4. Volatility of the stock market is guaranteed. “You’ve got to look in the mirror every day and say: What am I going to do if the market goes down 10%? What do I do if it goes down 20%? Am I going to sell? Am I going to get out? If that’s your answer, you should consider reducing your stock holdings today.”
  5. Finding undervalued companies selling below their intrinsic value is a lot harder today. “A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.”
  6. Start early and at a very eary age. Invest for the long term…stocks are relatively predictable over 10-20 years. “Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Walmart (WMT, Financial) in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.”
  7. Focus on the company behind the stock. Do not become overly attached to a stock. “Although it’s easy to forget sometimes, a share is not a lottery ticket…it’s part-ownership of a business.”
  8. Don’t try to predict the market. “Nobody can predict the interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what‘s actually happening to the companies in which you’ve invested.”
  9. Study history. Market crashes are great opportunities. “During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents, and blue-jeans (Levi Strauss) made a nice profit. Today, you can look for non-internet companies that indirectly benefit from internet traffic (package delivery is an obvious example); or you can invest in manufacturers of switches and related gizmos that keep the traffic moving.”
  10. It’s very tough for a company to go bankrupt if a company has more cash than debt or if they do not have debt. “The real key to making money in stocks is not to get scared out of them.”
  11. When you own stocks, it will alwalys be scary due to volatility and there is always something to worry about.  Everyone is a long term investor until stocks go down. “There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”
  12. When yields on long-term government bonds exceed the dividend yields of the S&P 500 by 6% or more, sell stocks and buy bonds. ““In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.”

Emotions can be a real performance killer according to Lynch, if market drops get you selling out in a panic, or market surges have you greedily snapping up overvalued shares. The best investors will do the opposite.

“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman

References:

  1. https://www.investopedia.com/articles/stocks/06/peterlynch.asp
  2. https://www.fool.com/retirement/2020/04/07/9-investing-tips-from-peter-lynch-that-you-shouldn.aspx
  3. https://www.gurufocus.com/news/341584/peter-lynch-golden-rules-for-investing-
  4. https://www.valuewalk.com/2015/07/peter-lynchs-investing-principles-and-25-golden-rules/
  5. https://www.suredividend.com/peter-lynch-investing-lessons/

The Importance of Return on Equity

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ROE measures how much profit a company generates per dollar of shareholders’ equity.

Return on equity (ROE) is a must-know financial ratio. It is one of many numbers investors can use to measure return and support investing decision. It measures how many dollars of profit are generated by a company’s management for each dollar of shareholder’s equity.

The metric reveals just how well the company utilizes its equity to generate profits.  It reveals the company’s efficiency at turning shareholder investments into profits and explains, mathematically, the ratio of a company’s net income relative to its shareholder equity.

ROE is very useful for comparing the performance of similar companies in the same industry and can show you which are making most efficient use of their (and by extension investors’) money.

Billionaire investor Warren Buffett uses ROE as part of his investment decision making process. Buffet cares deeply about a company that uses its money wisely and efficiently. He believes that a successful stock investment is a result first and foremost of the underlying business; its value to the owner comes primarily from its ability to generate earnings at an increasing rate each year.

Buffett examines management’s use of owner’s equity, looking for management that has proven it is able to employ equity in new moneymaking ventures, or for stock buybacks when they offer a greater return.

What is ROE

Return on equity is a ratio of a public company’s net income to its shareholders’ equity, or the value of the company’s assets minus its liabilities. This is known as shareholders’ equity because it is the amount that would be divided up among those who held its stock if a company closed.

The basic formula for calculating ROE simply is to divide net income from a given period by shareholder equity. The net earnings can be found on the earnings statement from the company’s most recent annual report, and the shareholder equity will be listed on the company’s balance sheet. The specific ROE formula looks like this:

ROE = (Net Earnings / Shareholders’ Equity) x 100 or EPS / Book Value

“ROE tells you how good or bad management is doing with your investment,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland. “Higher ROEs generally stem from profitable businesses that enjoy competitive advantages within a given industry.”

A high ROE doesn’t always mean management is efficiently generating profits. ROE can be affected by the amount that a company borrows.

Increasing debt can cause ROE to grow even when management is not necessarily getting better at generating profit. Share buybacks and asset write-downs may also cause ROE to rise when the company’s profit is declining.

On the other hand, idle cash in excess of what the business needs to continue operations reduces the apparent profitability of the company when measured by return on equity. Distributing idle cash to shareholders is an effective way to boost its return on equity.

Key Takeaway

Return on Equity measures how efficiently a company generates net income based on each dollar invested by company’s shareholders.

A steady or increasing ROE is a company that knows how to successfully reinvest their earnings. This is important because most companies retain their earnings in the equity of the business.

A declining ROE is symbolic of executive management that is unable to successfully reinvest their capital in income producing assets. Companies like this should elect to pay most of their earnings to shareholders as dividends.

References:

  1. https://smartasset.com/investing/return-on-equity
  2. https://www.forbes.com/advisor/investing/roe-return-on-equity/
  3. https://www.nasdaq.com/articles/5-ways-improve-return-equity-2015-01-21
  4. https://money.usnews.com/investing/articles/what-is-return-on-equity-the-ultimate-guide-to-roe

6 money myths debunked | Fidelity Investment

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Don’t be bamboozled. Believing these myths could hurt your bottom line.  FIDELITY VIEWPOINTS  – 06/30/2021

Key takeaways

  • Establish good saving habits. Be sure to save some money from every paycheck.
  • Invest your savings appropriately for your goals and time frame.
  • Debt isn’t always bad but must be used responsibly.

There is no shortage of bad information out there—and falling for some of it can cost you money. It could be other people who steer you in the wrong direction, or it could be the things you tell yourself. Whatever the source, believing these myths could be hazardous to your financial health.

Myth #1: It’s not worth saving if I can only contribute a small amount

In reality: If you start early, around age 25, saving 15% of your paycheck—including your employer’s match to your 401(k) if you have one—could help you save enough to maintain your current way of life in retirement. It sounds like a lot, but don’t lose your motivation if you can’t save that much. Don’t be discouraged if you start later than age 25. Beginning to save right now and gradually increasing the amount you’re able to put away can help you hit your goals.

Save as much as you can while still being able to pay for essentials like rent, bills, and groceries. Fidelity’s budgeting guidelines may be able to help determine how much you can afford to save and spend.

  • Consider allocating no more than 50% of take-home pay to essential expenses (including housing, debt repayment, and health care).
  • Try to save 15% of pre-tax income (including employer contributions) for retirement.
  • Prepare for the unexpected by saving 5% of take-home pay in short-term savings for unplanned expenses.

Myth #2: The stock market is too risky for my retirement money

In reality: It’s true that money in a savings account is safe from the ups and downs of the stock market. But it won’t grow much either, given that interest rates on savings accounts are typically low. When it’s time to withdraw that money for retirement a few decades from now, your money won’t buy as much because of inflation. The stock market, however, has a long history of growth, making it an important component of your longer-term investment portfolio.

For instance, for a young person investing for retirement, a diversified investment strategy based on your time horizon, financial situation, and risk tolerance could provide the level of growth you need to achieve your goals.

There are a variety of ways to invest. Building a diversified portfolio based on your needs and the length of time you plan to be invested can be as complicated or as simple as you prefer. You can build your own diversified portfolio with mutual funds or exchange-traded funds—or even individual securities.

Even if you choose to manage your own investments, you may not be entirely on your own. 401(k) providers often offer example investment strategies that could give you ideas on how to build a diversified portfolio. You can invest in the funds in the model portfolio in the suggested proportions or you could use the models as a source of inspiration for your own investment ideas.

If you find investing daunting or don’t have the time to figure it out just yet, you might consider a managed account or a target-date fund for savings that are earmarked for retirement.

Myth #3: I’m young, so I don’t need to save for retirement now

In reality: Retirement can feel very far away when you’re young—but having all of those years to save can actually be incredibly powerful. That’s because time and compounding are important factors in a retirement savings plan.

Compounding happens as you earn interest or dividends on your investments and reinvest those earnings. Because the value of your investments is then slightly higher, it can earn even more interest, which is then packed back into the investments, allowing it to grow even more.

Over time, the value can snowball because more dollars are available to benefit from potential capital appreciation. But time is the secret ingredient—if you aren’t able to start saving early in your career you may have to save a lot more in order to make up for the value of lost time.

You can start by contributing to your 401(k) or other workplace savings plan. If your employer matches your contributions, make sure you contribute up to the match—otherwise you’re basically giving up free money. If you don’t have a workplace retirement account, consider opening an IRA to get started.

Myth #4: There’s no way of knowing how much money I’ll need in retirement

In reality: How much you’ll need depends entirely on your situation and what you plan to do when you leave the workplace.

But Fidelity did the math and came up with some general guidelines. Aim to save at least 15% of your pre-tax income every year—including employer contributions. To see if you’re on track, use our savings factor: Aim to have saved at least 1x (times) your income at 30, 3x at 40, 7x at 55, and 10x at 67.* Of course, everyone’s situation is unique and you may find that you need to save more or less than this suggestion.

Read about all of Fidelity’s retirement saving guidelines on Fidelity.com: Retirement roadmap

Don’t worry if you’re not always on track. Saving consistently, increasing your contributions when you’re able, and investing for growth in a diversified mix of investments could help you catch up over time.

Myth #5: All debt is bad

In reality: It’s true that carrying a balance on your credit card or a high-interest loan can cost a lot—significantly more than the amount you initially borrowed. But not all debt will hold you back. In fact, certain types of debt, like mortgages and student loans, could help you move forward in life and achieve your personal goals.

Plus, the interest rates on mortgages and student loans are typically much lower than those on personal loans or credit cards, and the interest may be tax-deductible.

No matter what kind of debt you take on, make sure you shop around for the best rates and never borrow more than you can afford to pay back on time.

Myth #6: Credit cards should be avoided

In reality: As long as you pay off your card balance in full each month to avoid interest, making purchases with credit can be worthwhile. Many credit cards offer a rewards program. If you make all your everyday purchases with your card, you could quickly rack up points you can redeem for cash, travel, electronics, or to invest.

Also, demonstrating that you use credit responsibly can help you increase your credit score, making it easier to buy a car or a home later on. It may even earn you a lower interest rate when you borrow in the future. It can be difficult to dig out of credit card debt, but if you control your spending and pay the card off every month, it could pay you back.

References:

  1. https://esj.seniormbp.com/SeniorApps/facelets/registration/loginCenter.xhtml

Buffett on Inflation

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“Inflation often feels like an abstract concept, but it hits everyday people the hardest.” Warren Buffett

Inflation is when the dollars in your wallet lose their purchasing power — either because the money supply has dramatically increased or because prices have surged, according to Bankrate.com.

Effectively, inflation occurs when the cost of goods and services in the economy goes up over a sustained period of time. Yet, inflation doesn’t happen overnight, and it also doesn’t happen when the cost of one particular good or service goes up.

From an economics perspective, inflation refers to price increases to the broader economy. And, price increases aren’t always synonymous with inflation — and some economic experts say a little bit of inflation is actually good for the economy. That’s for two main reasons: One, it prevents a deflationary trap, which experts say can be even worse than deflation because money loses value. Another reason is because households make better financial decisions when they expect stable and low prices.

“We may see prices rise on certain things like gas or milk, but it’s not necessarily inflation unless you see prices rising sort of across the board, across many different products and services,” says Jordan van Rijn, senior economist at the Credit Union National Association (CUNA).

The Berkshire CEO described high inflation as a “tax on capital” that discourages corporate investment. The “hurdle rate,” or the return on equity needed to generate a real return for investors, climbs when prices rise, Buffett said. “The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil,” Buffett added.

Buffett pointed out inflation can hurt more than income taxes, as it’s able to turn a positive return on investment into a negative one. If prices have climbed enough, people who make a nominal return on their investment may be left with less purchasing power than before they invested.

Inflation Causes

Given the federal government’s unprecedented loose monetary policy, fiscal spending spree and money-printing splurge over the last year, many economists have warned that such fiscal irresponsibility could result in a destructive wave of inflation.

‘I worry about inflation. I do not believe inflation is going to be transitory.’ Larry Fink, chairman and CEO, BlackRock Inc.

Defenders of federal government pandemic monetary and fiscal interventions have insisted that any resulting price inflation is just transitory. But recent data is showing that price inflation is hitting new highs and many economists believe that inflation is deep rooted and non-transitory.

However, the June’s Consumer Price Index (CPI) shows prices once again sharply on the rise. From June 2020 to June 2021, the data show that consumer prices rose a staggering 5.4 percent. Larry Fink, Chairman and CEO of BlackRock Inc., isn’t convinced by the Federal Reserve’s arguments that U.S. inflation pressures will fade away once supply bottlenecks and other temporary factors resulting from the COVID-19 pandemic fade away.

Economists lump inflation causes into two categories: demand-pull and cost-push inflation.

Cost-push occurs when prices increase because production is more expensive; that can include rises in labor costs (wages) or material prices. Firms pass along those higher costs in the form of higher prices, which then cycles back into the cost of living.

On the flip side, demand-pull inflation generates price increases when consumers have resilient interest for a service or a good.

While price inflation has many causes, much of the current inflation can be traced back to the policy of the Federal Reserve. The Fed essentially created trillions of new dollars to pump into the economy in the name of “pandemic stimulus.”

“The quantity of money has increased more than 32.9% since January 2020,” Federal Economic and Education (FEE) economist Peter Jacobsen explained in May. “That means nearly one-quarter of the money in circulation has been created since then. If more dollars chase the exact same goods, prices will rise.” 

“We are seeing very substantial inflation,” Warren Buffet said at a recent shareholder meeting. “It’s very interesting. We are raising prices. People are raising prices to us and it’s being accepted.”

The typical person’s standard of living declines as a result of price inflation, because what really matters is not what number appears on your paycheck but the purchasing power of your paycheck. Working-class Americans suffer tremendously when their energy bill increases by nearly 25 percent in just one year, for example.

It is not a secret that stocks, like bonds, do poorly in an inflationary environment, according to Warren Buffett.

“There is no mystery at all about the problems of bondholders of in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner” Buffet states. “You hardly need a Ph.D. in economics to figure that one out.”

Regarding stocks, the conventional wisdom believes “…that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms; let the politicians print money as they might.”

The main reason it, stocks as a hedge against inflation, do not turn out the way conventional wisdom believed, according to Buffett, is that “stocks, in economic substance, are really very similar to bonds”.

References:

  1. https://www.bankrate.com/banking/federal-reserve/what-is-inflation/
  2. https://fee.org/articles/inflation-just-hit-a-13-year-high-here-s-why-you-should-care/
  3. https://markets.businessinsider.com/news/stocks/warren-buffett-berkshire-hathaway-warned-inflation-prices-tapeworm-investors-businesses-2021-5
  4. https://www.cnbc.com/2018/02/12/warren-buffett-explains-how-to-invest-in-stocks-when-inflation-rises.html
  5. https://fee.org/articles/the-costs-are-just-up-up-up-warren-buffett-issues-grave-warning-about-inflation/
  6. https://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/
  7. http://csinvesting.org/wp-content/uploads/2017/04/Inflation-Swindles-the-Equity-Investor.pdf

Roth IRA

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“Roth individual retirement accounts were created to help middle class earners set aside money for retirement that they wouldn’t have to pay taxes on at withdrawal.” Barron’s

The Roth individual retirement account (IRA) was created to provide an alternative to making non-deductible contributions to traditional IRAs. Roth IRAs are funded with after-tax dollars, which means at withdrawal at age 59 ½ the money is tax-free. Comparatively, traditional IRAs are funded with pre-tax dollars, so distributions are taxed at withdrawal.

You’re taxed or penalized when you withdraw your Roth IRA contributions and earnings if your Roth IRA account isn’t at least 5 years old or if you’re not yet 59½. The earnings portion of the withdrawal may be subject to taxes and a 10% penalty.

The contribution limit for Roth IRA accounts is $6,000 a year in 2021 (or $7,000 for people 50 and older).

There are also income restrictions for Roth IRA.

  • Single individuals with modified adjusted gross incomes (MAGI) of less than $125,000 in 2021 can contribute up to the limit, but their contributions are phased out if their MAGI is between $125,000 and $140,000.
  • If individuals earn more than $140,000, single taxpayers cannot contribute to a Roth IRA. For married couples filing jointly, the threshold is between $198,000 and $208,000 in 2021. 

Individuals can also use Roth conversions, where they take money from a traditional IRA and move it into a Roth after paying a one-time income tax on the transferred assets since pre-taxed dollars converted to a Roth are taxable at ordinary income rates. These transfers can also be known as a “backdoor Roth,” because they’re working around income limits to push money into these ultimately tax-free accounts. 

References:

  1. https://www.barrons.com/articles/peter-thiel-roth-ira-propublica-51624558641
  2. https://www.edwardjones.com/us-en/investment-services/account-options/retirement/roth-ira