30
Jun
Posted in Investing 101, Value Investing by Roger, the Amateur Financier |
(As always, when it’s Tuesday, that means it’s time for another thrilling edition of Investing 101. This week, we’re going to look at something a little bit different, in this case, value investing. Rather than a single investment or set of investments, as with most of our Investing 101 columns, we’re going look at an entire investing philosophy. Given the sheer amount of depth in this subject, there’s no way I can cover everything about value investing in one post, or for that matter, even in a week. Although, this week will cover quite a bit of value investing basics; yesterday’s post on present and future value covered some of the calculations frequently used by value investors. And now, more of the basics of value investing.)
Q: What is value investing?
A: That’s a rather broad question, and one that’s difficult to answer. Value investing means different things to different people, and the variety of opinions sometimes leads to misunderstandings. In a nutshell, value investing requires looking at the intrinsic value of a company, and buy stock in the company as if you were buying the company itself.
Q: As if I were buying the company? What’s that supposed to mean?
A: Well, unlike technical investors or others who focus on stocks as entities separate from the underlying business, value investors evaluate the shares of stock they consider purchasing as, well, ‘shares’ of the company they are considering. As a result, they look closely at the issuing company, evaluating its present state and future prospects, trying to determine how much the company is worth.
Q: How do you do that?
A: The most basic idea behind value investing is to calculate the intrinsic value of the company. By making some smart assumptions about how the earnings of the company will grow in the future, it’s possible to determine a reasonable estimate for how much the stock is worth in terms of future growth. It requires you to make assumptions (based on carefully considered research) on the future growth and run several calculations based on those numbers.
Q: That sounds kind of complex; are there any easier ways to run these calculations?
A: There are numerous online calculators that can be used to run intrinsic value calculations. One I particularly like comes from MoneyChimp. Or, if you prefer a more home made touch, I produced my own intrinsic value spreadsheet, based on the calculations listed in Value Investing For Dummies
.
Q: Wow, so all I do is plug numbers into these calculators, and they’ll tell whether I should buy these stocks or not?
A: In theory, yes. In practice, all intrinsic value calculations require you to make assumptions about how much the company value will grow in the future. As a result, the values you get are only as good as your assumptions. If you do plenty of research and come up with good values, you’ll likely have results that come close to reality. How you do that is the basis of value investing.
Hope that gives you a better understanding of value investing, as well as some tools to help you calculate the value of the stocks you in which you seek to invest.
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29
Jun
Posted in Value Investing by Roger, the Amateur Financier |
Which would you rather have, fifty dollars now or one hundred dollars in the future?
If someone approached you on the street and asked you this, there would probably be a lot of questions running through your mind, like ‘Why do you want to give me money?’ and ‘Just who are you, anyway?’ If the offer turns out to be genuine, though, another question should come up, ‘When in the future would I get the hundred dollars?’ The value of one hundred dollars to you in the future will depend on how long in the future you need to wait in order to receive it. If you would get the hundred dollars next week, that’s a good deal; there aren’t any (legal, guaranteed) ways you could invest fifty dollars in order to double its value in seven days.
On the other hand, if you would receive the $100 in ten years, it would be a much wiser course to take the fifty dollars today. Not only could you safely invest the $50 in a way that it will be worth more than $100 in the future (barring any badly timed downturns), but the one hundred future dollars will not have the same spending power due to the effects of inflation.
This is known as the time value of money; inflation and potential investment gains make the same nominal amount of money more valuable in when received or spent in the present compared to the future. As a result, many financial advisers and planners will talk about future value, the worth of an investment after a set period of time has passed, and present value, the needed amount of money to invest currently to achieve that future value. The equation relating these values is:
FV = PV*(1+i)^n
Where FV is future value, PV is present value, i is the interest rate (which could be the rate of return, the inflation rate, or debt interest, depending on the calculation), and n is the number of years between the present and future values.
Confused? That’s understandable; let’s go through an example to see how all these numbers relate and show how we could calculate each of these values. In our example, you’re about to inherit a lump sum of money from the estate of your great-uncle Mort. After attending his funeral (and avoiding any completely unfunny comments about his name), you want to crunch some numbers to see if your inheritance alone will be enough to allow you to retire early in a few decades. You want to be able to set the inheritance money aside, allowing it to grow, and not have to invest anything more to fund your retirement.
You’re currently twenty-five, and would like to retire when you turn fifty, with twenty-five times your current income in savings (adjusted for inflation). That way, you think, you will be able to withdraw 4% each year, spend an (inflation-adjusted) amount equal to your current salary, and still have little chance of running low on money. If you earned $40k last year, you’re shooting for a total retirement fund of $1,000k (an even one million dollars) in present value to completely replace your salary at a 4% withdrawal rate. If you think there’s going to be a 4% inflation rate over the next few decades (a bit higher than the historic rate), the future value calculation will be:
FV = PV*(1+i)^n = $1,000k*(1+0.04)^25 = $1,000k*(2.772) = $2,772k
You will need $2,772k in order to replace your current income. Now, let’s assume that in order to achieve this investment goal, you plan to invest in bonds and bond funds, which you expect to return at least 6% throughout the next two and a half decades. We can rearrange our future value equation in order to determine what present investment value we need to get to this sum:
PV = FV/(1+i)^n = $2,772k/(1+0.06)^25 = $2,772k/4.292 = $646k
If good old Mort left you an inheritance of at least six hundred fifty thousand dollars, you’re sitting pretty; you can simply invest that money, and when you reach fifty, you can live off the proceeds without putting in another dollar towards your investments. But, to continue our explanation of future value (as well as remind you not to depend on old relatives dying to fund your retirement), let’s assume you didn’t get quite that much; if your inheritance was only $400k, it would take longer to reach your goal. To figure out how much longer, let’s solve the equation for n, using the same interest rate (be warned, we’re going to have to use natural logarithms to calculate n):
n = [ln(FV/PV)]/[ln(1+i)] = [ln($2,772k/$400k)]/[ln(1+0.06)] = [ln(6.93)]/[ln(1.06)] = 1.94/0.0583 = 33.2 years
If you’re willing to delay your retirement from fifty to fifty-eight, you can use your desired, very conservative investment plan, and still retire early by most people’s standards. If you want to keep your retirement at age fifty, though, you could add some stocks to your portfolio and increase your expected returns. To figure out just how much, we’ll solve for i in the final variation on our equation:
i = [(FV/PV)^(1/n)]-1 = [($2,772k/$400k)^(1/25)]-1 = [(6.93)^(0.04)]-1 = [1.081]-1 = 0.081 or 8.1%
Thus, to still build your money up fast enough to meet your retirement plans without adding more funds, you will need to average a return of 8.1% over twenty-five years. You can probably achieve this level of return if you’re willing to add some stocks to your asset mix; it will be tough to get enough of a return with just bonds (without taking on significant risk with junk bonds or similar riskier bonds). A good balanced fund will likely provide the level of return that you need.
Now of course, this is a simplified example, using only a single, large investment with compounding only once a year. If you put in small amounts into your investments on a regular basis, the calculations get trickier. Still, having an idea of what your investments will be worth when you cash them out or knowing what you need to invest in order to meet your goals is always a plus.
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26
Jun
Posted in Great Debates by Roger, the Amateur Financier |
One of the most common pieces of investing advice given by financial professionals, right behind using tax-advantaged accounts and dollar-cost averaging, is to diversify your holdings. The argument is pretty simple: by holding a variety of investments, and multiple investments of each kind, you can ensure that one bad stock/bond/REIT/whatever you are holding will not do huge damage to your portfolio.
Of course, as with virtually every piece of investment advice, there are dissenting voices. One noted one is Robert Kiyosaki, the author of Rich Dad, Poor Dad
, who refers to diversification as ‘de-worse-ification’. His main argument is that attempts to diversify cause people to simply buy blindly and pray that their holdings rise, rather than properly investing.
What’s the truth? As with most financial debates, there are pluses and minuses to diversification. In an attempt to counteract some of the prevalent wisdom, let’s start with the minuses:
1) Blunts the Top Performers – One of the biggest flaws with diversification is that, by holding tens, hundreds, or even thousands of individual investments, you aren’t able to benefit from the full growth of the top performers. If you have a single stock that doubles in price over the course of a year, you will have nearly doubled your money (after expenses); if that stock is one of a thousand held in a mutual fund, the growth of that stock will be averaged with the gains (and possible loses) of all the other stocks, greatly diminishing your returns.
2) Leads to Overconfidence – Another problem with diversification is that it can lead to thinking, ‘if I have enough different holdings, there’s no way my portfolio can decline.’ Unfortunately, if 2008 taught us nothing else, it’s that even being diversified can’t always protect you; sometimes, all the investments within an asset class decline, and occasionally many asset classes are hit simultaneously. There are limits to what diversification can do to protect your assets.
3) It’s Boring – The last problem is purely psychological; while holding a diverse group of mutual funds makes for a good investment strategy, it’s not the most exciting topic to discuss over cocktails. The negative effects can extend beyond simply making you less popular at parties; if you are not interested and involved with your investments, you might not give your portfolio the proper scrutiny it deserves, and could end up with a portfolio that is far from your desired allocation or investments that are completely inappropriate for you.
So, there are some drawbacks to diversification. Still, there must be reasons why nine out of ten (or more) financial advisers recommend diversification. So, what are they?
1) Blunts the Low Performers – The inverse of the first disadvantage of diversification, which smooths out your returns in general. While it decreases what you could get with a proper investment in a high performing security, it will also increase your returns over the worst performing assets in the class. It also prevents the worry and trouble caused by bankruptcies; if the company that goes bankrupt is only one of the hundreds you are holding, the damage to your portfolio is likely to be minimal.
2) Makes Investing Easier – Another big advantage of trying to invest diversely is that, thanks to products like mutual funds and ETFs, it’s easy to find diversified investments that meet your asset allocation. Plus, it’s usually is less trouble to track the performance of a few broadly invested funds than to individually track dozens of stocks or bonds.
3) Tends to be Cheaper – Interestingly enough, thanks again to mutual funds and ETFs, it actually is cheaper (usually) to get a highly diversified investment than a more concentrated one. The abundance of no-load mutual funds and low cost brokerages makes it inexpensive to acquire and hold many diversified investment, whereas the commissions of acquiring even a small portfolio of individual stocks will add up quickly.
Given these relative benefits, what’s the best way to approach diversification? My advice remains the same as when I discussed how to build an investment pyramid. First, start by creating a set of broadly diversified investments; that way, you should have a good base to build on. Then, once you are diversely invested, you can consider putting a portion of your money into individual stocks (say twenty to thirty percent of your overall assets). This approach allows you to gain the benefits available with individual stocks, while avoiding many of the associated problems. You can have your cake, and eat it too!
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25
Jun
Posted in Weekly update by Roger, the Amateur Financier |
Well, it’s official. By the time you read this, I will be heading off to my last day of work at my current temp job. It was fun, while it lasted, but with the swine flu epidemic in the past, there’s just not enough need for me at Sharp. I like the people, I like the location, I even got into the work that I was doing, but alas, what is done is done, and hopefully, I can find something soon.
But not all my news is bad news; two weeks from now, I’m going to be moving out to the western side of Pennsylvania in order to live with my fiancée. It should be wonderful, although I’m a bit nervous about how well it will go. I just wish I had a decent job waiting for me out there; it’s going to be especially rough, going back to being unemployed. Still, it does give me more flexibility, which is also a good thing. And I’m optimistic that I can get something out there (or who knows, perhaps I can turn this blog into a full time gig).
So, enough about me; what do you think about me? Just kidding, now it’s time to peek in on some of the other great bloggers I follow:
Cash for Clunkers: Is it Worth It? – My good friend My Life ROI discusses the government’s new Cash for Clunkers program. It seems like an interesting idea, and if you are planning to get a new car anyway, it’s certainly worth considering. As he notes, though, it’s only really valuable if your car is worth less than the voucher (either $3500 or $4500, depending on the gas mileage of the older car); otherwise, you should just sell your old car and put the proceeds toward the new one.
Beach Reading on Personal Finance - Mr. Tough Money Love shares a few of his summertime reading suggestions. I especially support his recommendation of Dave Barry’s Money Secrets
; it’s an absolutely hilarious book, and if you have the opportunity, you really should read it. (It especially seems funny after lots of personal finance reading; Mr. Barry has the number of most financial gurus.)
12 Common IRA Mistakes to Avoid – Jeff Rose of GoodFinancialCents notes several mistakes that people frequently make when it comes to IRAs. Most are pretty commonly mentioned, but Jeff raises some thoughts I never would have considered, including inheritance and trust issues of which I had never heard.
The Problem With Target Date Funds – Frank Curmudgeon of Bad Money Advice makes some interesting points concerning target-date funds, particularly as a default 401(k) investment. He raises some good points, but seems to put too much blame on the government for first allowing target date funds as a default investment, then attempting to correct some of the problems that resulted with the recent downturn. I think the government is just doing what it’s supposed to do, trying to respond to its citizens, and I hope a good compromise will be reached that improves retirement for the average person.
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