The first rule of investing money is “don’t lose it.” In stock, bond and commodity markets in which most trading is controlled by institutions and professional investors, the little guy with $10,000 in his fist is the last to get the news, the slowest to trade on it, and the most likely to pay the highest fees.
What to do? There are some self-protection rules that can function as fortune preservers. None will make you rich, but they’ll help keep you from drowning in seas of red ink.
1. Never overpay for an asset
It sounds simple, but this rule calls for subtle judgment about what something is worth. There are many financial formulas to determine the future value of a stock or bond. In the case of stocks or bonds that produce cash flow, the value of the asset is the sum of everything that will be paid out as stock dividends or bond interest.
If a stock with a $100 price tag pays a five per cent annual dividend and you have a 20-year outlook (or time horizon), then the stock is fairly priced at $100. At $90 it’s a good deal as long as the dividend is reliable and a better deal if the company has a history of raising the dividend from time to time. At $150, the stock is a pretty lousy bet.
If an investor buys a stock that falls below his purchase price for many years, he still may still be able to come out ahead just by collecting dividends.
If you want to buy a stock with no dividend, then the fundamental valuation of stock price to earnings (p/e) per share comes into play. By tradition, Canadian chartered banks have p/e’s in the 12 to 15 range, growth companies in the 20 to 25 range, and stocks running on hormones in the 30+ range. Earnings are customarily next year’s estimates, a figure widely available on the Internet.
There is simple numerology at work here. If a stock has a p/e below 10, that means either than there is an expectation of declining earnings (or sales), that earnings, though robust from time to time, are not dependable, or that some other trouble is thought to be ahead. Low p/e stocks may be bargains, but you need to know why the price is low.
If a stock has a p/e above 30, it means, in the simplest case, that it will take 30 years to get your money back. Stocks with high p/e’s often turn into tragedies for investors.
If a stock has a p/e over 50, it is a momentum stock. You may be lucky and ride the momentum for a little while. The safe thing is to stay away. If you can’t resist the temptation, keep your stake to what you are able to lose.
2. Keep the faith
I like to say that the stock market is either a church or a casino.
As a church, with solid stocks with long histories of growth and rising dividends, essential and immoveable positions in the economy, experienced and predictable management, faith should pay off.
Buy a stock, keep it for a few business cycles, each of which may be 36 to 48 months long, and you should do well. Keep the faith and hold the stock for 20 years and the odds of making a decent return improve.
If you think the market is a casino, realize that the odds of making short term gains are worse than in Vegas.
In quickie stock plays, after costs, the odds of winning are less than 50 per cent.
On Bay Street and Wall Street, in London and Frankfurt, Paris and Hong Kong,
computers driven by complex mathematic models can trade price opportunities in microseconds. High speed trading is now thought to represent 80 per cent of the volume of trading in New York. Any bright idea you read in the daily press or even in an online news feed has already been exploited by these trading methods. But the machines can’t match faith for buy and hold investors. And that is the long term edge.
Commodity trading does not follow these rules. There is no long term payout for gold, copper, potash or, for that matter, tallow (actually a board traded commodity).
These markets are speculative, variously linked to energy consumption for oil and gas, to prices of crops for potash, and to fear of almost anything for gold. Statistics showing relationships abound, but most of the relationships are merely inevitable. After all, there are at least 100,000 index numbers generated every day around the world and in that forest of statistical trees, a few will rise and fall together.
Many index numbers are for things seldom traded or inaccessible to outsiders. Unless you are an insider in an agricultural commodity and know a thing or two about the market, you should stay out. Even then, prudence should rule.
3. Lower your fees
The old saying that fools rush in where angels fear to tread implies that one should hire a cautious angel to manage money. Mutual funds represent themselves as such angels. The managers of funds are usually chartered financial analysts. Often they know their fields with many years of experience.
In theory, everybody gets the information at the same time, but very few average investors listen to conference calls between companies and fund managers or follow statistical services. So mutual fund managers should beat their markets, right?
Wrong, because after the high fees charged by Canadian mutual funds — the highest in the world, by the way — individual investors usually don’t do as well as market indexes.
The alternative, of course, is to buy the index itself cheaply packaged in an exchange traded fund (ETF) and sold with very low commission by online discount traders. Brilliant or lucky managers will beat their indexes from time to time, but after the high costs of mutual fund administration, the odds are with the low fee ETF investor
Need proof? Say that you make an RRSP contribution of $10,000 and put the money into an average TSX mutual fund with a 2.5 per cent management expense ratio. You leave the money there. Over 10 years, the fee will take 25 per cent of performance, over 20 years, 50 per cent (well, slightly less because the fee is charged on a shrinking base).
An ETF with an annual management fee of 20 basis points, a fifth of one per cent, will take just four per cent of your fund value over 20 years.
ETFs come in many flavours: straight indexes, indexes with weighing set by cash flow per share rather than market weight of the stock, bonds arrayed by term to maturity, ladders of terms, by credit quality, by industry, by country and by sensitivity to interest rate changes. Just picking ETFs is a challenge.
The theory of indexing is based on avoiding selection error. That theory should drive one to buy the broadest indexes. That would be all stocks on the Toronto Stock Exchange, all stocks in the Standard & Poor’s Index of U.S. large cap stocks, all Hong Kong stocks, or even all big companies on all major exchanges — the Morgan Stanley Capital International Index does that.
The index investor who wants safety should eliminate risk by buying ETFs priced in Canadian dollars or hedged to the Canadian dollar. Global currency variation is hard to predict, can make or break an investment, and does not follow simple financial rules. Consider that the U.S. dollar traded at a 30 per cent premium to the loonie in 2001 and now trades at par or close to it, while the Dow Jones Industrial Average has barely moved in the last 10 years. Currency moves would have wrecked an otherwise flatlined investment for the unfortunate Canadian who bought the Dow index in 2001 — a year when, ironically, a book came out called Dow 30,000 by 2008. Robert Zuccaro’s book predicted that the index, about 12,800 as I write this, would hit that number well before now, a guess based on a straightline extrapolation of the dozen years leading to 2001.
The bottom line: don’t trust trends, don’t trust predictions. Keep your costs down, your options open, spread your money widely to avoid asset selection error, and stay for the long run. Do all that and the odds shift to your favour. †