Avoiding Common Investment Pitfalls

Posted on May 11th, 2010 in Investments, Newsletter Articles by wayne

I have found that some of the commonly accepted investment “advice” can be misleading, creating potential pitfalls for investors.  Some of this misleading “expert advice” comes from such respected journals as Money Magazine or the Wall Street Journal.

Let’s look at some ways to avoid the more common investment pitfalls.

1.  Always differentiate between investing and trading – Based on Benjamin Graham’s definition, buying a stock or fund to hold for a long period is typically considered an investment.  Other equity transactions are considered trading, with different rules and approaches because of their more speculative nature.  Before buying a stock or fund, always determine whether the transaction is an investment or a trade.

2.  Only use Stop/Loss orders when trading – Stop/Loss orders should only be used when trading.  If you use a Stop/Loss order with an investment, your investment could be sold at the worst possible time.  On May 6, when the DOW fell almost 1000 points before recovering, outstanding Stop/Loss orders were likely executed.  An investment portfolio, with Stop/Loss orders to sell at 15% below the opening price, would have lost 15% on May 6 instead of the 3% loss that the market suffered.

3.  Avoid redundant mutual funds – I recently reviewed a $500K investment portfolio that is being “professionally managed” by a well known discount brokerage and mutual fund company.  This portfolio contained 50 different mutual funds, with 13 US large Cap funds and nine Foreign Large Cap Funds.  A diversified fund portfolio requires no more than one fund for each Morning Star “style box” category.

4.  Avoid all sales fees with mutual funds - While most investors know to avoid front or rear end “load” mutual funds, many funds have a “hidden load” called a 12-b1 fee.  This annual fee of .25% or more can greatly reduce long term investment returns.

5.  When allocating assets, include ALL investible assets – Investors typically have several different accounts including retirement accounts, taxable investment accounts, real estate and savings accounts.  Once a proper asset allocation is determined, all assets should be included in the asset allocation.

6.  Always consider investment tax consequences – When taxable, tax deferred and tax free (Roth) accounts exist, put tax efficient investments in taxable accounts and tax inefficient investments in tax deferred and tax free accounts.  Closely follow the tax law changes that will occur, starting in 2011.  Some investments, such as stocks with high dividend yields, could change from being tax efficient to tax inefficient in 2011.

7.  Avoid making purchases based on a stock’s P/E – While the market’s overall Price/Earnings ratio can be a useful indicator of whether the market is under or overvalued, the P/E of an individual stock can be very misleading.  A low P/E for a company that is not growing may not portend a good investment, while a higher P/E on a rapidly growing company may show good value.  Price earnings growth comparisons or owner’s earnings vs price comparisons are much better indicators of a stock’s value.

8.  Avoid “Target Date” funds -  A recent “panacea” from the mutual fund industry is “target date” funds.  The concept is for the investor to pick the year in which they will begin withdrawing funds for retirement or other purposes.  The fund management will then take care of the rest.  However, different mutual fund companies have different asset allocations for funds with the same “target date.” A better approach may be to assemble your own “fund,” consisting of low cost, indexed ETFs or mutual funds.  Annually, modify the asset allocation toward more conservative investments as the “target date” approaches.

Whether managing your own investments or using an outside investment advisor, be sure that your portfolio avoids these common pitfalls.

When using an investment advisor, always ask if they have a fiduciary responsibility for both the advice that they give and the products they offer.  A fiduciary advisor is legally required to always place their client’s interests ahead of their own interests.  Many brokers and agents are held to a lower “suitability” standard, where the products and advice offered may legally allow them to place their own interests before their client’s interest.

Are You an Investor or a Speculator?

Posted on May 11th, 2010 in Investments, Newsletter Articles by wayne

When it comes to the stock market, are you an investor or a speculator? Many people believe that they are taking a “conservative” equity investment approach when they are actually using a very “speculative” approach.  Let’s explore the differences between a stock market investor and a speculator.

Benjamin Graham, the father of value based investing, made a simple distinction between investing and speculation.  In Chapter 1 of his famous book, The Intelligent Investor, he states: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.  Operations not meeting these requirements are speculative.”

According to Graham, if your “investment” is done in any fashion that does not provide for safety of principal combined with and an adequate return, you are speculating.  Based on this definition, many mutual fund managers (especially those with high turnover rates) are speculators.  If your mutual fund manager is a “speculator,” then so are you!

Perhaps the speculative investment approach pursued by many mutual fund managers is why index based mutual funds and indexed Exchange Traded Funds have recently become so popular.  Buying an index fund that tracks the S&P 500 Index entails investing in the stocks of the 500 largest US companies.  As long as the stock market is reasonably valued (or better yet undervalued), this investment approach provides a reasonable expectation of safety of principal combined with an adequate return over time.

The analysis that must be done with index investing is determining when the stock market is undervalued and when it is over-valued.  As can be seen from the dramatic increase in stock prices over the past 14 months, the best time to buy into a market is when conditions look the bleakest.

Based on the press coverage in March 2009, it would be easy to assume that the investment world was coming to an end, with the S&P 500 trading as low as 666. In hindsight, it is now obvious that March 2009 was the best time to buy into the market, as almost all stocks were trading well below their long term valuations.

Fourteen months later, the S&P 500 is now trading at over 1150, a 70% increase from the March 2009 low.  Excepting the current European turmoil (and of course that pesky 9.9% unemployment rate), the press is now touting how well our economy has recovered.  An index fund investor, who may be considering an increase to their stock allocation, must determine if the market is still undervalued or whether there will be a better time to increase equity positions in the future.

Investors in individual common stocks must evaluate both the market and individual stocks.   As with index investing, investment principal is put at risk if the stock market is overpriced.  If the stock market is not overvalued, the investor must then analyze individual stocks to determine if they are reasonably valued.

There are many ways to analyze a stock investment.  We prefer the Owners Earnings (OE) approach, as defined by Warren Buffet.  A company’s OE provides the intrinsic value of that company.  Our initial screen is to find financially strong, high quality companies with low leverage and increasing dividends.  From this screen, we look for stocks whose prices are more than 30% below their Owner’s Earnings valuation.  Once purchased, we hold these stocks until the stock price exceeds Owner’s Earnings or the company no longer meets our financial and quality screen.  With this approach, our stock holding period is typically measured in years.

There are many other ways to evaluate individual stocks.  As long as the analysis approach chosen will identify stocks that should retain their value (safety of principal) and provide an adequate return, the approach meets Graham’s definition of investing vs speculation..

Many of my clients, friends and relatives have tried short term trading and other speculative investment approaches.  While some people may succeed at speculating,  I have never met any “speculator” who has been consistently successful over a multiyear time period.  For me, speculation is like Las Vegas, while you sometimes win, in the long run the “house” ends up with the money.