High Yield Stocks and Bonds: A Risky Game

These days it is very easy to find stocks that promise very high dividend yields and bonds that offer apparent sky high returns. Some of these stocks and bonds belong to some of the most prominent companies out there. For example, a quick search on MorningStar yielded the following stocks offering dramatic dividend payments: CitiGroup - 22%; GE - 10%; Pfiser - 8%; Wells Fargo - 6.5%. These are big names offering impressive yields. Are they a good investment?

I don't know the answer to that question, however, there are some key principles that should be considered in connection with such an investment decision. First up, let me say that as far as stocks are concerned - as opposed to bonds - I am of the opinion that dividends do not matter from an investment perspective. I have previously written extensively about the subject, and there is no point in repeating those arguments here. However, even if you believe that high dividends make a stock more valuable, there is good reason to view high yields with suspicion.

Risk / Reward Balance for Bonds - an iron clad law of investing is that higher returns inevitably come with higher risk. This makes sense when you think about it - why would you accept more risk unless someone offered to compensate you for that extra risk? This compensation is the return that you generate. With that in mind, it is pretty safe to assume that a bond that offers a high yield carries with it a high degree of risk.

Dividend Calculation for Stocks - the dividend yield on a stock is calculated by taking the dollar value of the dividend paid for each share, and dividing it by the price of that share. As an example, a stock priced at $100 and paying an annual dividend of $3 has a dividend yield of 3%. The dividend yield on that stock can increase in two ways: the company's board of directors can choose to pay shareholders a higher dividend - say increase the dividend from $3 to $6 thereby doubling the dividend yield to 6%. However, the dividend yield would also increase to 6% if the price of the underlying stock fell by 50% to $50. 

Most stocks that offer the insane dividend yields get there not by increasing their dividends, but by virtue of their stock falling off a proverbial cliff. Now, that in itself may not be a good enough reason to pass on those stocks if you think you know something that the rest of the investment community does not. However, in most cases, there is a good reason why investors show a lack of confidence in a stock by dumping it en masse.

Dividends Are Not Set in Stone - Finally, it is important to understand that there is nothing that prevents a company's board of directors from reducing that company's dividend at any point. In fact, it is a pretty safe bet that a company whose stock is getting crushed will cut its dividend yield: there is typically a sound business reason for a stock to tumble, and it usually involves business problems for the company. In such circumstances it is reasonable to expect a competent board of directors to cut dividends to conserve cash.

Bottom line - high yield seekers beware: high yields are often nothing more than a high risk mirage.

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Investing and Over-Confidence

A couple of months ago, while traveling on business, I got together with a member of my extended family, a guy in his 20's who is in the process of learning to become an investment advisor. We spent about an hour together, during which all he could talk about was how he was going to make a killing trading stocks, bonds and commodities. What struck me was that this guy was very well versed in the language of professional investing while being completely oblivious to the true risks and opportunities of his chosen profession. 

He explained to me how investing was all about discipline, but his definition of discipline was slightly different from mine. My relative's investment strategy involves doing a lot of what he calls research, making a large number of bets, and always unraveling a position if it ever lost more than 5% of its value. I was somewhat amused and more than a little horrified that this level of knowledge and over-confidence was sufficient to make one an investment advisor. I asked my relative whether he has heard of the LTCM collapse. He said that he did. For those who are unfamiliar with the story, LTCM was a hedge fund that collapsed in 2000, in spite of having some of the world's most sophisticated investors (including an Economics Nobel Laureate) leading the organization. I asked my relative what made him confident that he could avoid financial calamity when much more experienced investors evidently could not, and he responded that discipline was the answer: never holding a losing position.

Yikes. This reminds me of teenagers when they first take the wheel of a car. They think they got it all under control until the smelly stuff hits the rapidly rotating blades of a wind making machine. Of course, we don't allow teenagers to teach others how to drive, but we do let teenager equivalents tell others where to invest their hard earned assets. Do you know anybody like that?

By the way, here's a hint: if you think you are on to an investment strategy that is going to make you a millionaire, and you are not already a Nobel laureate or have reasonable hopes of becoming one, you're probably wrong.

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Fall of a Stock Picker

In yesterday's Wall Street Journal, there was a front page article about William Miller, who I suppose is the manager of Legg Mason Value Trust, a mutual fund which according to the article "outperformed the broad market every year from 1991 to 2005. It's a streak no other fund manager has come close to matching". In spite of Mr. Miller's phenomenal run, in this latest market downturn he stumbled so badly that according to the WSJ, "These losses have wiped away Value Trust's years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods according to Morningstar." The WSJ quotes an investor in this fund as saying: "Why didn't I just throw my money out of the window -- and light it on fire?", and complaining that Mr. Miller's strategy "worked for a long time, but it's broken." I would like to point out that throwing your money out the window and then lighting it on fire, is redundant. You could reduce your expenses by taking either action, but both are probably not necessary.

So what's my point? Only this: investing is not about beating the market over the short term. It's not even about beating the market consistently for 20 years. It's about generating enough returns to guarantee your financial future. Even if you think you found a star-performing fund manager, or you think you can pick stocks better than anyone else you know, you should have zero confidence that this streak will continue. Apparently Mr. Miller is a very talented investor. Either that, or he is lucky beyond belief. However, even his market beating returns were completely wiped out by a short term mistake.

What's the answer? As always, my answer is index investing: (i) trust in the long term average returns of the stock market and don't try to beat them because the house always wins, and (ii)  minimize your investment costs because that is the one element that is completely under your control. Oh yeah, and don't freak out and sell when the market turns south. Markets do that on occasion.

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IPO Investors, Beware!

For the past several months, a close friend of mine has been salivating about the upcoming IPO of VMware (NYSE: VMW). He thought that it would be a great investment opportunity. He even tried, unsucessfully, to get some shares at the IPO. VMware finally went public earlier this month in a wildly successful offering. Turns out that my friend was right. The IPO was an excellent investment opportunity. My friend invested at $55 a share, so as of Friday evening his investment certainly paid off (the stock closed at $71.30).

However, not all IPOs have a happy ending. In fact, a number of academic studies have shown that for the first 3 to 5 years after an IPO, shares of newly public companies tend to underperform the general market. See for example this article, and this excerpt. This is such a well known phenomenon that I first heard about it when I took my very first finance class in business school.

My friend did very well for himself, but I am not clamouring for a share of that pie. In fact, I am going to stick to my tried and true indexing strategy and not try to outperform the general market. While my friend seems to have beat the odds so far, on average he is playing a game that is stacked against him. Remember, some people also win money at the slot machines, at the roulette table or by playing their state lottery, but that doesn't mean that playing those games is a prudent investment strategy.

Thanks for the offer, but I'll take my equity investments slow, steady and well diversified.

Beating the Market or Faking It?

Here is a story I heard a while back (I have no reason to believe that it's true): a new financial advisor moves into town and wants to drum up some new business. He buys a mailing list and drafts a marketing letter. In the letter he talks about stock XYZ. In 50% of the letters he praises the stock and forecasts that the stock price will go up in the following two weeks. In the remaining 50% he explains that the stock price will go down during the same period.

He mails the letters, waits two weeks and repeats the process, but this time he only sends marketing letters to the 50% of residents who got the version of the original document which turned out to be true, i.e. if the stock went up only the ones that received the positive remarks about the stock receive a new letter, and vice-versa.

If the financial advisor repeats the process four times, each time using a different stock as the subject of his fraudulent letter, at the end of the period 1/16 of the town's population will be convinced that the new financial advisor is a stock picking genius, having guessed the short term performance of four separate stocks correctly with a 100% success rate.

Of course, there are many reasons why this scam would not work. For example, some of the residents could compare notes and realize that conflicting advice was being sent to them. However, this is not the point of the story. My point is that residents who received the correct predictions would have no way of knowing whether the advisor was providing insightful advice or whether he was merely lucky four times in a row. After having received four correct predictions, many of the residents would probably hire the services of the scheming advisor, even though in reality he did not add any real benefit to their investment decisions.

Although this story sounds far fetched, in reality it is something that happens every day. However instead of happening with a single financial advisor, it happens with a hoard of financial planners, brokers, fund managers and so forth. Some say a stock will go up, some say a stock will go down. Some happen to be right. Some will happen to be right four times in a row. Because there are hundreds of thousands of professionals in the financial services industry, some will happen to be right dozens of time in a row. In many cases their success will be based on pure coincidence. The laws of statistics virtually guarantee that some advice givers will be correct a seemingly implausible number of times by pure coincidence.

I concede that there may be a select few whose success is based upon knowledge and expertise rather than luck, but the real question is:

HOW WOULD YOU KNOW WHICH IS WHICH?

So what remains? Index funds. Don't try to out-guess the market. Don't try to outperform the rest of the population. Simply aim for average returns and reduce your costs. Academic studies have repeatedly shown that using this seemingly lackluster strategy will yield a higher than average return.

Feng Shui & Business

I recently had an interesting discussion with one of my colleagues regarding Feng Shui. She is a believer. She told me a story about a business located near Golden Gate Park in San Francisco. For years, businesses located on the spot failed one after the other, until one business owner invited a Feng Shui master to advise him. The master told the business owner that for the business to succeed, he must paint the walls of establishment a deep green. The business owner followed the advice and sure enough the business thrived in the same spot for the next 20 years.

When the owner finally retired, a new business went into the same location. The new owners repainted the walls a different color, and ever since then no business survived in that location for more than a few months. My colleague took the story as proof positive that Feng Shui works... I took the story as proof positive that people will believe anything.

It's not that I am saying that Feng Shui doesn't work, although I certainly don't believe that it does. What I am saying is that there is a serious problem with people drawing far reaching conclusions from anecdotal evidence or from urban myth and using those conclusions for making financial decisions. In this specific case the story was about Feng Shui, but it could just as easily have been about astrology, numerology or about financial tips from a semi-respectable business guru.

In addition, I have a problem in principal with people that are willing to believe that something like the color of their walls is a decisive factor in the success or failure of a business venture. After all, if all it takes to succeed in business is the right coat of paint, why work hard? Why come up with a business plan? Why hire the best employees? Why advertise or focus on customer service? All you need to do is get a brush and three gallons of paint, and voila, problem solved.

This line of thinking extends to personal finance. People invest their hard earned money based upon unproven theories, hot tips and wild speculation. Think I am wrong? Consider "technical stock analysts" - there is not a shred of scientific evidence to show that there is any real basis to this investment strategy, yet there are hoards of people that make buying and selling decisions based on it. Trusting in such fiction gives some people a sense of control in what is essentially a chaotic and unpredictable environment. Personally, I'll take those boring index funds, that have been repeatedly shown to beat a large majority of actively traded funds.

Investing in Your Company Stock: Pros and Cons

My wife will be starting a new position next week, and her new company provides their 401k matching funds in the form of company stock. This is an unsavory practice that I hoped had passed from the world after the Enron scandal. Forgetting about that for minute, I thought I would take the opportunity to write about the pros and cons of investing in your own company stock:

Why You Should Invest in Your Company Stock

1. Understanding Your Investment - Warren Buffet is famous for saying that you should only invest in what you know and understand. One would think that the company you know the most about is the one you actually work for. You know if the company is well run, you know if morale is good, you know what the customers think about your company. In short, you have a lot of information which may allow you to make some intelligent investment decisions.

2. It Is a Company You Believe In - Otherwise why would you be working there?

3. It is Easy - sometimes all you have to do to invest in your company stock is to NOT act. Some companies award stock options or restricted stock to their employees. Others offer an employee stock purchase plan. Sometimes, unless you sell the stock you are awarded, you are automatically an investor.

4. Discounted Stock Offerings - many companies have an employee stock purchase plan (ESPP) which allows employees to purchase company stock at a discount, using a set portion of their salary. These purchases are typically done twice a year, and at the time of purchase you are guaranteed a 15% return on your investment, i.e. free money. Not taking advantage of such gifts is stupid. I intend to write a post about ESPP later this week.

5. You Don't Get a Choice - sometimes you are granted options or stock without having the right to sell them. It's a gift horse, no looking in the mouth please.


Why You Shouldn't Invest in Your Company Stock

1. The Double Whammy - if your company goes under, you lose your job AND your company stock is now worth zilch... can you say ENRON?

2. Restricted Trading - SEC regulations restrict company employees and other insiders from trading the stock at certain periods of the quarter. The blackout period lasts until your company releases its quarterly earnings statement each quarter. During this time your investment is completely illiquid by law. If your company will be releasing some bad news, you may be stuck holding a bad investment with no way to get out.

3. Bias - When I work for a company, I tend to think that my company is superior to the competition, whether this is true in reality or not. I have no proof of this, but I suspect that many people share the same positive biases towards the company they work for. A biased investor is a poor investor. If you can't keep a sober market outlook, you should probably not be investing in your company's industry sector at all.

4. Diversification - I recently read a post on My 1st Million at 33 (an excellent PF blog that I strongly recommend) in which Frugal explains that about 20% of his investment portfolio is invested in his company's stock. Frugal's appetite for risk is much higher than mine, and he is a sophisticated investor, but I don't care how much you love a company, or how great you think its prospects are, holding 20% in ANY one stock makes for a very undiversified portfolio. I shared my opinion with Frugal in a comment on his post (Hi, Frugal!)

Bottom line, there are definitely some advantages for investing in your company stock, and under some conditions it is the right thing to do. However, while the "common wisdom" is that you should have no more than 10% of your portfolio in your company stock, my opinion is that the risks far outweigh the benefits and the smart strategy is to sell, sell, sell.

Vegas, Gambling and Your Investment Strategy

This is Shadox, coming to you live from the sin capital of the world, Las Vegas, Nevada. Yes, it's true. I am here on a two day business trip, and will be going out to hit the town in a few minutes. But before I do, I wanted to share a quick thought about the connection between Las Vegas and people's investment strategy, personal finances and net worth.

What is it with Gambling? Seriously, I simply don't get it. Before I left for the airport this morning, one of my colleagues asked me if I gamble. My answer was "No. I understand statistics". It's not that I am getting on my high horse again (although you can hear the sound of hoofs in the background), it's just that I simply don't get why people willingly gamble, when they know chances are that they will lose their money.

I guess that the answer to this is twofold. There are some people who gamble, knowing full well that they will probably lose money. They do so because they enjoy the process. They do it for fun. These are people willing to pay a "Dream Tax" - the fee you pay for having the opportunity to dream of breaking the bank. They are, in essence, no different than someone who pays $50 for a fun night out. OK, I can understand that rationale, but it doesn't work for me.

The other group of people, and I suspect this is probably the majority of gamblers, gambles because they actually think that they can beat the house. They think they can win big because they have a system, they are very lucky, they have skills most people don't have, or they have blue eyes. Whatever their reason, they think they are being logical in thinking they can beat the odds.

Due to statistics, some of them do indeed beat the odds and make money at the roulette table or the slot machines. Many of these consider this proof positive that their system works and that they will continue to beat the odds in the future.

So, what does all this have to do with personal finance? When you think about it, the answer is: EVERYTHING. The world is full of people that are convinced that they can beat the house, and that the odds do not apply to them. In Vegas they call them gamblers, but out in the real world they call them day-traders, stock pickers, house flippers and get-rich-quick scheme participants. In a town that was built on the premise that there is a sucker born every minute, you can see these people sitting by the video poker machines, or spending their money at the Craps table. They are easier to spot out here, but that person who was telling you about how his new stock pick is going to make millions, is as much a gambler as any of the ones playing the tables on the Vegas Strip.

It's Great to be Average!

For my first post on this new blog, I want to relate a conversation I had with a friend earlier today. My friend recently invested in shares of EMC (NYSE: EMC), and did so based on information that the company is about to spin off their VMWare division. Although EMC may be a good investment (I don't know), I am questioning the wisdom of buying and selling individual stocks.

The typical investor gets most of his information from the mainstream news media. This information is widely known, and in all likelihood the same information is known to professional traders, brokers, investment bankers and research analysts (unless you are using illegal insider information). If the "big boys" have access to the same information they have probably acted on it and the price you will pay for the stock already reflects the good or bad information you are using to make your trading decision. In other words, the information you plan to use is probably already priced into the stock.

What strikes me as amusing is that in every stock transaction there is a seller and a buyer. The seller sells the stock because he thinks the price of the stock is about to drop. Of course, the buyer buys because he believes the opposite. If you trade a stock you are essentially betting that you understand the market better than the guy on the other side of the deal. However, the guy on the other side of the deal is probably a professional or institutional investor who gets paid to know the market and who specializes in a narrow group of target companies.

While most people never dare to claim that they can beat a professional tennis player in a 1:1 tennis match, and most sane individuals will not try to beat a professional race car driver at his own game, many think they can beat the professional investors at stock picking. Can anyone tell me why that is?

Now the punch line: research shows that most people can achieve better returns on their investments than can a professional investor. The strategy for success is simple: invest in an index fund and don't trade. This strategy essentially guarantees you a return equal to the average market return. Most professional investors under perform the market.

In summary: if you are both picking stocks, the professional investor has an advantage. He has more information and investing is his day job. Even armed with all this research and information, the typical professional investor will under perform the market. You as a private individual have an even smaller chance of beating the market by picking stocks, but by indexing you can assure yourself of average market returns.

Here's to being average.