It seems that perfection is reached not when there is nothing left
to add, but when there is nothing left to take away.
—ANTOINE DE SAINT-EXUPÉRY
Oddly enough, my experience as a value investor has taught me to keep it simple, stupid (KISS). I have always been a full-time professor—teaching, doing research, writing books, spending time with my spouse, raising six kids. I don’t spend eight hours a day studying stocks or following the stock market. Most days, I don’t even look at stock prices.
Keynes was a master investor, as well as a master economist, and he reportedly made his investment decisions while eating breakfast in bed, though his approach was the exact opposite of value investing. In the wonderful Chapter 12 of his treatise The General Theory of Employment, Interest, and Money, which revolutionized economics, Keynes argued that it is easier to anticipate changes in investor psychology than it is to estimate the intrinsic value of stocks. He likened buying and selling stocks to childhood games:
It is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.
Keynes explained how the key to winning such games is to understand and anticipate one’s opponents:
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
This may have been easy for Keynes, but not for me! I share Keynes’s enthusiasm for investing in one’s spare time, but I am more comfortable buying stocks that are attractively priced than I am trying to guess which stocks are going in or out of favor. I play games with my children, but not with my investments.
When I have money to invest, I look at well-managed companies (as gauged, for example, by Fortune’s annual list of the most admired companies) that have large dividends and/or earnings relative to their stock price. I am wary of stocks whose prices have increased dramatically and tempted by stocks whose prices have fallen, figuring that I am more likely to find bargains among stocks the market hates than among stocks the market loves.
I buy what I like using an inexpensive online broker and forget about it. I don’t waste time checking stock prices every day (or worse, every hour or minute). I do notice (how can one not notice?) if there is a stock market crash. I do notice if bubbly things are happening (like the Wall Street Journal article about Bill’s Barbershop). That’s about it.
Here are a few other KISS rules of thumb.
Stocks can be bought and sold using full-service brokers such as Morgan Stanley, UBS, Merrill Lynch, Edward Jones, and Raymond James that compile mountains of data, prepare in-depth analyses, and make buy/sell recommendations. Investors have individual account executives (please don’t call them “brokers”) who give advice based on the firm’s research. Many investors appreciate the individual attention and comfort of having someone help them make decisions, but they pay for it with high fees. In addition, account executives have a fundamental conflict of interest since the more their customers trade, the more revenue is generated for the brokerage firm.
Discount brokerage firms, in contrast, do little more than answer the phone, give current prices, and record trades. Cheapest of all are trades made over the internet without the assistance of account executives or telephone operators. Commissions are lower because the firm does not do research or offer advice and doesn’t need as many employees to deal with customers. Many discount brokers give investors free internet access to enough information to make sensible investment decisions.
If you are going to buy and sell stocks yourself, choose a firm that offers low-cost online trading, such as Ameritrade, Charles Schwab, eTrade, Fidelity, Merrill Edge, or Vanguard, and that gives you free access to useful research. If you have a large portfolio, you might want to go with more than one broker, because the Securities Investor Protection Corporation (SIPC) only insures brokerage accounts up to $500,000 if a broker goes bust.
Buying stock with money borrowed from a brokerage firm is called buying on margin, where the margin is the money the stockholder puts up. If you buy 200 shares of ZYX stock for $50 a share (a total cost of $10,000), a brokerage firm with a 60 percent margin requirement will require you to put up at least $6,000 (and loan you the remainder). The brokerage firm charges you interest on this loan, but, as with any leveraged investment, you come out ahead if the rate of return on your stock exceeds the interest rate on your loan.
If your equity—the market value of your stock minus your current loan balance—falls below a specified maintenance margin, you will get a margin call from your broker requesting additional funds. The Fed requires a 25 percent maintenance margin, but many brokers use a more conservative 30 to 40 percent.
I’ve never bought stock on margin.
If you think a stock’s price is heading downward, you can sell shares you don’t own by selling stock that your broker borrows from another investor. This is called a short sale, and it must be covered at some point by buying stock to replace the borrowed stock. Short sellers try to follow the age-old advice to buy low and sell high, but they sell first and buy later.
Short sellers do not receive the proceeds from the short sale; the brokerage firm holds on to it and earns some interest for itself. Not only that, brokers require short sellers to put up margin, perhaps 50 percent, and then charge interest on the remaining fraction. Short sellers pay in-and-out commissions, lose the interest they could be earning on their margin, pay interest on the rest, and pay dividends on the underlying stock—seemingly expensive penalties for being a pessimist.
I’ve never sold stock short.
When first starting out, brokers try to build a client base by making cold calls to people who have been identified as potential customers, often as a result of advertisements offering free, no-obligation financial reports. Those who respond to the ad receive follow-up phone calls from brokers hoping to find customers. These cold calls are called “dialing for dollars” because the only way a broker can make money is by clients making trades.
Brokers have a persuasive incentive to recommend active portfolio management (“account upgrading” is the euphemism, churning the goal)—sell Wells Fargo to buy Chase; then sell Chase to buy Bank of America; then sell Bank of America to buy Wells Fargo; and on and on. Brokers are like sharks—they need movement to survive.
Most brokers are conscientious professionals who know that excessive expenses and dismal performance will alienate customers. As with any profession, however, some brokers are unscrupulous and, like vicious sharks, churn their clients’ accounts mercilessly.
A front-page story in the Los Angeles Times that detailed some stockbroker abuses was subtitled “Beware, Unwary.” In one case, a seventy-year-old retired radio actress saw her $550,000 nest egg shrink to $67,000 while thousands of pointless trades generated $310,000 in commissions. When she asked her broker about the blizzard of trade confirmation slips mailed to her, she says he told her to “throw them away.” This is like this old joke: “How do you make a small fortune in the stock market? Start with a large fortune.”
Most broker-client relationships are not horror stories, but the nightmares do warn that broker and customer objectives do not always coincide.
I avoid brokers by using online brokerage firms.
Brokerage fees are either a percentage or a flat fee, or a combination of the two. For small trades, the commission can be staggering; for example, most brokerage firms have a minimum commission of, say, $9.99 even if you just buy one share of a $5 stock. As a percentage of the cost, brokerage fees drop for larger trades, but these savings may be offset by the effect of the transaction on the market price since it may take a significant price increase to find a seller and a substantial decrease to find a buyer. If you sell one stock to buy another, you have to pay two transaction costs. At, say, one percent round-trip, active trading becomes pretty expensive. Trading once a year, the stock you buy has to have a 2 percent higher annual return than the stock you sell to cover the cost of the trade. This differential rises to 24 percentage points if you trade every month. Please don’t trade every month and, God forbid, don’t day-trade.
It is generally a bad idea to jump in and out of stocks—sell Apple to buy Google; then sell Google to buy Amazon; then sell Amazon to buy Apple; and on and on. One problem is the endless brokerage costs. Another is the taxes that must be paid on capital gains. If you own stocks, bonds, or other assets that have increased in value, these capital gains are taxable, but you don’t pay the tax until you realize the gain by selling the asset. If, for instance, you buy 1,000 shares of stock for $20 a share and it rises to $30, you do not have to pay a tax on the $10,000 capital gain unless you sell. All realized capital gains are taxable, and up to $3,000 ($1,500 if married, filing separately) of realized losses can be used to reduce taxable income. Another wrinkle is that the capital gains tax rate is lower on long-term holdings (more than a year). The exact tax depends on multiple comparisons of short-term and long-term gains and losses, but we don’t need to go into those details here.
The lower tax rate on long-term gains provides an obvious incentive to defer the realization of gains, at least until they become lightly taxed long-term gains. Even after a year, there are persistent benefits from postponing taxes in order to continue earning dividends and capital gains on the deferred taxes.
In our example, suppose that you realize your $10,000 gain by selling. If it is a short-term capital gain and you are in a 28 percent tax bracket, you must pay the government $2,800, leaving only $17,200 to put back in the market. If you don’t sell, you can continue earning dividends and capital gains on the full $20,000. In essence, the Internal Revenue Service (IRS) has loaned you your $2,800 tax liability, and the only “interest” you pay on this loan is taxes on the extra dividends and capital gains. Even better, there is no capital gains tax at all if the stock is held until your death, since your heirs do not pay taxes on capital gains that occurred before they receive their inheritance. No bank will loan you money at such favorable terms.
Table 11-1 shows some illustrative calculations for a portfolio of ten stocks that is initially worth $100,000. Every year for thirty years, the portfolio earns 5 percent dividends and 5 percent capital gains, a total return of 10 percent. The buy-and-hold strategy is to never sell, so the only taxes paid are 15 percent taxes on the dividends. The “annual trader” strategy is to turn the portfolio over every year, holding each year’s portfolio just long enough to qualify for a long-term capital gains tax of 15 percent. The “active trader” strategy is to turn the portfolio over four times a year, with the capital gains taxed at a 28 percent rate.
One set of calculations assumes a $10 commission on each transaction; the other calculations assume no trading commissions in order to focus on the benefits of postponing capital gains taxes.
Turnover deflates performance dramatically, which illustrates the old saying, “The broker made money, the IRS made money, and two out of three ain’t bad!” In the short run, the advantage of a buy-and-hold strategy is due mostly to the avoidance of brokerage fees; in the long run, the postponement of capital gains taxes becomes more important.
One persuasive reason for selling a stock is to realize capital losses and get a tax credit. You can’t make money by losing money; but once a loss has occurred, it can be profitable to realize the loss so that the tax credit can be invested. Suppose that the value of the 1,000 shares you bought for $20,000 falls to $15,000. If you realize your $5,000 loss by selling, you can deduct $3,000 from your current taxable income and carry forward $2,000 to be deducted from future income. In a 28 percent bracket, your $3,000 loss reduces your taxes by $840, which you can invest. Instead of having $15,000 invested, you will have $15,840 earning dividends and (you hope) capital gains.
A strategy of deferring gains and harvesting losses is very simple and appealing, effectively $100 bills from the IRS.
Every fall, I look at my portfolio to see if any prices are substantially lower than the prices I paid and, if so, I consider reaping the tax benefits from realizing capital losses.
Sixteen women in Beardstown, Illinois (population 5,766), got together in 1983 to form an investment club that they called the Beardstown Business and Professional Women’s Investment Club. It was an irresistible story. They were grandmotherly (age 70) and got together to trade recipes, gossip, and stock tips. They reported an annual return of 23.4 percent for their first ten years, 10 percentage points better than the 14.9 percent annual return on the S&P 500.
They appeared on television and wrote a charming book called Beardstown Ladies’ Common-Sense Investment Guide that included recipes for cooking food and picking stocks. It was a bestseller, so they wrote four more books, repackaging their recipes and common-sense advice.
It turns out they calculated their 23.4 percent return by comparing the size of their portfolio in 1994 to its initial value in 1983, not accounting for the monthly dues that had been put into the portfolio along the way. A large part of the reason that their portfolio was growing was that they kept putting in more money.
Being America, this revelation led to a class-action lawsuit against the book’s publisher that was settled with the lawyers getting cash and the wronged customers being allowed to swap their Beardstown books for other books, such as 116 Ways to Spoil Your Dog.
I sympathize with the Beardstown ladies because it takes a lot of work to do a correct accounting that includes all the money going into and out of a portfolio. Money going in from regular and irregular savings, money going out to pay for cars, colleges, and vacations. Portfolios being split during divorces and enlarged during marriages. Taxes being paid on realized capital gains and being saved on realized capital losses. Before writing this book, I considered digging through my records and figuring out how well I had done. I had a general idea that I had done well, but maybe I was being fooled by selective recall. I spent about an hour combing through old brokerage statements before I decided it wasn’t worth the many more hours that would be required. For example, every year that I had realized capital gains or losses, I would have to redo my state and federal tax returns, taking the alternative minimum tax into account, in order to determine how much I paid or saved in taxes because of my gains and losses.
Then I remembered that I had started a self-directed retirement plan back in 1987. I found the initial documents and saw that I had put in $26,334. (The odd number reflected the rules for establishing such plans.) I never put another penny into this plan and I never took a penny out, so whatever this plan was currently worth was an accurate tabulation of how well the portfolio had done. The current market value was $1,812,639, which works out to be a 15.4 percent annual rate of return. The return on the S&P 500 over this period was 10.3 percent. If I had bought an S&P 500 index fund, with no expenses, my $26,334 would have grown to $481,726. The extra 5 percentage points over almost thirty years compounded to a portfolio nearly four times as large!
I hadn’t bought any winning lottery tickets. I made a few contrarian investments, and I got out of the market during the dot-com bubble and got back in after the bubble popped. Mostly, I just bought first-rate companies at attractive prices relative to their dividends and/or earnings: Apple, Coca-Cola, GE, IBM, Johnson & Johnson, Unilever, Procter & Gamble, Costco, JP Morgan, Wells Fargo, and some closed-end funds (more on that later in Chapter 14).
My investment strategy has been similar in my other accounts, so I imagine that the results have been comparable; in fact, many of the stocks are the same. My returns in my nonretirement accounts may even be somewhat higher because they benefited from tax-harvesting losses on occasional clunkers.