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Letter to an Investor as a Young Man

By Jim Fink on December 29, 2010

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If I knew then what I know now, I would never have made a mistake, or at least not as many.

 — Michael W. Domis

Youth is wasted on the young.

– George Bernard Shaw

Long-term investing can be very profitable, but few people reap anywhere near the maximum investment benefits possible because they make mistakes — both of commission and omission. As a result, most people’s retirements will not be as comfortable as they had hoped. Nobody knows that better than me; I’ve had more than my fair share of investment regrets. As my hero Dennis the Menace once said: “How come dumb stuff seems so smart while you’re doing it?” I’m not sure of the answer, but I think most of my investment mistakes have boiled down to four causes: (1) ego; (2) laziness; (3) recklessness; and (4) stress.

Since time immemorial, parents have warned their children not to make the same mistakes they have made. Since I’ve been around the block a few times, I thought I would carry on that tradition by writing a letter to my son Alex on some basic rules of investing that I wish I’d known when I started dabbling in the markets more than two decades ago. Alex is only one year of age, so it’ll be a while before he appreciates what I write today. Nothing I have to say is as profound as the one-word piece of advice that Mr. McGuire gave Benjamin Braddock in the 1967 movie The Graduate, but maybe some of you 20-something young’uns out there can benefit from reading it now anyway:

Letter to My Son

Dear Alex,

As a young man who has just graduated from college, the gravy train of parental support is ending. It’s time for you to strike out on your own in the world. At a minimum, that means getting a job and saving for your retirement. If you decide to get married and have some kids, all the better (no pressure).

As you know, I’m not what you’d consider super-wealthy, but your mother and I do alright; we’re not complaining. Looking back, I could kick myself for the mistakes I made with money that prevented us from living the really good life in Aspen or Palm Beach. The good news is that you can learn from my past mistakes and avoid them. If you do, there is every reason to believe that you will be a millionaire many times over by the time you retire.  Got your attention?  I thought so. So listen up; I want to visit you in your Aspen mansion one day. Below are thirteen investing mistakes to avoid that will help you get rich beyond your wildest dreams.

1. Ignore the Advice of Your Elders

When I was younger, I thought I knew everything. I read a lot of investment books advising me to limit risk by diversifying and keeping position sizes small but I ignored it. I thought the people writing about their mistakes were just losers and I was smarter and wouldn’t lose like they did.  It turns out that the stock market is inherently unpredictable over the short term. No matter how smart you are, you WILL get the direction of a stock wrong quite often. Be humble. Overconfidence is a wealth killer.

2. Get More Than One Graduate Degree

After graduating from Yale College, I didn’t know what I wanted to do with my life, so I just decided to avoid the issue by going to graduate school for two years. After that, I still didn’t want to get a job and went to law school for three years. By the time I got a job as a lawyer, I had amassed more than $150,000 in student loan debt. For the next seven years, I had virtually no discretionary income; whatever I made either went to food and shelter or debt repayment.

A good education is important, but don’t overdo it. Spend college figuring out what you want to do and then do it. Hanging out in school not only incurs humongous debts, but it also reduces the number of years that you are earning an income; a double whammy against wealth accumulation.

3. Wait Until Your 40s to Invest

I didn’t get serious about saving and investing until I turned 40. This delay has had a colossally detrimental effect on my wealth accumulation.  The power of compounding over long periods is amazing. You don’t need a lot of money to make a lot of money if you start early.

For example, a person who starts saving at age 40 and invests $5,000 per year will have contributed a total of $100,000 by the time he retires 20 years later at age 60. Assuming an annual investment return of 8%, that $100,000 contribution will have generated a nest egg worth $267,000.

In contrast, a person who starts investing earlier at age 25 and invests only $2,000 per year will have contributed a total of only $70,000 by retirement but will have amassed a nest egg of $402,000, 51% more than the person who started at 40!

To achieve an 8% annual return, you’re going to need a substantial slug of your portfolio in common stocks. Historically, common stocks have outperformed virtually all other asset classes over the long term (except maybe timber). But the past does not guarantee the future, and stocks are extremely volatile (i.e., they can go down a lot), so be careful.

4. Put All of Your Eggs in One Basket

I initially learned about investing by watching CNBC and they only talk about common stocks, so that’s the only asset class I invested in. It turns out that there are other types of investments like cash, U.S. Treasury bonds, inflation-protected bonds (TIPS), real estate, managed futures, precious metals, etc. When the financial crisis of 2008 rolled around, my entire portfolio plunged along with the S&P 500. Meanwhile, treasury bonds and gold skyrocketed without me.

If I had read InvestingDaily.com’s special free report on Asset Allocation Strategies, I would have known that investing in different asset classes other than stocks can reduce the downside volatility of a portfolio and increase returns over the long run. Always remember the simple arithmetic of investing:

Gains and losses of equal percentage magnitude have asymmetrical effects on wealth, with losses having the greater effect.

Look to add asset classes with low correlations to common stocks (i.e., they zig up when stocks zag down) in order to reduce the magnitude of potential losses.

5. Bet Too Large Going for the “Big Score”

More than once I’ve been so sure that a stock is going to skyrocket that I’ve put most of my money into it. I’ve discovered that my worst losses occur when I am most confident. Why? It’s not that my track record with stock picking is worse when I am confident; actually, it’s about the same win/loss percentage. The problem is that I invest a much larger position of my portfolio on my “sure thing” bets so the inevitable losses are much more damaging. As I wrote in So, You Want to be a Trader?,  proper position-sizing is all-important.

6. Don’t Learn About Stock Options

I had always heard that stock options were “risky” and were for gamblers only. Boy, was I wrong. It turns out that stock options can actually reduce the risk of your investment portfolio and provide monthly income all at the same time. Option strategies such as selling covered calls, selling puts, and purchasing long-term calls and spreads would have really helped smooth out my portfolio returns and given me more cash to invest in safe, fixed-income investments.

Now, don’t misunderstand me. Options are very powerful, leveraged tools that can blow up on you if used improperly. They can expire worthless, so only use them responsibly. To wit: (1) buy long-term options that don’t expire for many months or years; and (2) sell short-term options that expire soon and which defray the cost of your long investments.

7. Focus on Fundamentals Only

Superstar value investors like Warren Buffett and Peter Lynch say that they invest only according to the fundamentals of each of their stock picks, but in truth no stock is an island. A stock’s fundamentals are affected by macroeconomic factors in their industry. As I wrote in How to Pick Industry Sectors, top-down investing can help save you from making a lot of investment mistakes.

In addition, you should also take note of a stock’s price action via technical analysis. Often, trouble will show up in a stock chart before a company’s fundamentals begin to deteriorate. This may be because large investors with insider, non-public information are trading the stock in advance. Illegal? Yes, but it happens and a stock chart sometimes gives you a hint of this nefarious (but informative) activity before the fundamentals.

Despite what I just said, fundamental analysis and value investing should be the core of your investment philosophy. Just not all of it.

8. Avoid Dividend-Paying Stocks Because They’re “Boring”

I know what you’re thinking: dividend stocks are boring. Their businesses don’t provide enough growth opportunities to use all of their cash flow so they are forced to return some of it to shareholders. You want to invest exclusively in “glamour” stocks that don’t pay dividends and plow all of their cash back into the business.

Think again. Buy dividend stocks.

Remember one of Aesop’s fables: A bird in the hand is worth two in the bush. As I wrote in The Best Stocks are Dividend Stocks, companies that pay cash dividends actually have better earnings growth than companies that don’t. The reason is that dividends impose fiscal discipline on corporate management and prevent them from wasting money on low-return projects and wasteful empire building. Don’t fall for phony promises of future riches. Focus on well-performing businesses that respect shareholders enough to return some cash today.

9. Buy 52-Week Lows

I used to think that I was getting a real bargain buying stocks selling at their lowest price levels of the past year. After all, buy low and sell high, right.? Wrong. A 52-week low is often just a temporary stop on the way to even lower prices. As I wrote in black swans, the stock of BP (NYSE: BP) continued to fall long after the initial news hit of its disastrous Gulf Coast oil spill.

Focus on winning stocks with good fundamentals. As I wrote in The Growth vs. Value Debate, oftentimes growth stocks trading at higher valuations are the better long-term investments because of their high compounded earnings growth.

10. Listen to Hot Stock Tips

If you ever hear that your friend’s barber has a hot stock tip that is ready to quadruple in value, run away as fast as you can. Most people lose money in the stock market because they trade based on rumors, hype, and bad information. Why would you want to follow in their footsteps? It’s like cheating on a test by copying the answers of the class moron. Do your own homework.

11. Trade During Your Vacation

You work hard so when you go on vacation, just relax. Leave your investment portfolio alone. Don’t trade anything and don’t even look at your portfolio while on vacation. I can’t explain it, but there is some cosmic rule of the universe that says that your investments will perform their worst during this time. Why ruin your vacation by spending your time watching your stocks fall off a cliff? And trading during your vacation will inevitably make things even worse. Investing is hard enough when you concentrate full-time. When you make ad-hoc trading decisions in between frolicking at the beach and going to your favorite crab shack restaurant for dinner, you’re bound to make a bad mistake.

In fact, let me extend this advice to say the following: don’t trade during periods of emotional distress. Just as a vacation distracts you, so do emotional moments. Sometimes I found myself trading just to “make myself feel better.” Needless to say, stress clouds investment analysis and the trades I made at these times were among my worst ever.

12. Overtrade

The key to investment success is to start investing early in life and continually contribute throughout your working life. Let the miracle of compounded returns work its magic over the long-term.  Churning your account making a lot of trades may be fun, but it just incurs a lot of commissions that will make your broker’s retirement a prosperous one, not yours. As investing legend Jeremy Grantham likes to say:

Getting the big picture right is everything. One or two good ideas a year are enough. Very hard work gets in the way of thinking.

13. Forget About Tax-Advantaged Retirement Accounts Like 401ks and IRAs

You’ve heard of the old saying “A penny saved is a penny earned?” Well, it applies to taxes too. Unfortunately, we live in a time of humongous government budget deficits and President Obama has added to the budget pain by dishonestly pushing through an incredibly expensive new entitlement program called healthcare reform. Increased tax rates – including higher capital gains taxes — are a virtual certainty going forward.

Tax shelters are going to be more important than ever. Avoiding a 20% or higher capital gains tax is the same as earning 20%. Even the best investors like Warren Buffett haven’t compounded their wealth much higher than 20%, so take full advantage of tax-advantaged accounts while they last. Contribute to your company’s 401k plan at least up to the point where you get the maximum employer match. For a young person, there is no better tax shelter than a Roth IRA. Pay taxes now and then enjoy tax-free compounded returns without having to worry about paying higher future tax rates.

Good Luck

That’s all I got, Alex. If you avoid even half of this list of mistakes, you’ll probably end up richer than me. However, if you’re anything like I was at your age, you’re probably going to smile, give lip service to my advice, and then ignore most of it. That’s ok, the greatest teacher is often adversity. But after you’ve made a few investing mistakes, I hope you’ll realize I may actually know something and read this letter again. It’s never too late to learn. 

Love,


Dad

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Roger Conrad’s Utility Forecaster: An Oasis of Safety and Growth

Lesson No. 8 is one of the most important. The best way an investor can guard against scary market drops is to invest in conservative, dividend-paying utility stocks that provide “essential services.” Electricity, natural gas, and local telephone services are consumer staples that people need in good times and bad to light their rooms, cook their food, and talk to family.

Dividend expert Roger Conrad focuses exclusively on cash dividends in his award-winning Utility Forecaster investment service. Cash truly is king when it comes to reinvesting dividends in the best companies and building real wealth. If you are a conservative investor who wants to enjoy both high dividend yields and near-perfect safety, you owe it to yourself to give Roger’s “essential service” newsletter a test drive today.

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