The allure of diversification …

There is a certain appeal to diversification, particularly when seen as a risk-minimization strategy.

Rick sums this ‘certain something’ up nicely in this recommended twist to how he would set up his own Perpetual Money Machine:

Nothing in life is without risk- but you can minimize risks by diversifying- use multiple types of wealth capacitors some properties, some stocks, even some bonds. You can further diversify with a mixture of commercial and residential properties, properties in different locations, etc.

Similarly you can diversify stocks through buying small cap, large cap, mid cap, and foreign stocks.

If you diversify you can be fairly sure that one bad event doesn’t ruin everything. Of course if the sun goes supernova all bets are off but barring that you should do fine.

And, this is certainly appealing …

… don’t forget that I have been well diversified in almost every area that Rick mentions: multiple businesses; multiple RE investments in different classes (residential; commercial; single condos / houses; multifamily; retail; office; etc.); stocks (but, no mutual funds of any kind … and, I intend to keep it that way!) … but, I don’t recommend it!

Why?

I see two problems with this:

1. You spread yourself pretty thinly – you risk becoming a Jack of All Investments But Master of None … this lack of specialized expertise (which you can, of course, try and ‘buy in’) and focus can actually INCREASE your investment risk, hence DECREASE your investment returns, and

2. You automatically consign your returns to the mean/average – not all of your investments can perform as well as your best investment …. if you are comfortable with this ‘best’ investment (or, at least one of your ‘above average’ ones) surely you would put more effort into doing more of those?

The usually arguments FOR diversification then say things like “well, look at the sub-prime and what that’s done to [Investment Class A], therefore you should also do [Investment Class B]” …

… but, they conveniently forget that [Investment Class B] tanked 5 years ago, and will probably tank even worse 5 years hence, whilst [Investment Class A] recovers.

If you diversify you run the risk of averaging your returns down.

In other words, if you can choose your investments wisely your best hedge against risk are a combination of:

a. Time: make sure you can hold the damn thing for 10 to 30 years … if you have a short investment horizon, no amount of diversification will protect you.

b. Higher Returns: if you can hold long enough, every investment worth its salt will recover – and, then some; and, isn’t a ton of cashflow a great ‘insurance’ against risk?

Of course, if you can’t choose your investments wisely, then a ‘regression to the mean’ becomes a GOOD thing … just don’t expect to get rich if you can’t develop any special expertise

Nope, Rick, my Perpetual Money Machine – which asks me to generate my active income one way (e.g. my job or business), and then create passive income in another way (e.g. stocks or real-estate)  gives me all the diversification that I need!

Accumulating 7 million dollars worth of property in 7 years?

I wrote a series of posts about how to build a Perpetual Money Machine, and Caprica asks:

Here’s how I made it to $7million net worth in just 7 years, Caprica:

http://7million7years.com/2008/04/25/my-7-million-dollar-journey/

But that’s not the question that you actually asked; you asked how to build up $7 Million dollars worth of PROPERTY (i.e. real-estate) in 7 years, and that’s another matter entirely.

For example, you will notice that I didn’t reach my 7m7y from real-estate alone (and, you’re not likely to be able to, either): my ‘energy source’ was a business (actually, more than one), but my ‘capacitor’ was (largely) real-estate.

If you are asking if you could build a $7 Million real-estate portfolio in 7 years, using just your income from a job (even a pretty high paying job) I would have to say “not bloody likely, mate” …

… your income just can’t ‘fuel’ enough real-estate deals to produce the annual compound growth rate that’s required!

To see what energy source and compound growth rate combination that YOU need, FIRST you must start with knowing your Number / Date:

If you need, say, “1 million in 20 years’ (and, let’s assume that you’re starting from, say, $10,000 in the bank instead of my $30k in the hole), a job (as your ‘energy source’) + real-estate together with stocks (as your ‘capacitor’) should do the trick.

But, if it’s “7 million in 7 years” you want (starting with the same $10k), then you’ll be needing a more aggressive set of ‘energy sources’ and ‘capacitors’ for your perpetual Money Machine, i.e.:

Your own business (excess cashflow) + real-estate.

It’s all in your required annual compound growth rate … find yours, and work backwards from there …

… but, Caprica – as I suspect do many of my readers, after all of this time – already understands this:

I realized after I posted my response I already knew the answer …, which was to start one or more businesses to help you generate enough money to buy your passive income source.

Increase your return per unit of risk?

Why bother?

I wrote a post about an insidiously appealing – yet flawed – approach to investing promoted by the financial services industry (I wonder if high turnover helps them or hinders them?) called ‘re-balancing’ …

… even if it were sensible (it’s not), it requires an even more flawed base to sit upon: a diversified portfolio. Now that is something that the financial services industry makes money from!

That post inspired a discussion with Jeff, who provides some useful number-crunching to support his ultimate argument for rebalancing:

Consider two cases in the first you rebalance in the second you don’t:

Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancing

No Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recovery

Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.

What if the order was different?

Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
62.5K 62.5K 125K Rebalance
31.25K 62.5K 93.75K Market drops 50%
46.9K 46.9K 125K Rebalance

No Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
37.5K 50K 87.5K Market drops 50%

Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance.

So, it seems that rebalancing is inexorably tied to diversification: do one and you should do the other, but what of the reverse?

Let’s turn again to Jeff [AJC: I cut/pasted a couple of Jeff's comments ... you can read the entire thread in its original form here] , who says:

If you have elected to diversify your portfolio I would argue that you should rebalance to maintain your initial asset class mix.

You add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.

The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on.

Rather than focusing on return per unit of risk, shouldn’t we look at risk per unit of required return?

Surely we should:

1. FIRST look at what RETURN we need in order to achieve a required financial goal, and

2. THEN compare the risk-profile of the various choices that can produce the desired return or better (hence, required annual compound growth rate) NEEDED to get us there, and

3. USE THAT menu of qualifying investments to make our investment selection from?

If your financial goal – e.g. Your Number – is sufficiently large and/or your desired timeline – e.g Your Date – sufficiently soon, diversifying/rebalancing may be among the highest risk options available, along with any other investment strategy that fails to meet your required annual compound growth rate!

Diversification/Rebalancing simply may not return a high enough amount to fuel the annual compound growth rate required to get you there!

In which case, you only have some combination of the following three choices:

i) Reduce your Number, and/or

ii) Extend your Date, and/or

iii) Accept a higher level of technical risk in your investment choice/s

But, is there a point in life when it makes sense to switch to a risk-above-return strategy?

Yes!

As Jeff says:

As I get older I will be increasing the % of bonds that I hold and will be rebalancing.

But, I would not (first) look at my age … again, I would first tie this to my financial goal i.e. my Number:

When I reach my Number (or, if I fail and am within 7 years of my latest retirement age), I would shift to a Making Money 301 Wealth Preservation Strategy, such as:

1. That promoted by Prof. Zvi Bodie (Worry Free Investing) – putting 95% – 100% of my Investment Net Worth into Treasury Inflation Protected Securities (TIPS) and the remainder (0% – 5%) into call Options over the S&P 500, or

2. That promoted by Paul Grangaard (The Grangaard Strategy) – putting 70% of my Investment Net Worth into a low cost S&P 500 Stock Index Fund and 30% into a bond-laddering strategy to cover my anticipated spending for the next 5 years (then ‘repeat’ every 5 years), or

3. Putting 80% of my Investment Net Worth into positive cashflow (before tax) real-estate (I would ‘jiggle’ my deposit amount to ensure at least a 6.5% return p.a.) and keeping 20% in cash and CD’s as a buffer against vacancies, repairs and maintenance, taxes, etc.

4. If all else failed, or as a ‘last ditch’ effort to avoid leaving too much in cash/bonds, a diversified portfolio of stocks and bonds … possibly to be rebalanced each year.

But, the last word goes to Jeff:

This, of course, doesn’t mean anything unless the new return is something that you desire.

Indeed

Keep an eye on the Investment Clock …

You probably wear a watch … it tells you where you are (time-wise) and hints as to where you should be (running late for an appointment, of course!).

But, did you know that there’s also an Investment Clock?

The investment clock is one of the best indicators on the movement and condition of the finance, property and equities markets. It was first published in London’s Evening Standard in 1937 and showed the movement of markets within a decade cycle. Many people, however did not readily accept the probability of events turning out in a cyclical fashion so it took a while for some to warm to this new area of thought.

As late as last year, I was reading articles that said that we were at One O’Clock on the Investment Clock: rising interest rates and fear that stocks were on the verge of falling (and, fall they did) …

… then, something surprising happened: the clock did a ‘fast-forward’ to where I think we are today:

At the bottom of the cycle when fear and bankruptcy are abounding and interest rates are down, remember that this is the time to be positive. It is the time when there are bargains galore, ready for the taking.

The driving factor behind the business cycle is the capitalist system itself. Recessions are a way of ridding itself of excesses. Things like speculative lending by banks, high risk real estate trading and inflation. Society simply starts going a bit faster than the economy and places a lot of strain on resources. This means we are left with inflation and high interest rates. The bank then imposes a credit squeeze for a period, long enough for those excesses from the system to force inflation down.

Always remember that during a slump the price of most things will fall, but the value of cash does not. In fact, the value of cash goes up because it is measured by its increased ability to buy things more cheaply. This is the best time to hold cash and come out of those holdings when the economy is in the doldrums.

Nobody knows how long we will languish in the ‘doldrums’, and if you count the recent stock market rally as a ‘good news’ indicator it may be almost over, but it’s clear – at least to me’ … we are already in the cycle where assets are cheap … both stocks and real-estate with the added bonus that interest rates are also cheap …

… Bargain Hunter’s Heaven.

Here’s what to do:

1. Start looking for good quality companies with a strong history of earnings growth that are undervalued (did you know that GE has produced 10 years of 10%+ year-over-year earnings growth?) that are selling for low P/E (that’s the price compared to earnings … if you can pick up GE at P/E’s of 13 and hold for a long time, you have a sure-fire winner!) and HOLD. Don’t feel obligated to borrow to buy these, but increasingly, this will be a good strategy as stocks will be the first to rebound.

2. Start looking for good quality income-producing real-estate that you can afford to HOLD … these will be the last to recover (could be a 7 to 10 year cycle to fully recover) but, prices will begin to steadily increase. So, buy soon to lock in these yummy low interest rates before they, too, start to rise. The combination of low prices and low interest rates is equally a sure-fire winner.

3. Start a service business that helps large corporates – as they recover, they will need to outsource more and more services. It can be tough (corporates can be tough to deal with) but they can also pay off big and provide a ready exit strategy (as the outsourcing ‘fashion’ begins to swing back to ‘insourcing’ and your largest customers fight to buy you out).

Just don’t forget to always keep an eye on the clock …

Buffett's motivations questioned?

Last month, as a reader service, I published one of the most important financial statements made in recent years, but it wasn’t made by the Treasury, the Feds, or even the Banks (!)  …

… it was made by Warren Buffett – to give the average US investor confidence by sharing his personal financial strategies for today’s ‘crisis’ market.

Naturally, there were cynics: isn’t it amazing that people who usually have nothing (like one particular financial journalist) like nothing better than to criticize those who have everything (like one particular multi-billionaire investor)?

It’s the same counter-intuitive, yet all-too-human, failing that sees us buy when the market is high and panic/sell when it is low. Sad … but, true.

Here are some comments by Marketwatch.com, where “David Weidner penned an article about Warren Buffett” that Motley Fool thinks is “equal parts sad and stupid”; Motley Fool says:

Weidner responded to Buffett’s article by making the following points/accusations:

• That because Buffett can get better terms than you, his advice does not apply to you.
• That Buffett wrote the Times article to talk up shares because his recent investments in General Electric (NYSE: GE) and Goldman Sachs (NYSE: GS) preferred shares were underwater, and he needed to “stir up some buying” to get their prices back up.

That the stocks Buffett’s buying for his personal account are irrelevant, since he made his fame with his gains at Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).

I am not going to report here all the reasons why this is short-sighted bunkum, when Motley Fool have already done such a good job for me

How to build a conglomerate …

I wrote a post a while ago, in response to a reader question, that questioned the sanity of an entrepreur following my path and owning multiple concurrent businesses.

I said: bad idea!

However, Diane points to a number of conglomerates (a collection of related or unrelated businesses under common corporate control) that make money because they diversify into multiple businesses and sectors:

Most conglomerates are good examples of diversified businesses (GE comes to mind). One could also buy complementary businesses. Your risk level is affected the same way as it would be with diversifying any investment.

Your example of multiplying the management teams (and thereby increasing risk to each business) is interesting, Adrian. This is precisely one a buyer of companies is looking for (like your friend Brad) – inefficient management with an underlying fairly decent business. You buy and consolidate, combining the common management (HR, Acctg, IT) that runs across each company, combine anything else you can “leverage” (logistic chains, purchasing power, for examples), and save money, thereby reducing costs and making it even more attractive to investors (depending on which kind you want).

And, it’s true: a conglomerate can diversify a company’s risks, just like diversifying a stock portfolio … the problem is – just like any other diversification strategy – you equally ‘wash out’ your successes with your failures.

My issue is that this may work as a ‘risk mitigation strategy for large companies, but it’s too risky for smaller (e.g. sole, or family) operators.

Large conglomerates build up over time, usually using one successful business to fund the rest. The key is having good management in each … the risk (for a small player, like you and I) is trying to BE that management.

A great example is Warren Buffett: he started Berkshire Hathaway by buying a controlling interest in a mediocre textile company and raised cash simply by stopping the dividend stream to the shareholders …

… he used that cash to buy an insurance company, and used policyholder cash from the insurance company to buy more companies.

The interesting thing is that he does NOT look for companies with poor management; rather he buys GOOD companies with GREAT management and keeps them in place, doing what they do best: creating more cash for his next company purchase … and, so on goes Warren’s $40 Billion – $60 Billion (his personal net worth in Berkshire Hathaway) ‘cash machine’ that owns more than 75 companies!

The problem is that Warren only got to this point because he couldn’t find one company that ‘did the trick’ … he would, however, put 60% to 80% of his entire net worth in just one investment/business, if he could find it!

The correct way to look at debt …

BradOK asks:

What’s a better use of my money – pay down debt or invest it in the market?

To which JillyBean responded:

At what rate of interest is your debt? How much debt do you have? Do you have an emergency fund? If you invest your money, what is the purpose for the money — short term or long term? The markets are on a downward spiral and very volatile — it might be more prudent to answer the above questions to determine the answer for the actual question.

You could always compromise and do both! It never is bad to pay down debt.

But, I am always working from the assumption that you want to get rich /stay rich …

… if that’s also your mindset, you might have more clarity if you rephrased the original question as “what’s better, to INVEST in debt or INVEST in the market?”

Once it’s clear that you are making an INVESTMENT every time you pay off debt – even personal debt – or, decide not to, then you will realize that you simply need to consider relative returns.

Then it will suddenly become clear that INVESTING in debt returns you a guaranteed rate equivalent to the interest rate (plus ongoing fees, if any) being charged. On the other hand, investing elsewhere MIGHT return more, over the long-term.

So, your real question that you need to answer is: “What investment will give me a greater AFTER TAX return than my highest interest rate currently outstanding debt?”

If you can find one (and, you have the required skills/interest/knowledge/stamina) then invest in that, otherwise pay down some debt.

Naturally, start with the highest interest rate debts first and work your way down (remember the ‘debt avalanch’?)

We're split down the middle …

… some agree that paying down your mortgage is the dumbest decision that you can make (not really the dumbest …. but certainly down there with the best – I mean, worst) and some simply don’t agree.

Right now, though, I want to pick up on one of Nick’s comments, since he has summed up the ‘pro-pay down argument’ really well:

I do a decent amount of investing myself, and while I don’t claim to be a master of the trade, I do well. That doesn’t change the fact that I don’t know how my investments will turn out. Everything could go horribly wrong, and I could end up taking quite a hit… or it could go really well and I could make a killing.

I don’t think anyone really knows for sure how well their investments will perform. I think anyone who does is either lying or fooling themselves. It is all about managing risk.

Putting a sizable portion of your cash as a down payment, and making prepayments to pay off your mortgage, is very good way to minimize risk. You end up with lower monthly obligations, less debt, more equity… Of course, this means less free money to invest and less money making potential..

Once again though, risk management philosophy comes into play. Is your primary residence something you want to take the risk with? In today’s market, putting less down, and making lower payments would turn out to be a very costly mistake if your investments don’t net the return you wanted (you’ll be stuck paying up to hundreds of thousand of dollars more in interest over time).. and this is only assuming you merely break even on the money you invested (and are not in the red).

I think everyone’s long term plan involves moving to a nicer house in a nicer area. This is something perfectly attainable by playing this situation safe. IMO, it is dangerous to put such basic life plans on the chopping block. I think this is how people could potentially get into serious trouble.

Now, don’t get me wrong. I’m not saying that you should immediately put any money you have towards prepayments, or you should put all your money down on that new house. I’m saying that you need to carefully balance this based on your confidence about making good investments and the amount of risk you are willing to take. In other words, I think its foolish for just about anyone to put very little down and not make prepayments when they can (i.e. tax return time, or portions of a raise). I think its equally foolish to put ALL of your money towards prepayment and down payment.

Make no mistake, that large down payment is a very good protection plan when you lose your job, your wife has a kid, or you encounter some medical emergency. Those lower monthly payments make things more manageable and prevent you from being overrun with debt.

A prepayment of only $300 a month on a $350,000 principal can save you well over a hundred thousand dollars in interest over 30 years. That money goes straight into your bank account or investments when your mortgage is paid off early.

These items are your safety net… and that’s part of good risk management isn’t it? To maximize gains and minimize risks. You can’t just focus on maximizing gains – you need to protect against potential pit falls as well.

By all means have your money work for you, and try to get investments that produce greater returns than your mortgage rate… but start off by minimizing your monthly payment (sizable down payment) and put a good effort in to pay your house off early (prepayments)… You know, just in case those investments don’t work out.

I have some questions of my own; let’s use Nick’s $300 per month example:

1. Is the $300 a month a sizable proportion of the amount that you intend to invest overall? If so, do you know what you are getting for it?

Nick says that paying down his mortgage by an extra $300 per month will save him $100,000 in interest over 30 years … let’s accept that number for now and assume that this $100k can be somehow freed up at the end of the 30 year period:

$100,000 in 30 years will have almost the same buying power then as $31,000 does today (assuming that inflation averages just 4%).

That should provide Nick a yearly stipend of just over $1,500 in today’s dollars (commencing in 2038, assuming that 5% can then be ‘safely’ withdrawn each year).

Now, there’s a problem right there; how can 5% be a ‘safe’ withdrawal rate in 2038?

If inflation is still just 4% Nick needs to find a ‘safe’ investment that will return him 9% after tax (4% to keep up with future inflation and 5% to spend) … he can’t get that return in retirement by paying down his mortgage any more, it’s already paid off!

So, now – in retirement – he has to look for a more ‘risky’ investment than the one he used to get there!

Therefore, I am assuming that Nick will either keep his paid off house and actually entirely forgo this income entirely or move into a smaller paid off house or unit to free up $100k of equity …

… in any event $1,500 or zero a month sounds pretty similar to me

2. Do you know what returns you can get elsewhere?

Even if Nick isn’t relying on this $100k (then why bother with it in the first place?!) – because he is also  investing elsewhere – what could he achieve if he also invested his $300 a month elsewhere?

Well, Nick is ‘saving’ 6% interest in the current market [AJC: if you aren't prepared to fix an incredibly low interest rate like this, how can I help you?!], which could be equivalent to a 7.5% – 8% after tax investment return.

[AJC: Unlike investing in income-producing investments, there is possibly no income tax to be paid on your mortgage interest payments/savings ... of course, there could be a tax disincentive if you have been itemizing your home interest on your tax return and can no longer claim that deduction]

But, what if he can find an investment that returns more than 8% after tax?

Even an extra 1% (after tax) additional return will improve Nick’s 30 year outlook by 20% (at least, for the $300 monthly extra that he is putting into his mortgage).

3. Do you care?

For me, this is the key question: can Nick achieve his financial goals even without investing this $300 a month elsewhere? If he can’t, is he willing to let these goals go for the apparent ‘safety’ of a home partly or fully paid off?

So, my real question to Nick is: can you achieve your financial goals at the same time as paying your mortgage off? It’s possible (hell, I did it!) but, for most people, not likely … they are already skating too close to the wind even before pulling extra money out of their investment portfolio.

To me, it’s the same thing as asking if you can fish for trout in a babbling brook without getting wet:

It’s possible, but you won’t probably won’t make a great catch unless you are prepared to (slowly, carefully, and not deeper than you can handle) wade in …

Your Perpetual Money Machine won't start?

AJC has written his first article on US News magazine’s ‘alpha consumer’ web-site. It’s all about what US News calls Recession 2.0 … check out the article here then PLEASE leave a comment on the US News site!!!

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Your Perpetual Money Machine won’t start?

… then it probably just needs a little oil and a good kick!

I am, of course, talking about the Perpetual Money Machine that I covered in a series of posts last month. But, Caprica, who lives in Australia asks:

But not all perpetual motion machines are that seamless. If you want to invest in cash flow positive properties here in Australia, either you are buying into regional areas that are subject to seasonal trends or you become a slum lord. Furthermore, the boom on “cash flow positive” properties and the high interest rates here in Australia has meant that the cash flow positive opportunities have all but dried up.

Similarly, a Berkshire Hathaway portfolio can easily loose large chunks of value during declining markets (sub prime for example).

Is there a such a thing as perpetual motion machine (short of having more than 7 million in the bank earning interest) that means that I don’t need to deal with difficult tenants or worry about every jitter in the market?

Caprica is right, of course … not all Perpetual Money Machines are ‘seamless’, run entirely smoothly, or even start without a ‘kick’ in the right place!

But, start – and run – they will, if you do it just right …

You see, there is one ingredient that you need, Caprica, regardless of where you live: time.

Any reasonable property can become cashflow positive if you allow time for the rents to build up such that you ‘overtake’ the costs … in our analogy, it takes time for the ‘capacitors’ to build up enough ‘charge’ to kick-start our Perpetual Money Machine.

It helps if you can buy when the market is off its highs; it helps even more if you can lock in interest rates when they are still relatively low; it helps if you can put in your research and buy a property that will rent reasonably well and appreciate over time (but, we aren’t looking for ‘home runs’ in either category, here).

Similarly, stocks may go up/down, you just need to keep pumping money in (i.e. buying more stocks) until you have a buffer (excess of stocks) that will allow you to ride the waves and sell down a little at a time to live off (after you ‘retire’).

Equally, it helps if you have the fortitude to ignore the waves entirely -better yet, be contrarian – knowing that the inevitable ‘upwards correction’ will come ‘eventually’.

The Perpetual Money Machine will work anywhere, anytime … you just need to give it time to warm up properly

… a forced flight away from stocks!

If you’ve ever thought about starting your own online business but didn’t know where to start, check out my latest post on I’m About To Find Out If You Can Make Money Online!!

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I wrote a post a while ago about the Myth of Diversification – just another piece of financial ‘wisdom’ almost designed to keep you form retiring early / retiring rich …

Yet, despite the current melt-down that should prove that there is no real safety in diversification, the principles remain as mainstream as this comment from Francis illustrates:

That’s the idea behind diversification and re-balancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high.

It really doesn’t take a genius to make a few million if you can just buy low and sell high …

… but, it takes genius to know when to buy low and when to sell high!

Who knows where ‘high’ and ‘low’ really sit: they are relative, which serves (partially) to explain why market timing doesn’t work!

As the Dalbar Study shows:  mere mortals should not be in the business of trading stocks / timing the market; people who attempt this reduce their returns from 11.9% to only 3.9% … !!

No, we are simply investing for the long term, that’s why I asked Francis:

I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.

Quite rightly Francis responded by pointing out that we aren’t Warren Buffett, saying:

Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.

As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.

But, if we really aren’t Warren Buffett, how do we KNOW when “the valuation of particular resources is out of whack”? Well, according to Francis, that’s when ‘rebalancing’ comes into play …

But, how does re-balancing provide a ‘reasonable compromise’ to the fact that we are all (WB aside) “terrible at market timing”:

Let’s say that you have $100,000 invested: 50% of your money invested in stocks and 50% invested in bonds.

Let’s then say that stocks ‘devalue’ by 50% overnight (a huge market crash) … in the case of an Index Fund, this could simply be a cyclic response to the market that has occurred many times in history.

Suddenly, your portfolio has shrunk by $25,000, so now you have $25,000 worth of stocks at post-crash prices and $50,000 worth of bonds (their price/value hasn’t shifted in this hypothetical crash). That is, you have 33% in stocks and 67% in bonds … so what do you do?

Well, you buy $25,000 more stocks … or, do you sell $25,000 of bonds?

The reality is that most people don’t have the $25,000 in ‘loose change’ to rebalance by topping up their portfolio, so they shift money FROM bonds INTO stocks.

Yippee … except, what happens when stocks recover and/or bonds dip?

In that case, you’d be taking yourself OUT of the stock market (a 9.2% – 11.9% annualized return, depending on who/how is doing the measuring) into the Bond market (a 4% annualized return?) …

… a forced flight away from stocks!

Would Warren Buffet do this?

Heck no! Warren Buffett doesn’t worry about market dips; he knows the market always recovers, as long as the underlying businesses keep making money. In fact, he looks at market dips as a buying opportunity (didn’t he load up on Kraft, while we were all bailing out of the market).

He identifies quality when he buys (bet he didn’t own any Enron), but, he recommends that you buy a little piece of all of America’s finest companies (a.k.a. an Index Fund, so even if you do happen to buy Enron, it’s only a tiny sliver of what you own), if you don’t know how to do what he does.

Warren doesn’t ‘rebalance’ his portfolio into cash (no dividends even, because cash/bonds doesn’t produce as high a return as his investments can) … and, he certainly buys more when the market dips and NEVER sells.

Here’s what to do:

If stocks are the asset class that you like and if you think that the stock market (as represented by an Index Fund or one or a few individual stocks, if you prefer) represents acceptable value:

1. Buy stocks … as many as you can afford; and,

2. Keep buying whenever you can afford more; and,

3. When the market dips, it’s ‘on sale’ … buy even more; and,

4. Never sell.

That’s it … now you are Warren Buffett.