Tag Archives: stocks

The 8 tips to Making a Fortune from Your Investments

invest why when where how
invest why when where how

It is the dream of many new investors to someday become financially independent from their portfolio.  If you want to make a fortune from your investments, it helps to take a step back and survey your opportunities, both in terms of probable future income and life expectancy, as well as the different methods that are available to you in your quest to compound your wealth.  Allow me to share some of my thoughts on the matter with you.

In the United States, the lifetime earnings of a person with a bachelor’s degree stand at roughly $2,100,000.  Overwhelmingly, college graduates marry other college graduates, bringing that figure to $4,200,000.  (From an economic standpoint, it’s not a stretch to say that wedding rings are the new social status indicator and marriage patterns are not immune to assortative mating, which has some interesting, if not concerning, implications for income inequality.)  As the CEO of your life, how you and your husband or wife allocate that money will have a tremendous influence on your household’s ultimate net worth, passive income, and even happiness levels.

 This is especially true given the significant financial benefits of marriage.

One of the biggest differentiators between those who end up living paycheck-to-paycheck and those who find themselves with a bank vault full of stock certificates pumping out torrents of dividends to enjoy is whether one has a tendency to buy depreciating assets or productive assets with his or her surplus funds.  Depreciating assets are those that, once acquired, begin losing value.  The quintessential example is an automobile.  While it might provide utility, a car is one of the worst outlays you can make from a financial perspective.  People who will never, in their entire life, have the foresight to say, “I’m going to buy a $50,000 block of Hershey and hold it for the next 50 years”, “I’m going to buy $25,000 worth of Coca-Cola and, someday, put it into a trust fund for my granddaughter” or even, “I’m going to add $500 a month to my Exxon Mobil DRIP” will, instead, think nothing of going to a car dealership, buying a new car at 0% interest for $700 a month payments, and stretching it out over 60 months for something that is destined to be utterly worthless.  I have witnessed it time and time again.  Due to the nature of compounding, that first 10 or 20 years in the workforce creates outsized results so the person who was wise enough to begin acquiring cash-generating assets starts to break out and separate himself or herself from the pack.  That ultimately turns into a gulf that is difficult, if not impossible to bridge.

In other words, if you are privileged enough to be highly educated, married to another highly educated person, living in the most affluent economy in the history of human civilization, whether or not you end up financially independent – with few exceptions, such as a non-foreseen health crisis – is almost assuredly going to come down to your own ability, or inability, to manage your income with prudence.  That simple truth, no matter how unpopular it may be to admit in polite company, is the reason minimum-wage janitors like Ronald Read end up being secret millionaires with $8,000,000+ and lawyers with prestigious resumes earning 1,000% more per year have a fraction of the wealth.  You either employ your money, putting it to work for you, or you work for your money, selling your time (hours of your life, quite literally) for what you need that week.  Nearly everyone starts out doing the latter but a fiscally wise man, like Read, ends up in a situation where his paycheck is much smaller than the dividends, interest, and rents he’s collecting.

What, then, is the recipe for getting rich?  Do a few things right and it largely takes care of itself.

  1. Economic data leaves absolutely zero question that if you 1.) graduate high school, 2.) go to college, 3.) get married, and 4.) have children in that order as reporters and academics are fond of reminding everyone, your odds of ever falling into poverty are slashed to the point of being practically meaningless.  It’s the cheat code in the financial game of life.  Take advantage of it.  Any deviation stacks the deck against you in a powerful way.  There is no getting around it.  There is no denying it.  The evidence is irrefutable and the data set gargantuan.
  2. Always live below your means even if you’re just saving a small amount of money.  The discipline it builds is a good life skill to have that will pay off elsewhere, too.
  3. Put that surplus to work in the most tax-efficient way you can.  For most people, this is going to be a twin combination of a Roth IRA and Roth 401(k).  Established correctly, you can probably avoid paying taxes on most of your investments for the rest of your life.  If you are fortunate, and/or disciplined enough, to reach the maximum contribution limits each year, begin building up assets outside of tax shelters that can take advantage of the stepped-up basis loophole when you die.  That will permit you to pass on those assets to your children and grandchildren without ever triggering the capital gains tax.  All of your deferred tax liabilities are forgiven.
  4. Avoid debt whenever possible, especially credit card debt and student loan debt.  When you rent money from other people, which is effectively what borrowing is, you invite them into your life.  They can make demands on your future output.  They can cause you tremendous hardship if you break your promise.  Attending your dream school isn’t worth spending the next 15 or 20 years of your life in what amounts to servitude, existing only for the pleasure of the shareholders of Sallie Mae, Navient, Citigroup, and Wells Fargo.
  5. Reinvest your dividends.  Reinvested dividends are like adding fuel to the fire when part of a diversified portfolio, accelerating your wealth accumulation.  Speaking of diversification …
  6. Diversify your income sources and your assets.  Everyone talks about asset diversification but income diversification is just as important in my book.  Life is much better, and much less stressful, when you have multiple streams of income coming in so you don’t rely on any particular one of them.
  7. Never invest in something you don’t understand and never invest money you can’t afford to lose.  I’ve gone so far as to call the latter the most important rule of investing.
  8. Let your money compound for as long as possible.  Crazy things happen when you pass the 25 year mark.  Case in point: Mere historically average rates of return will produce 1,000% gains over that time horizon.  Get it up to 50 years, and you’re looking at 10,000%.  Of course, there’s no guarantee the past will repeat the future and investing always holds the potential for severe, if not permanent, losses – just ask investors in Austria between 1900 and the present due in no small part to the annexation of the country by Nazi Germany during World War II – but it’s not hard to understand the reason compounding has been called the eighth wonder of the world.

That last one is particularly important.  There are two ways to take advantage of it:

  1. Start investing as early as you can in life.
  2. Live as long as you can.  That means putting your health first.  Follow your doctor’s advice, which almost always amounts to: Don’t smoke.  Don’t drink.  Don’t do drugs.  Don’t be obese.  Don’t operate heavy farm equipment while on prescription medication.  Always wear your seatbelt.  That pretty much covers all of your bases to the degree things can be controlled.  Even an extra five years can be magical once you’ve built a hefty portfolio.

As simple as it sounds, that’s the crux of the wealth building process.  Put the right things in motion, be, in the words of billionaire Charles Munger, “consistently not stupid“, and your money takes on a life of its own, expanding, growing to the sky, showering you and your children with prosperity.  In the short term – and anything under five years is short-term – the rest of it is noise.

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5 Reason to Invest in Dividend stocks

dividend_stocks_inside_small

If you’ve ever had occasion to look into the academic research comparing different types of returns from stocks that have different characteristics, as a class, dividend stocks tend to do better than the average stock over long periods of time.  There are a multitude of reasons as to why this occurs but it’s a powerful enough force that many investors have done quite well for themselves over an investing lifetime by focusing on dividend stocks, specifically one of two strategies – dividend growth, which focuses on acquiring a diversified portfolio of companies that have raised their dividends at rates considerably above average and high dividend yield, which focuses on stocks that offer significantly above-average dividend yields as measured by the dividend rate compared to the stock market price.

I happened to be up working late on launching the new asset management company my family is establishing this year and, despite it being 3:46 in the morning, am not quite ready to go to sleep.

 I thought it would be useful to sit down for a moment and break out five reasons dividend stocks are so intriguing to investors who prioritize long-term wealth accumulation.  My hope is that by giving you a basic framework, you can understand some of the forces at play; how human nature, accounting, business management, and the stock market all come together in a way that can allow a prudent investor to enjoy streams of passive income from his or her holdings.

1. Dividend Stocks Might Be Better for Many Ordinary Investors Than Stocks That Don’t Pay Dividends Because the Cash Flow Restrictions Result in Lower Accruals

Though it may be a bit early in the article to hit you with this one, I want to start off by talking about it first because it is the one I consider particularly important.  Usually, investors aren’t exactly interested in learning about advanced accounting techniques or diving into an income statement or balance sheet.  Nevertheless, it’s the heart and soul of the investing process.  After all, a business is ultimately only worth the net present value of the discounted cash flows it can and will produce for its owners.  In fact, when valuing a company or stock, most professional investors use a form of modified free cash flow rather than reported net income applicable to common.  In my case, my preferred metric is something known as owner earnings.

A company that pays dividends has to physically come up with cash that investors can receive; cash that is mailed to them in paper check form, direct deposited into their checking or savings account, or sent to their broker for deposit in their brokerage account.  As the saying goes, “you can’t fake cash”.  Either the dividend shows up or it doesn’t.  This has the effect of causing companies that devote money to dividends to have lower so-called accruals between free cash flow and net income.  In plain English, that means there are fewer meaningful adjustments in the accounting records of the corporation so the “quality of earnings” is higher in that the reported profits are almost in line with the conservatively calculated free cash flow.  It is a well established fact that, over longer periods of time, companies with lower accruals handily beat companies with higher accruals when measured by total return.

2. Dividend Stocks Might Be Better Than Stocks That Don’t Pay Dividends for Many Ordinary Investors Because the Significant On-Going Cash Commitment Reduces Funds Available for Managerial Allocation

Executives and managers are only human.  When cash begins to pile up in surplus, many men and women find themselves facing a constant pressure to spend it, even if spending it would be a mistake or lead to less optimal outcomes.  For those in Corporate America, when that spending is devoted to mergers and acquisitions, it can result in a much larger domain and all that comes with it, usually stock options, restricted stock, higher salary, bonuses, pension benefits, and, perhaps, even a golden parachute.  On the whole and in the aggregate, companies that pay dividends have a first-line of built-in inoculation in that the folks running the enterprise simply don’t have as much money on hand as they otherwise would have had were there no dividend in place.

This means that executives have to be far more selective when identifying potential merger and acquisition candidates than they otherwise would have had to be in a world of easy money.  Each project needs to be compared and contrasted to others with only the best projects selected and merely “good” projects discarded.

3. Dividend Stocks Might Be Better Than Stocks That Don’t Pay Dividends Because They Enjoy a Phenomenon Known as “Yield Support” During Stock Market Crashes

Imagine that you are looking at a stock that trades at $100 per share.  Now, imagine that stock pays a 3% dividend.  The company itself is extraordinarily stable.  Earnings cover the dividend sufficiently and those earnings are from diversified underlying sources so there’s only a tiny probability of a dividend cut.  Now, imagine that the stock market begins to crash.  This company falls to $90 per share, $80 per share, $70 per share.  It keeps going, down through $60 per share, $50 per share.  At some point, provided that dividend is safe and investors are convinced it is going to be maintained, the dividend yield on the stock itself is going to be so attractive that it brings in buyers from the sidelines; people who otherwise cannot stand to see the yield right there in front of them without doing something about it.  Consider that the exact same $3 per share dividend would be a 6% dividend yield if the stock were trading at $50 per share instead.  This explains why dividend stocks tend to fall less during bear markets.

4. Dividend Stocks Might Be Better Than Stocks That Don’t Pay Dividends Because of the Return Accelerator Phenomenon

But that’s not all.  That yield support leads to another phenomenon that has been studied by respected Wharton professor Dr. Jeremy Siegel, which he calls the “Return Accelerator” or bear market protector.  In essence, investors who reinvest their dividends accumulate more shares during stock market collapses as the dividend yield expanding allows them to gobble up more equity with each dividend check they shove back into their account or dividend reinvestment plan.  As we discussed in my in-depth article on investing in the oil majors, that is one of the reasons the oil companies, as a class, did much better than the average component of the original S&P 500 stock market index back when it was introduced in 1957.

In fact, Dr. Siegel demonstrated that the worse the volatility, the better the long-term investor did!  The reason has to do with the mathematics.  The lower the cost basis of each subsequent purchase, the faster the average weighted cost basis of the entire position is drug down and the more shares the investor accumulates which, themselves, pay dividends.  This means it takes a much smaller increase – certainly far less than the previous breakeven point – to get the position into profitable territory.

5. Dividend Stocks Might Be Better Than Stocks That Don’t Pay Dividends Because They Provide a Huge Psychological Advantage to Certain Types of People

As the father of value investing, Benjamin Graham, once wrote, “The real money in investing will have to be made – as most of it has been in the past – not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.”  When you own a company that distributes some of its profits in the form of a cash dividend, it becomes a lot easier to focus on things that matter like “look-through earnings“; to make the connection between the success of the enterprise and you actually getting your hands on some of the cash that flowed through the corporate treasury.  It can make you more patient, focusing on whether or not your dividend checks are getting larger with time, mostly ignoring the quoted stock market value.  This, in turn, can lead you to buy and hold investments, reducing frictional expenses, increasing your odds of taking advantage of things such as deferred tax liabilities, and, ultimately, the stepped-up basis loophole.

It may not sound like a major advantage but, in the real world, it can mean the difference between failure and success.  One of the things most secret stock market millionaires have in common is they aren’t particularly keen on hyperactivity.  Whether it’s retiree Anne Scheiber amassing $22 million from her New York apartment or a minimum-wage janitor like Ronald Reed accumulating $8 million in equities through paper certificates and DRIPs, they tend to find exceptional companies, diversify so as to avoid wipe-out risk, and then hold on as if their life depended upon it.

 

 

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