Investment Playground.NET

I haven’t had a new post in a while. I apologize.

My wife gave birth to our first child yesterday - a healthy boy. So that’s why I’ve been a bit out of the posts lately. I think you’ll agree that my excuse is valid. But don’t worry - my baby will get to work soon and I’ll be doing daily posts as always.

So it seems fitting that for this post - from my hospital room - that I write about opening a 529 account.

Basically - when your kid turns eighteen years old, you will have a large bill come due. That’s the way you need to think about this. So it’s silly to think about saving “down the road” or praying he or she gets a scholarship. When this bill comes due - will you be able to pay up? A 529 plan is an education-based saving plan. The benefits are huge as your investments grow on a tax-deferred basis, and any distributions are federally tax-exempt. Also - you control the distribution of your investments - not the beneficiary (your child). Further, if your child does indeed get that great scholarship, you can easily switch the designated beneficiary at any point to anyone - including as a gift to someone. One of the easiest ways to make sure to have enough money to college is by investing a small amount automatically every month starting at birth. If you run the math, a $100 monthly investment earning 10% a year gives you enough for school. Your kid gets college for only $100 per month.

Every state offers a 529 plan. Check out what your state offers. Check out savingforcollege.com for a full detailed analysis.

Talk to you after we return home with our baby.

The financial system is at the brink of breaking. We all have money invested in the markets - and it’s important to learn what the hell went wrong the last few weeks. Financial services are making 40% of all corporate profits in America, and this sector is getting hurt. Basically if you have any money in index funds or mutual funds, by definition we are sensitive to what happens in the financial sector. There’s a lot of hyped-up discussion as to what’s been happening - I swear most of these guys don’t understand it themselves. This is the basic summary:

Overly leveraged debt. Begininning in the 1980s, the market saw the Fed drop interest rates significantly, which led to a great bull market. This boom largely went for another 20 years or so, with some routine cyclical ups and downs. The market increased about 1200% in this 20 year time frame. A typical year of a mixed portfolio yielded 14% in returns (higher than the historical 11% since 1929). When the boom ran out with the economic collapse supported by our current administration - investment managers went looking for more ways to satisfy the unsatiable. Money was cheap, so they took on more debt. The economics are quite simple. If you are leveraged, your returns are magnified. However in a downturn, your losses are catastrophic. And this is fundamentally what happened. In the 1980s - the debt the financial sector held was 10% of the amount of non-financial debt. Now - 50%.

Confused? Consider it like this. If you save up $5000 and invest in the market. Let’s say you entered at the beginning of 2008 and this proved to be an awful idea, and you were down 10% within two months. Your NAV - net asset value - is now $4500. You piss and moan and sell everything just to save the humiliation from your coworkers. Now how about this scary scenario: you didn’t have the $5k to invest, but your bank offered you a great loan - 5%. And you take this newfound “cheap money” you have and invest it, because you’re just oh-so-sure you can get higher than 5% in the market. Then all of a sudden when you lose 10%, you now owe more than you have. The bank is breathing down your throat - and you have to raise money quick. So you go to a couple friends. They spot you the cash so you can invest it and do well enough where you can pay both your friends and the bank. But you allocated all of the money toward Bear Sterns and now you owe way more than you have.

 The nightmare continues like this - except its much scarier on Wall Street because you’re talking about billions of dollars in losses for EACH company. Banks have become debt machines that trade on their own accounts. Estimates of the total losses by the end of this are in the trillions of dollars (that’s twelve zeros - $1,000,000,000,000).

What’s the lesson here? Greed is a power so strong that it can cause an entire class or industry to make all the wrong choices at the same time. Be pleased with your earnings, and walk away when you can. Greed never got anyone anywhere but back where they started - zero.

About two weeks ago, I got caught up in speculation mode and bought into Citigroup at $19.95 per share. I saw an undervalued company that the market beat on - and scooped it up. Getting caught up in speculative trades is easier than you think. Even disciplined investors can easily be swayed by millions of investors with billions of dollars.

I sold Citigroup today for $23. I convinced my friends to do the same (successfully), who sold closer to $24. My total return in two weeks was about 12%. I am pleased with my decision to sell, and a little less so pleased with my decision to purchase. Here’s why.

Citigroup is one of the more solid companies in the world. They have historically held the highest market cap position in the financial sector for quite some time (until recently). With the market beating down the entire sector (rightfully so), I saw the stock’s value somewhere nearer to $28 per share or so. I’m modestly pleased with my stock purchase because it was a true value decision. Just buy and wait for the knee jerkers to leave the room. But I’m not thrilled with my decision because a value pick is only as good as the company is. And all we had to do was to keep reading and researching and Citigroup has a lot of fundamental management issues in the company. Firstly, they along with many other major banks in the sector are losing money fast. Although Citigroup posted $28 billion of revenue last quarter, they had a $10 billion loss in net income (due to subprime write-downs and the like). Secondly, they have a new inexperienced CEO in there (Vikram Pandit). Although he may very well turn the company around - the winds are against him. The company has an earnings release on the 18th of April, and you can expect some major volatility leading up to that. As Warren Buffet said “Better to buy a great company for a fair price than a fair company for a great price”. Which is essentially why I’m split on whether or not this was a good purchase.

As for as selling the stock - I avoid greed and gambling and uncertainty. Buying the stock on a major drop while counting on this volatile market paid off quickly for me. Get in, make your money and meet your goals (I had a sell price of $23 on the stock before I even purchased it), and then get out quick. Avoid the volatility. For the record, I think Citigroup is a buy until about $28. I’ll say it’ll hit this price within twelve months. I however won’t enjoy this long term play simply because it’s out of my risk profile. If you’re more of a gambler - then by all means scoop up some more shares on the next drop. But not because I told you to.

I don’t like trading - the risk is too high for not enough compensation. I’m not a gambler. This stock probably was the riskiest I’ll push myself. Now its time to turn my earnings into another stock pick.

There’s a lot of hype involved in the stock market. It’s an exciting avenue filled with twists and turns. But true intelligent investors know how to avoid the high risk game. True investors can separate good companies from bad and low prices from high. Admittdely, it’s very easy to get caught in the game. You hear about a great stock pick, you do 12 minutes of “research” on Yahoo Finance, you have a gut instinct that this stock is “the one”, next thing you know you’re buying it. A purely speculative purchase. Sure you might strike the nail on the head a few times, but you also are enabling potential huge losses. Plus you lose a lot of sleep every night wondering if you missed your chance to sell. Sounds a lot like a night at the casinos, doesn’t it?

I don’t like to gamble. I think it’s a nasty habit that has an unusually addicting sensation - together making a dangerous combo. And speculating as to what stocks can go higher based on the market hype is just that - a gamble. The cardinal mistake that you can make while chasing positive ROI is following the hype and throwing your savings into a roulette table. A true investor has to have the courage and discipline to do thorough research and not follow the hype. When you hear of a hot sector or a hot stock - don’t get caught up in the hype and “follow the crowd”. Warren Buffet calls these people “lemmings”. Lemmings usually follow the crowd even when they jump off a cliff (I’ll write a quick post on that later).

Bottom line - and I’ve said it plenty of times - find good companies with good management which are selling at good prices. Be patient and discipline, and only then you’ll be a true investor.

Firstly - I have to ask a favor. Over the next few weeks, this blog will be seeing some major changes. We’re transitioning to a new site with a new host, and this means new formatting and error checking along with other problems. Of course I’ll be on top of any errors we have, and continue to give you regular investing tips and suggestions. In the meantime, thanks for your loyalty.

Here’s a quick primer on the Federal Reserve Funds Rate. The Fed cut interest rates by 3/4 of a point today. Everyone was forecasting a full point, but the market reacted favorably to the 75bps anyway.

What is the fed funds rate? The fed funds rate is a benchmark used for what banks charge other banks in short term lending. To pass on the costs, banks will charge you on your loans something modestly higher than this rate so that they can earn a profit. So when the fed rate is down from 5.25% in summer of 2007 to 2.25% today - you can get access to funds easier.

Why do you care? Time to think about refinancing your car loan or home loan or perhaps consolidating your student loans. Most people unfortunately live on debt - so when you can get lower rates for your debt, obviously you come out winning. More money left over for saving and more money available for investing.

Why was it cut? If the rates are lowered, the Fed is hoping that you - the consumer - will do exactly what the last paragraph said. Basically flush the system with more money instead of tightening your spending. Also - the Federal Reserve cuts rates when they want to entice more activity between banks. At the end of the day - its all about loosening the money supply so that more money flows freely.

Side effects? Inflation. When people have access to money easily, they bid prices up higher and higher. Now that $2 gallon of milk you buy is actually $5 (in some parts of the country). Remember when you used to make a call for a nickel at a payphone? Now it’s fifty cents. Inflation is a big problem - which is why people sometimes prefer the Fed not to cut rates.

Action Item: Start cold calling banks for refinance rates. Make sure to mention that the Fed cut rates recently, and if their rates will fall as well.

If you’re trying to find out where to invest your money - you’re well aware that it is a mess out there. We’ve got the most volatile trading days ever recorded, the dollar slumping to never before seen lows, oil prices at $110/barrel, subprime mortgage delinquencies in record numbers, foreclosures on every block in the country, a surplus of unsold homes throughout the nation, the banking sector writing off billions of dollars and asking for hundreds of millions in help, dogs and cats living together — mass hysteria!

But what is really going on?

The crux of the entire problem falls into real estate. There - that’s the whole problem. Everything else that is unrelated is simply magnifying an already bad issue. This is a consumer-based recession. This means that the stock market isn’t to blame for all the losses - the consumer is. We’ve been bidding up real estate prices so fast and so high for the last ten years - that now we are at unmanageable levels. When anything in life has an asking price that is worth more than its intrinsic value - it’s only a matter of time for the prices to go down to something more reasonable. Write that down. So with real estate prices dropping, consumers now have mortgages worth more than their home’s value. Many people are in financally-trying situations because they can’t seem to sell their home, or they own two homes and can’t make the payments on one. The many unfortunate ones are forced to foreclose on their homes, and banks don’t like this one bit because now they own real estate (they are not in the business of managing properties). The banks now try and dump their real estate for super low prices, further pushing down the general real estate price market. The further down the prices go, the more trying financial times that people end up in. So what do consumers do - spend less! And there you have it - a consumer based recession. As long as consumers spend less, consumer-focused companies don’t do as hot. When they miss their earnings and revenue estimates, their stocks drop. And once their stocks drop, those same consumers now lose money in the equity markets, causing them to tighten their spending even more!

It’s a viciuos cycle, and oil and heating prices, a slumping dollar, inflationary concerns, and increased volatitility are all simply exacerbating this situation.

“So when is the end of this?” Wait for real estate prices to return to somewhat normal levels, most likely at some point in 2009, and it’ll be a slow and gradual rebuilding over the following five years. Once people are comfortable making their monthly payments all over again - their spending will loosen - and the economy will do somewhat better.

“10%? Why would I give you all my money so you can earn me only 10%? It’ll take me ten years to earn that money back!”

Let’s discuss a philosophy called Return On Investment (ROI). When you invest into an illiquid asset - your money is tied up for quite a while. You can’t use it for your kid’s college fund - you can’t use it for a vacation you’ve been planning. A good investment returns you 10-20%, meaning every year you can expect to make back 10% of your initial investment. I’ve heard the above argument probably over a hundred times. People start to think how long it’ll take to earn your money back. This is not an investor mentality. This isn’t a loan - it’s an investment.

If you want to increase your wealth - don’t ever ever think in terms of “how long before I make my money back.” You are trying to use capital to earn capital. If you invest $100k into a piece of real estate, and it makes $1k per month of net income, you’re earning 12% return. And after five years let’s say you sell the place for $100k. You made 12% for five years and then earned your full return back. So on a basic math level: 100% + 12% * 6 or 172%. That’s a great return!

Whatever you choose to do with your spare change, make sure it earns you about 10-20%. And then reinvest it so that you can further your earnings. Ten years later - retire and write a book about how you’re a millionaire.

I’m always a believer that it takes capital to earn capital. All of my investments success are calculated using ROI (or return on investment). Meaning if I put $10,000 to use and it earns me $2000 per year, I have a 20% ROI. The key question that most people ask me is - “naveedsmind how do I get to $10,000 in the first place??”

Bottom line - saving money on a consistent basis is the first step to successful investing. Allocating a certain dollar value or percentage to your savings account is fundamental. We all have dreams of being real estate owners, brilliant stock pickers, building and buying businesses, having pricey vacations, living off of huge dividends — none of it happens without saving money to invest first. Most people work just so they can pay the bills. Maintenance of life takes a priority over frivolous saving - they tell me. “How am I supposed to save money when my car payment takes up anything extra?” or “naveedsmind you don’t have three kids and alimony charges - what do you know??”

All I know is that the longer you focus on maintaining your day-to-day lifestyle instead of saving – you’re not doing anything to better your lifestyle either.

Rule #1 – Instill in your head that I will save a flat amount of money out of each paycheck by any means necessary

Rule #2 – Start small but consistent. Ask yourself – if I were to start losing money – what’s the maximum I could “lose” before it kills me? Once you have that number – increase it by half. We’ll see if it really kills you in the long run (doubtful).

Rule #3 – Give up something in exchange to save money. Look at your monthly income/expenses – what can I go without. Let’s say you have three fancy dinners every month at about $35 each. Cut it down to two and immediately increase your saving by $35. Or cut down your bar nights by one in any given month and you probably will save almost $100.

Rule #4 – Save BEFORE paying your bills. I know this sounds ridiculous. But there’s a general understanding that if you pay everyone else before you pay yourself – there’ll be nothing leftover at the end. Somehow – every month – you run out of money and you have no idea how? Automating your saving is also a wise idea. Twice a month – on the same day that I get paid – a have a flat amount immediately transferred over to my savings account. This way I’m sure to pay myself first.

Rule #5 – Live like a pauper. People that know me likely think I’m flat broke. I seem to always “barely have enough money to pay bills”. It’s okay! They don’t realize that I’m building my egg in steady amounts before paying my bills – and because of that I am “broke”. Being broke while having a meaty savings account is a good thing.

Rule #6 – Be patient and consistent. $300 per month, or even $1200 per month may not buy you some monster investment. But you do this for just a year of your life – you’ve got $14k right there – or your $3600 if you’re at $300 per month. $3600 is not a bad starting investment. It’s enough for your high interest emergency fund – or its enough for one or two mutual funds of your pick.

Here’s some simple motivation for you. My first investment property was purchased with less than $7,000 in cash. Some discipline, patience, and commitment can go a long way.