The following article examines how the best gauge of risk tolerance is actually the level of composure one has when something unexpected occurs: Tune In, Chill Out

“People say they’re willing to lose 20%, then they lose 2% and they panic.  A more meaningful indicator is composure — your short-term, emotional reactions to unpredictable and uncertain events, such as the market’s ugly sell-off on Friday. How will you handle yourself in the heat of battle? Far too many investors discovered in 2008 and early this year that losing money in quick, sharp cuts was more than they could bear. Those thoughtful risk-tolerance quizzes got shredded when stocks went into free fall. Panicked investors sold what they could, often at any price.”

Some comments on Buffett’s, “Be fearful when others are greedy, and be greedy when others are fearful” quote…

“There’s a good reason why there aren’t more Buffetts among us:  Buffett is not only more risk tolerant, he’s more composed.  When the shooting starts and money is on the line, Buffett comes across as cool and unemotional.  And he fires back.  Think Clint Eastwood with a calculator.”

On how you can increase your composure…

“First, commit to an investment policy with a long-term or big-picture focus that recognizes there will be major pitfalls along the way.  This is your battle plan.  The most effective policy statement lays out objectives.  These include return goals — how  much money you’d like to make — and the potential obstacles to that happy outcome. In this way, you get a sense of how emotions dictate your actions.”

“Second, divide your wealth into different mental accounts with varying degrees of risk. Investors should not be diversifying asset classes; they should be diversifying risk.”

Now don’t get me wrong, there’s nothing terrible about following this advice.  A retiree who adheres to this plan has a great chance their portfolio will last the remainder of their life.  But isn’t there a better option?  One where the retiree needn’t worry about outliving their nest egg?  Luckily, there is a better plan.  Instead of drawing down one’s portfolio, a retiree can simply live off the dividends and interest their nest egg produces.  Following this method guarantees that one never runs out of money.  It is also easy to stick to, and will eventually leave one’s heirs with a tidy inheritance.  The one caveat of living off dividends and interest alone is that it usually requires significantly larger retirement savings.

This issue is discussed in further detail here:  Retiring on Investment Interest: Can It Be Done?

“A true interest-only strategy can work only for those with excess capital. If you retire with $1 million but only need $55,000 per year of supplemental income, keeping with our 6% assumption, you will need $917,000 to produce your income. That will leave   you with $83,000 that could be used for emergencies or irregular expenditures.”

“Be thorough and careful when working out the numbers.  Interest-only portfolios can work, but if you assume that one will work for you without working out the details, you may find yourself without adequate retirement funds.”

Due to the larger capital requirements needed for a dividends and interest only plan it may not be feasible for individuals who are
currently nearing retirement.  However, I believe this plan is perfectly achievable and a worthy goal for young investors.  There is no reason why someone with a long time horizon and a decent career can’t accumulate enough capital to implement this great plan come retirement.

What’s a shareholder friendly company?

A business that is shareholder friendly always operates with the shareholder’s best interests at heart. They tend to be lead by competent managers who communicate openly and routinely reward investors. Businesses that exhibit these three traits are more likely to have favorable long term investment returns than their counterparts.  Let us examine these traits in further detail…

Competent Management

The number one trait that shareholder friendly companies have is a team of great managers running the business.  Determining whether or not management is competent can be a subjective process.  After all, there are no hard numbers you can crunch to figure this out.  Instead you have to look at other more subtle details like experience level and motivation.

Your initial step should be to research the company’s top executives.  These are the folks leading the business and making all the major decisions.  Are any of these individuals original founders of the company ?  Have they been at the firm for 20 or 30 years?  If so, then you probably have a group of managers who are knowledgeable and dedicated to the company. If the CEO or Chairman is new to the firm then do they at least have years of industry experience?  There’s nothing worse than a CEO who doesn’t understand his own operating environment.

Once you check out the experience level of the management, you need to ensure their motivations are aligned with yours. Does the company have a high level of insider ownership?  If so, you can be sure that those running the business want the stock to go up just as much as you do.  Another thing to check out is the level of insider buying vs selling.  Nothing inspires confidence more than when the CEO is buying shares on the open market.  Conversely, if top management is dumping share after share one must question the company’s future prospects.

Open Communication

Your next step on your quest to find shareholder friendly companies is to look at how management communicates with investors. Shareholder friendly businesses go out of their way to be open and honest with investors.  Listen to the latest quarterly conference call. Does management discuss bad news as openly as good news?  Or do they try and dodge the tough questions when they’re asked?  Is there any vagueness or attempt to hide important facts?  If that’s the case, please recognize that Bernie Madoff and Ken Lay were the same way.

Rewards Shareholders

The last step in the process is checking to see if the company uses its cash to reward investors.  This can be done either by paying dividends or buying back shares.  Check out the company’s dividend history.  Do they have a long history of paying dividends?  If they pay a dividend, do they routinely increase the amount?  The answer to these questions tell a lot about management’s feelings toward sharing the wealth.

In addition to checking the dividends, explore whether or not the company has a stock repurchase plan.  You can find this information in the 10K and 10Q filings.  If there is a repurchase plan, check here to see if the plan is actually decreasing the number of shares outstanding. Sometimes repurchase plans are enacted to offset share dilution caused by overly generous stock compensation plans.  If outstanding shares are decreasing year after year it’s a great sign that management is committed to increasing the stock’s price.

As you can see, determining if a company is shareholder friendly can be an involved process.  However, if you use this guide and answer the questions I’ve pointed out, you’ll be able to rest easy knowing your money is invested in rewarding enterprise.  If you enjoyed todays post, please stay tuned to for my next post in the Researching Stocks series which should be out shortly.

Here’s what the new details should look like:  Senate Close to Deal Replacing Homebuyer Tax Credit

“The deal would reduce the size of the tax credit to 10 percent of the sale’s price, capped at $7,290, the people said. The credit would be available on home purchases that are under contract by April 30, and borrowers would have 60 days more to close the sale.”

“The income eligibility for first-time homebuyers would remain the same at $75,000 for individuals and $150,000 for couples. The income criteria for step-up buyers would be $125,000 for individuals and $250,000 for couples.”

“The credit would be limited to homes costing $800,000 or less. There is currently no price cap on home purchases.”

]]> http://generationyinvestor.com/2009/10/27/update-homebuyer-tax-credit/feed/ 0 http://generationyinvestor.com/2009/10/26/senate-plans-to-extend-then-phase-out-homebuyer-credit/ http://generationyinvestor.com/2009/10/26/senate-plans-to-extend-then-phase-out-homebuyer-credit/#comments Tue, 27 Oct 2009 00:06:06 +0000 Stephen Kline http://generationyinvestor.com/?p=1117 Leaders in the Senate are currently working to extend and then systematically phase out the $8,000 first-time homebuyer credit.  The credit which was originally destined to expire on November 30th, has helped to boost low-end home sales across the country.  Under the proposed extension, buyers closing on their homes prior to April 1st would receive the full $8,000 tax credit. [...]]]> Leaders in the Senate are currently working to extend and then systematically phase out the $8,000 first-time homebuyer credit.  The credit which was originally destined to expire on November 30th, has helped to boost low-end home sales across the country.  Under the proposed extension, buyers closing on their homes prior to April 1st would receive the full $8,000 tax credit.  The value of the tax credit would then drop $2,000 each quarter until it expires at the end of next year.

Whether or not this extension gets passed, it will be interesting to see how the housing market acts over the next 6 months.  One could argue that even if the credit is extended, it has already used up the majority of its impact.  If you think about it, first-time homebuyers who were interested in taking advantage of the credit have most likely done so by now.  So the benefits of extending it are probably quite minimal.  I’ll be looking out for some deterioration in home sales / prices in the upcoming months.  As I’ve stated previously, credits like this one and cash for clunkers boost current demand by pulling future demand forward.

If we get through the next few months without a significant lull in housing activity, it would be a very positive signal that we’re seeing a true recovery; as opposed to a temporary improvement caused by government intervention.

Where do you see the housing market going in 2010?

That’s why today I’m bringing you some highlights from a recent interview he conducted with Bob Pisani.  The interview is lengthy, but it’s available in both print and video.  It’s worth reading or watching the whole session if you’re interested and have the time.  Here are some highlights: A Conversation With Art Cashin, UBS

Here they discuss the prospects for inflation…

PISANI: So where do we go here? The feds have flooded the markets with liquidity and yet, it seems to be pooling into areas like banks where it’s not doing an awful lot of good for the moment. At some point, something’s gotta happen though, right?

CASHIN: Yeah. But here’s where it gets dangerous. The good news out of the bad news is because that money has no velocity, we have no inflation. And the Fed talks about taking away the punchbowl. Now once that money gets velocity, once it gets lent or spent, then you can have inflationary pressures build.

If I fly over Bob Pisani’s house and I drop a trillion dollars in green pictures of dead presidents down on his lawn and he’s so nervous he picks it up and puts it in his garage, that’s no inflation. Nothing’s really happened. But when he starts to spend it or if he starts to lend it, then money’s got what they call velocity. And inflation could explode suddenly. No sign of it now, no sign of a great fear, although there’s a new debate in the fed, but no sign of it now.

On the recent stock market rally…

PISANI: Why has the stock market done so much better than you thought it would?

CASHIN: When you get phases like this…if you remember the dot com bubble, you had to be in. You went to cocktail party. We talk about fear and greed and supposedly the fear of losing money. Let me tell you, in doing this nearly 50 years, one of the most powerful fears and motivators of people in Wall Street is the fear of being thought stupid.

When you go to that cocktail party and they say, ‘Hey Bob, you playin’ this rally? You’re really long?’ [You think] ‘No, I’m kind of skeptical about it’ and you think you’re gonna be the butt of jokes. People actually risk money not to be thought stupid.

On the causes of the credit crisis…

PISANI: Would you agree there were many sources of this crisis?

CASHIN: Oh, absolutely. And not the least of which was no defined responsibility in the securitization. If I put together a package and I sold it to you, that was your problem. So I didn’t do the due diligence to make sure that this guy could pay for that mortgage or could pay for whatever. So that also was a key part.

But the Fed, not to give them a big enough excuse, but they, like all of us, have certain things they watch. And this time they got stuck with the dog that didn’t bark. Greenspan was looking for signs of inflation. That’s when he’d know when to rein things in. That’s when he’d know to come off the very low interest rates that he had. But he didn’t get it. And he kind of misread the signal. ‘Gee, why am I not getting inflation here?’

It’s productivity. People are producing much better. The point that he missed was inflation was overseas. We had people working for lower wages, no demand for higher wages. We exported the problem. The dog never barked because everything occurred so far away. And that’s why they never raised rates. And that’s why it left things wide open to the kind of bubble that we had.

By taking extra money and investing it in the stock market, one is forgoing a risk-free return on their money in favor of an investment that’s inherently risky.  This isn’t necessarily a bad thing, provided that the investor understands that the potential for greater returns comes at the expense of increased risk to their hard-earned capital.  Only by dialing up the risk do we up the potential for higher returns.  This is the reason comparing the long-term return of stocks to the risk-free return of prepaying a loan is unwise.  Instead, I suggest comparing the loan prepayment return to that of another risk-free investment such as a treasury bond or CD.  When you make an apples to apples comparison you’ll see that prepaying the loan isn’t such a bad choice.

Remember, most of the truly disastrous financial mishaps in history were caused as a direct result of ignoring risk.  If risk was accounted for properly on Wall Street and Washington we wouldn’t be in our current situation.  Always be sure that you understand the risks before making a financial decision.

***This post is referring to individuals who are already fulfilling their financial obligations (i.e.: they have no high-interest debt, have an emergency fund, and are already contributing to retirement accounts.)  Thus they are asking what to do with additional free cash from earnings or perhaps even a windfall such as an inheritance***

As a case study, I bring you the story of The Simkin family: Getting back on the retirement horse

“Jason and Patty Simkins, both 40, have saved next to nothing for retirement in the past year.  They were rattled by the rocky market, which caused the value of their portfolio to tumble 40% at its low point.”

“So when Jason switched jobs last fall… he neglected his new 401(k).  Saying, “I didn’t want to throw money into it if it was just going to be lost.”

“But now they’re disappointed to have missed out on additional gains from the market’s rebound.”

“Realizing they need to catch up on retirement (and, with two kids, save for college), they’re ready to put a toe back in the water.”

I think all of us can relate to The Simkin’s story.  Last year as the markets were being pummeled day after day, even the most iron-willed of us surely contemplated exiting the markets, or at the very least stopping our ongoing contributions.  The problem with this, as the Simkins indicated, is that they’ve consequently missed out on the juicy 60% returns the market has put in since bottoming.  Now, only after this enormous rally, are they looking to restart their retirement plan contributions.  This my friends is not the modus operandi of successful investors.

Instead, I offer the following plan to passive retirement investors…

First, familiarize yourself with the concept of asset allocation.  Once familiarized, develop a diversified asset allocation that coincides with your risk tolerance and time horizon.  (note: you’re probably less risk tolerant than you think)

Second, contribute to your retirement accounts using a dollar-cost averaging plan.  This entails investing a fixed amount of money on a monthly or per paycheck basis.  These contributions should match the asset allocation you created in step one.

Third, every quarter check up on your portfolio and revisit your asset allocation.  Are your current holdings in-line with your plan? If not, rebalance your portfolio so it isn’t too aggressive or conservative.

Finally, once every year you need to reexamine your risk tolerance and time horizon.  If they’ve changed, chances are you need to modify your asset allocation.

There you have it.  Following these simple steps will give you a disciplined financial plan that you can implement in an emotionless manner. Give it a try and your odds of being a successful long-term investor are high.

How Dirty Are Hedge Funds? – Where do you draw the line between in-depth research and non-public information?  After all hedge fund investors aren’t paying managers 2 and 20 for just average results.  This is indeed a slippery slope.  (@ Forbes)

The New No-Jobs Generation: It’s Really Not That Bad – The class of 2009 graduated into one of the worst job markets since the great depression.  Those that have found jobs are settling for less pay, and many others haven’t been as lucky.  But does this gloomy situation have a silver lining?  (@ Forbes)

Pay Yourself First – Saving money that’s left over at the end of the month doesn’t work out well.  We have bills, loans and other expenses that empty our wallets just as quickly as they get filled.  If we do manage to have some dough left over, we tend to blow it on fun and entertainment.  The answer to this dilemma is to pay yourself first.  (@ Get Rich Slowly)